Should you invest your money in a friend’s business?

If one of your best mates comes to you with a great business idea he thinks will make a ton of money, should you chuck him a few bucks to help him get started?

Your mate Fred is a great cook. You’ve enjoyed many of Fred’s meals, and you’ve always come away wanting more. If it were down to the food alone, “Fred’s restaurant” would most likely be a winner.

And a winner in the restaurant business can really pay well. A good friend who has invested in several restaurants tells me that, when successful, they can generate a 12% to 25% annual return on his money.

Trouble is, the restaurant business is hyper competitive.

Does Fred have the business nous to back his skills in the kitchen?

Neither of you know.

But even a 12% return beats leaving your money in the bank. The more you and Fred talk about it, the more tempted you are to reach for your cheque book.

But Should You?

Before you invest money in a mate’s business, there are two questions that need to be answered:

1. Should you ever mix money with personal relationships?

2. How can you know whether a startup will succeed?

There’s so much uncertainty around these two questions it’s tempting to politely decline Fred’s offer to partner up.

And yet, direct investment in a successful business is a really good way to build wealth… as long as the business is a success…

Let’s tackle these questions one at a time, starting with the first one.

Warning: Your Friendship is at Stake

If you are Fred’s sole or primary backer, what could be at stake is not just your money, but your friendship.

If you do reach for that cheque book, your relationship with Fred could change dramatically. And not necessarily for the better.

Let me explain…

Until now, your friendship with Fred has been fun. He’s a mate. You enjoy hanging out at the pub solving the world’s problems. You love gossiping about who’s sleeping with whom, watching the footy or cricket, or playing poker and golf.

It’s been a relationship of equality. Even if you’re okay for money and Fred isn’t.

But when you put money on Fred’s table, the Golden Rule comes into play:

He Who Has the Gold Makes the Rules

Let’s say you agree to invest in Fred’s restaurant. You chuck him some money to get him up and running. He’s grateful. But remember; as an investor, you will not participate in the day-to-day running of Fred’s business.

This might be tough for you.

With your money on the line, you may find yourself dropping into Fred’s restaurant a couple of times a week, just “to see how things are going.”

And whenever you get together with Fred, instead of talking about the footy and the latest goings on in Canberra, the first topic of conversation will inevitably be: “How’s business?”

Fred might feel you’re interfering.

You may feel annoyed that Fred ignores all your wonderful advice.

What’s more, whenever you want to do something special with your old pal on a weekend, you’re suddenly going to find him busy.

You may be thinking that if everything goes well with the business, no worries. You’d both be laughing all the way to the bank.

But if it takes longer than expected for Fred’s business to begin making money, your friendship could end up in shreds.

Worse still, what if things go wrong and the business fails completely?

That could lead to all manner of recriminations as to who did or didn’t do what, including you getting angry with Fred for “blowing all my money.”

That’s the key point here:

Money Changes Everything

To maintain your friendship with Fred, regardless of the outcome of the business, you both must realise you’re entering a business partnership.

Like a successful marriage, a successful business partnership requires a clear delineation of roles, and the ability to speak freely, openly and dispassionately about all issues—without the conversation degenerating into a shouting match.

To ensure your friendship survives the worst possible scenario, you and Fred need to sit down and talk through all the possibilities.

Make a list of everything that could go wrong. And agree in advance on how both of you would handle each scenario.

It’s one thing to accept the possibility of failure and the total loss of your investment.

It’s another thing entirely to see the business close its doors, and actually experience the loss.

You must both be prepared for the reality of every possible scenario. If you’re not, your friendship with Fred is unlikely to survive.

If this list of potentially bad scenarios just gets too long, it might be better to just say “No” to Fred’s request.

Politely, of course.

Fred may be surprised by your decision to decline his offer. But if he’s a good friend, he’ll accept your decision graciously.

An Alternative Option: “Pass the Buck”

You see, here’s the thing with Fred: coming up with a great idea is one thing. Turning it into a successful business is a completely different kettle of fish, requiring a completely different set of skills and talents.

You may think Fred’s onto something, since he makes the best beef wellington you’ve ever tasted. But you lack confidence in his ability to run a business. And you don’t want to run his business for him. You’re only interested in investing in his business, not managing it.

If that’s the case, you could make him an offer along these lines:

“Look, mate, even though I agree you have a great idea, there are lots of issues involved in starting a business, and I’m not sure how to evaluate them. So if you can bring someone in who can make those judgments, I’ll be happy to co-invest.”

That also gets you off the hook of having to determine what could be another very touchy issue:

Does Fred Have What it takes to Succeed?

This is two questions in one.

• First: what are the essential ingredients that enable a startup to succeed?
• Second: does Fred have them?

