FINANCIAL PROBLEM SOLVED!

"This investment seems risky"

Problem

A colleague asked me to invest $25,000 of "seed money" in a start-up venture. The company plans to make a unique technological security device. We won't get stock until a large company contracts to fund the development and manufacturing. I have confidence in the people involved, but still, it's a lot of money. Should I invest, and how can I protect myself in case the venture fails?

Solution

When you're investing in something risky, such as a start-up venture, only put up money that you can afford to lose without too much regret. Also be sure the rest of your portfolio and assets are in order before you make the speculative gamble.

To determine whether this start-up is a prudent investment, you'll need to complete a "due diligence" process. That means investigating every aspect of the venture—not just conducting a quick search over the Internet. You could perform due diligence yourself or hire an attorney, an accountant, an expert in the security industry, or all three to do it for you. The process could cost as much as $5,000, which would bring your investment total to $30,000.

You'll need to do background checks and gather information in three areas:

The people involved. Who are the other partners? You'll want to know about their expertise in the technology or security field, and about their successes or failures in other businesses. Look for any previous regulatory or legal problems.

The financial and legal structure. Where is other money coming from? Scrutinize the offering memorandum and verify the sources and uses of the funds raised. Ferret out commissions, finder's fees, and up-front consulting costs. If they seem too high, your money might not be put to best use.

Have an attorney find out if your colleague's firm is complying with the complex federal and state securities regulations. And make sure you know what happens if your colleague or the principal suffers one of the "four Ds": death, disability, divorce, or disenchantment with the project.

The business. Examine the company's business plan: market research, sales and promotion activities, staffing, and administrative management plans. Do the numbers look reasonable? Are the new firm's projected sales too ambitious? What if the new security product doesn't work as anticipated?

Your attorney should review the legal documents to be sure they clearly spell out your rights and obligations. You also want to protect yourself against personal liability, to prevent anyone from coming after you and your personal assets in case the business goes bankrupt or is sued. Get everything in writing, defining exactly what you're buying and what your exit options are.

If the venture fails, the chances of recovering your money will depend on the written terms of your investment agreement, and on whether fraud occurred. You might be able to recoup some or all of your investment through litigation, but that's expensive and time-consuming, and it tends to ruin friendships.

If you can't get your money back, you may be able to write off some or all of the loss. You'll need written evidence of your original investment amount, as well as a bankruptcy filing to prove that it has no current or future value.

Try to negotiate the investment terms that are best for you, and get your financial adviser involved, so you don't make the investment in a vacuum.

This issue's problem solver is Gary R. Greenbaum, CFA, CFP, MBA (gary@investmentcounsel.com), a financial adviser with Greenbaum and Orecchio in Old Tappan, NJ.

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Financial Problem Solved! "This investment seems risky".

Medical Economics

Jun. 20, 2003;80:45.