Protecting your investment in a startup

Investing in a startup has a high potential rate of return, but, since so many businesses fail each year, it is also one of the riskiest investments one can make.  Because the risk of losing one’s investment in a startup is very real, investors should enter a new venture with their eyes wide open and should size the investment appropriately to avoid jeopardizing their overall financial stability. 

The 2015 Virginia Chamber of Commerce’s State of the Commonwealth report states that most businesses started in Virginia “are able to survive for at least a year.”  But the Chamber’s data suggests that these nascent small businesses “are not necessarily well equipped to deal with the tasks they subsequently confront as they attempt to grow.” While the Chamber and its partners certainly aspire to improve the odds for Virginia’s newest businesses, this finding serves as a warning for potential investors in such ventures. 

When starting out, new business owners may be disinclined to use banks as lenders due to bureaucratic hassles and tight restrictions on lending (just ask anyone who has applied for a mortgage recently about banking red tape). Instead, they often seek capital investment from those closest to them; friends and family.  But a smart individual investor, who is usually putting his or her own family’s capital at risk with the startup capital outlay, will place restrictions on the borrower and establish clear boundaries for the investment. 

Prior to releasing any funds to a new business, an investor should insist upon reviewing the venture’s business plan.  A business plan delineates the owner’s intentions for the entity as well as its roadmap for growth. To protect an investment, then, a lender is well advised to carefully analyze the plan to determine if the owner’s projections are realistic.  Investors should also insist on periodic updates on the company and possibly access to the company’s books.

From the investor’s perspective, the ideal corporate structure for a new business is an LLC, since owners and investors cannot be held liable for the young company’s debts and unpaid bills.  Without the protections of an LLC, vendors and stakeholders can hold investors personally responsible for what is owed.  And remember, the newly formed LLC will, of course, be responsible for providing investors with K-1s, but a passive investor cannot deduct losses until he is also experiencing passive investment gains (PIGs).

If an investor has a specific timeframe for a return on his or her investment in a new business, it might be best to invest in the form of a loan.  Since dividends are not guaranteed, loaning money with a defined term can provide the investor with an income stream of regular loan payments with interest and will enable the lender to be higher in the capital structure of a company, which could mitigate downside if things go bad.  It is recommended that investors lend to new businesses at a risk premium to compensate for the speculative nature of the enterprise and the illiquidity of the investment.  Investors should even go as far as to insist upon a lien.  And, of course, they should make the loan official with proper legal documentation.

Another option for the startup investor is to receive preferred stock in exchange for the investment. Preferred stock can be structured to be converted to common stock at a later date.  The preferred stock option also enables the investor to be higher up in the capital structure than the owner, which is advisable in a risky, illiquid venture.

Certain business types have much higher margins than others and, therefore, offer a greater likelihood that investors will be paid back. The best route to success for the investor is to support a business with differentiating factors and with the potential for positive cash flow in the near-term.  Ideally, an investor wants the business to produce cash to pay interest or dividends with a path for liquidity.

Finally, an investor should go in to the new business venture prepared to walk away and should refrain from throwing good money after bad.  If an investor is open to investing a total of $150,000 in the new entity, for example, he or she may only want to commit $100,000 initially.  That way, the investor can re-evaluate the business’s performance over time and has options; to invest again later if profits are on the near horizon or, alternatively, to limit the capital outlay if things are headed south. 

While not assured of high rates of return, those investors who place careful restrictions on a startup investment and go into the venture informed and protected, can certainly increase the odds of positive outcomes. 

Michael Joyce, CFA, CFP, founder and president of JoycePayne Partners of Bethlehem and Richmond, Va., is responsible for overall invest¬ment strategy, management of investment portfo¬lios and financial counseling services. He can be reached at [email protected].