I’ve started two businesses. And I’m happy to say that both were highly successful. But with the benefit of hindsight I realize that back then I was like Fred: I had what I thought was a great product idea—and no business or management experience whatsoever.

No question, I got lucky. And luck is a factor that venture capitalists, whose whole business is based on identifying startups that are highly likely to succeed, do their best to rule out.

So let’s find out what people far more experienced that I am say on this subject. Including:

• Bill Gross, founder of the venture capital firm Idealab, which has been involved in more than 125 startups—of which 40 listed on the stock exchange in a IPO (initial public offering) or were acquired ;
• PayPal founder Peter Thiel, an early investor in Facebook, Uber and Airbnb, among many other successful startups; and,
• An American friend of mine, Larry Abrams, who’s been a one-man venture capital fund for more than 30 years.

These three business experts all agree on the major characteristics required for a startup to have a high probability of success.

What’s surprising is not the components, but their order.

Number one on their list is not the product, its marketability, or even the money.

It’s management.

Bill Gross puts it this way:

“The strongest correlation to success has been the founding team—much more than the idea, or the amount of money raised, or almost anything else I can think of. The best successes came when there were at least two strong people, with opposite but complementary skills, who had a great deal of mutual trust and respect for another. . . If I see a complementary team like that, I would try to find almost any way to work with them”.

Gross could have been describing one of the most successful startups of all time: Apple Computer. A company synonymous with Steve Jobs and Steve Wozniak. Jobs was the visionary and salesman; “Woz” was the developer/executioner.

PayPal founder Peter Thiel agrees with Bill Gross almost word for word.

And this underlying theme of two (or, at most, three) founders who trust, respect, and are open and honest with each other seems to be a common factor in successful startups—according to a number of other venture capitalists.

Can a ‘One-Man Band’ be Successful?

Why do these experienced venture capitalists stress the importance of a team?

Can’t a one-man band be successful?

Sure it can. And profitable, too.

But if the founder is away for any reason—or, God forbid, gets run over by a bus—the business will struggle.

More importantly, from your point of view as an investor, a business started with a good team will be more profitable, and your money will be more secure, than in a one-man band.

Why?

Because everyone has strengths and weaknesses.

In a team, each person’s weaknesses are complemented and covered by somebody else’s strengths.

Without a partner—the right partner or employee (which I’ll get to in a moment)—Fred’s weaknesses, whatever they may be, could well be his downfall. That means your investment is at risk.

I speak from experience.

Why 1 + 1 + 1 = More Than 3

My own management flaw is delegation.

My first business, the investment newsletter World Money Analyst, which I started back in 1974, was a one-man show.

I had no problem delegating routine tasks, like processing orders or updating the mailing list. But when it came to the writing, whether it was for an issue of the newsletter or marketing materials, the buck stopped with me. I was the bottleneck. The more projects I took on, the slower everything happened.

As a consequence of this and my other weaknesses, I skated close to bankruptcy a couple of times.

In the end, the business was profitable. But its profitability was far outpaced by other people in the same business who were able to do what I was not: delegate successfully.

After I sold World Money Analyst, I teamed up with two friends and we started another newsletter business. One that became far more successful and profitable. My delegation problem was no longer a hindrance: the division of labour resulted in each of us doing what we were best at.

1 + 1 + 1 = more than 3.

In the six years I was involved in this partnership, my one-third share of the profits added up to far more money than I’d made in the 17 years of being a “one-man band”.

This is something to bear in mind when you’re considering throwing money behind Fred’s burgeoning business endeavour. Who is he going into business with? Is he going it alone?

That being said, as Fred’s mate,
You Have a Great Advantage…

Bill Gross, Peter Theil and Larry Abrams will only invest in a startup when they can judge the management team.

That means getting to know the management team personally, evaluating their individual abilities, and seeing how they interact with each other.

You already know Fred.

You understand his strengths, and can help him identify the weaknesses he needs to make up for (or hire to compensate for).

Aside from a good management team to run Fred’s business with him – how else can you tell if his restaurant is likely to be a success… and give you a better shot at making a 25% return on your investment?

Unfortunately, there’s no magic formula for success. If there were, just about every startup would flourish.

The fact is, most fail. In fact, Forbes magazine placed the failure rate of start up businesses at 90% in a recent article.

So how does Fred give his restaurant the best chance of success before he’s burned through all of your cash?

The solution is to test the market, in two stages.

First you need to conduct market research.

Do people in the location Fred is planning to open in actually want the kind of grub he’s planning to serve up? Send him out onto the streets with a clipboard to find out.

Are there lots of other restaurants in the area? This can be a very good sign.

What do other local business owners say about operating in the area?

