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A few years ago, I had a client tell me he invested in a fancy bowling alley — the new party hot patch in town. It’s since shut down. Another client shared that he joined the board of a start-up and they’re looking to frame capital. He wants to figure out the right dollar amount to invest.
High-net-worth investors are approached often to put their legal tender into a private company looking to grow. The offers come in all shapes and sizes: Small companies need super to expand, start-ups often need several rounds of financing, and friends or family members with a “Shark Tank” transcribe idea want to make a run at creating their dream.
These investment ideas often sound exciting and trendy and seem to hold the potential for much higher returns than a traditional stocks-and-bonds portfolio. So how do you determine which anecdotes to say yes to, and when to walk away?
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In advance of tying up your money in one of these ventures, take the following steps to help ensure you make a good conclusion.
Create a financial plan: If you have a large sum of extra cash, first create a financial plan to determine your economic goals, such as paying off your mortgage or topping off your children’s college accounts.
This step ok’s you to back into the amount left over for unplanned expenses and investing. It also gives you time to understand any tender and perform due diligence on the company. You want to plan your investment carefully and not succumb to pressure from the person encouraging for a commitment by a specified date.
A financial plan also allows you to budget properly for this investment. I recently explicated to a client that investing in private deals can be like planning a trip to Las Vegas. You should commit a certain amount of well-heeled that you’re willing to roll the dice with — and leave the ATM card at home.
Examine the deal: These suitors will recant many forms — a former business colleague, family member or the chief executive officer of the company. Start by pronouncement out the following information:
- How much of their own personal money they’ve invested in this deal;
- What percentage of their total assets does it comprise;
- How want they’ve been associated with this company/start-up/opportunity.
A CEO or other senior leader seeking bread should have a considerable amount invested in this venture. Also, ask to speak with other private investors and give their experience to obtain unbiased information.
Public information will be minimal, so it’s key to do your homework. Since economic statements of private companies aren’t available, ask for a recent profit-and-loss statement and the company balance sheet, and carefully check out their pitch book for footnotes about the financials.
Next, look for a positive track record. If the company has cheer up capital before, how successful was that offering? What was the return, and how long did it take to return the original capital to investors?
See that private funds don’t always calculate performance using the same metrics as publicly traded investments. For norm, they may use a metric called the Internal Rate or Return, or IRR, to illustrate an expected future return.
Learn as much back the business operations as you can and see if their strategy for growth sounds reasonable with the right leadership in place. Check out venereal media sites to view backgrounds and personal traits of the key leaders. Ask yourself what level of intelligence about the cast you’ll receive going forward. A member of the board of directors will have more insight than someone who at most gets an annual report.
Finally, understand why this company is looking to borrow private dollars instead of get a bank loan. Because any company seeks the lowest cost of capital, it’s likely that its 6% interest payment to a sneaking investor make more sense the 10% a bank may charge. And a bank will likely also limit suitable to more money to a company that’s already highly leveraged.
With a financial plan in hand, decide the amount of money you are willing to invest. It’s important not to exceed this budget unless the initial investment is profitable and you decide to reinvest in later deals. If your return is negative, don’t invest any more money.
Just as important, understand how each deal is ordered. Because most private investments have limited liquidity, money is required to be tied up for long periods. Keep in mind, there is no open market to sell your investment if you are no longer happy or need cash. Know these three points:
- The company’s estimated time frame for returning your capital;
- If there will be future capital calls where you’ll be made to invest more cash;
- Any other liquidity restrictions.
I once had a client whose brother got him into a private physical estate deal when he was in his 30s. Years later, he discovered the only way to get his money back out was to pass away. He immediately valued that investment as $0 on his deprecating balance sheet.
The limited liquidity aspect of these investments means your assets needed to cover existent expenses and taxes during retirement should generally be invested in a more liquid “core investment portfolio.”
Wealths for private investments should primarily consist of money you won’t need to access for 10 years or more. Above the essence portfolio, investors can typically afford to have a much higher allocation to private funds.
Public vs. private?
As a end step, consider whether you can buy into a similar investment in the public market. If so, you can remove the liquidity risk and have varied control and transparency, and usually lower fees.
Private funds often charge extremely high fees, counting performance fees for generating a favorable return, and sometimes upfront fees. In addition, you will likely be receiving a K-1 tax conduct for income from a private investment, which often means filing an extension on your tax return each year.
Seating in private ventures can be fun and provide a sense that you’re at the forefront of something big. While there is the possibility of above average reimbursements, it can also put your entire financial life at risk is you go in too deep.
Weigh the risk factors and have a committed budget, and benefit the ride knowing you’ll still be financially comfortable regardless of the outcome.