Second, Before you spend even a cent on opening Fred’s new eatery you need to find out whether his fare is actually going to get people to part with their cash. This is the only way you’re really going to know if Fred has a viable business. For this you need to undertake a real market test…

A “Soft Opening”

Howard Schultz tested his espresso café concept in a corner of the original Starbucks store in Seattle, which then only sourced and sold coffee beans.

Dairy Queen’s developers—John Fremont, “Grandpa” McCullough and his son Alex—tested their soft serve ice cream in a friend’s ice cream store. When they sold more than 1,600 servings in just two hours, they knew they had a winner.

Tradeshows, focused on your target market, can be a good venue for such a market test.

Nick Woodman made the first sales of his GoPro camera at an action-sports tradeshow in San Diego in September 2004. GoPro is now valued at $2.25 billion.

Even if everybody raves about your concept idea, you still need to find a relatively inexpensive way to discover if they’re going to part with their hard-earned cash to get it—from you.

So if Fred is set on starting his restaurant, you could suggest that he cater a few parties, weddings or similar events. Indeed, knowing how good a chef he is, you and your mutual friends could probably organise one between you.

Or set up a stall at one of those weekend markets. A low-risk, low-overhead, mini-restaurant.

At the same time, something along those lines would also test Fred’s ability to organise his venture.

These are great ways to help Fred start his business without putting a penny on the table.

So, Should You Invest Your Money in Fred’s Business?

There can never be a simple “Yes/No” answer. Personal relationships complicate things.

But if you are considering investing money in a friend’s business, here’s a summary of the main points you need to consider:

1. The concept. If Fred is a great cook or an ace programmer (or whatever else his skill might be), you can be confident that he can create the product.

But the business concept makes a big difference to both the profit potential and the initial capital requirements.

A business concept is a bridge between an idea and a business plan. It helps the entrepreneur and investors to identify the specifics of their proposed venture.

A restaurant, for example, is an idea.

A business concept, on the other hand, includes information such as the target demographic, unique selling proposition, etc.

A business concept may involve a new product or simply a novel approach to marketing or delivering an existing product. Once a concept is developed, it is incorporated into a business plan.

2. Your friendship. If you feel that by funding Fred your friendship could be at serious risk, either scale back the amount you’re willing to put up so, that Fred will not feel beholden to you alone, or just say no.

3. Fred’s character. As awkward as it might feel, if you value your cash – and want to see it again – you need to make various judgements of Fred’s character.

If he’s a bit of a know-it-all, then he’s not going to take kindly to advice or suggestions from you—or anybody else.

That kind of attitude doesn’t guarantee failure, but it can decrease the odds of success.

But if he’s a team-builder and willing – if not eager – to take expert advice and change his plans based on feedback from the market, then the outlook is significantly better.

4. Fred should have some skin in the game. Fred must be totally committed to the business, 24/7. And in addition to his time, he should also have some money on the line. The prospect of losing his own money (in addition to yours) should motivate him to succeed.

5. How much should you pay? If you do decide to put money on Fred’s table, how should the project be valued?

As Larry Abrams puts it, it’s essential to buy into a startup only at “a reasonable valuation”.

Determining a reasonable valuation, he says, “is art, not science”.

After all, it’s hard enough to decide on the best price to pay for a blue chip stock – even when you have decades of financial and operational experience at your disposal.

Every startup is a speculation. The chances of losing money can outweigh the chances of success. And when speculating, it’s advisable to only invest money you can afford to lose.

Even a hardened venture capitalist who is experienced in making those types of judgements expects to make money on only two or three of every 10 startups they back.

Unfortunately, there is no fixed formula for valuing a startup. After all, any profits are only potential ones.

One way to start thinking about it is to consider the following four numbers:

• The capital requirements – how much cash does Fred need to get operational
• Break-even sales revenues – how much does he need to make in year one to cover all of his costs
• Maximum potential profits – is Fred even likely to turn a profit in year one… are you comfortable if he doesn’t?
• Your best estimate of likely profits, based on market tests.

The last figure gives a potential valuation of the business.

If you can find out or guesstimate what restaurants in the area are making, and what they are selling for, divide that number by the capital requirements and you can project a potential return on investment.

On the basis that only two or three out of every ten startups succeed, the minimum target for me would be the ability to multiply your money five times.

Then take a leaf from Benjamin Graham’s book, The Intelligent Investor, and deduct a hefty “margin of safety” to allow for uncertainties.

Only make an investment in your friend’s business if the resulting amount comes in at less than or equal to the amount of money you can afford to lose.

First published in Creating Wealth, April 2016. Copyright © 2016 by Mark Tier
Parts of this article are included in How to Spot the Next Starbucks, Whole Foods, Walmart, or McDonald’s