How to respond without risking your relationship.
You may know this scenario well: An acquaintance corners you at a party and launches into a pitch about why you should invest in their new venture. Perhaps you are truly intrigued and want to consider the opportunity. Or maybe you’ve been burned by “investing” in a friend’s startup before. Either way, having a thoughtful process, response, and knowing those next steps ahead of time will give you the confidence to make an educated decision.
Understand your investment process.
No one should expect you to make a financial decision without doing your due diligence. Any investment decision requires analysis and thought, especially when it is in the early stages or “seed’ rounds. These types of investments often take a long time to “season” and will most likely be illiquid or unable to be sold during that time. This extended time horizon can present many challenges to even professional investors. When considering these types of investments, there are a myriad of issues to consider, but at a basic level, you should understand a few:
- Does the investment fit with your portfolio and your diversification strategy? You don’t want to end up with tangential investments and risks that you don’t fully understand and that make no sense in your overall wealth management plan.
- Where is the investment in its lifecycle? The earlier the stage of investment, the more likely it is that the company will need to raise additional capital for further growth. Said another way, the initial ask is really the first of a series of asks. Investors need to understand that to maintain overall ownership, they will need to continue investing in follow-on rounds. Otherwise, their shares may become diluted, meaning their ownership stake could shrink over time.
- What type of capital needs to be raised? Where you invest in the capital stack and the legal structure of the funding makes a tremendous difference in terms of your control and exposure, especially if things don’t go exactly as expected. Understanding your rights as a stakeholder, i.e., where you are in the capital stack, is as, if not more, important than what the new business will do in the future.
- How much of an illiquidity premium will this gain you? Higher risk should yield higher return, and if it will take years to get your capital back, the terms should reflect that.
- What are the limits of your own knowledge? This is often referred to as your sphere of competence. Building significant wealth in one area of business does not always mean it will be easy to replicate in another area. A little humility can go a long way, especially if the idea sounds truly exciting.
Size any investment accordingly.
It’s a well-known truism that giving or loaning money to a friend or family member can quickly sour the relationship. So if you decide to invest, be comfortable with the fact that not only could you never see a return on your investment, but you could also lose the entire amount of your principal. Sizing an investment is a foundational element of risk control. When it comes to friends and family, risk takes on many forms, including risking your relationships. Understanding this and clearly communicating the types of risks you are comfortable taking is critical.
Allow your advisor to be the gatekeeper.
An experienced, trusted advisor acting as a fiduciary is invaluable in this process. Early-stage investing is fraught with issues and dynamics that are simply not present in public market investing. Regulatory bodies and entities abound in public markets, helping to ensure safeguards and frameworks to protect investors. Conversely, in this space, very few, if any, of those guardrails exist. An advisor with experience in these types of investments should be well-versed in the types of questions to ask and the risks that may be present. Allowing a professional in the space to assist in or guide your diligence process can help you avoid many of the pitfalls present. Allowing them to “be the bad guy” when declining to make an investment can allow you to make the correct financial decision while maintaining your valuable relationships. If, on the other hand, they think it might be a worthwhile pursuit, you can use their analysis as a way to establish optimal parameters and terms for how you will invest.
Ask for a clearly articulated business plan.
If you decide to move forward, you will be doing the entrepreneur a favor by requiring them to present a full business plan. It’s not enough that they are passionate about their idea or knowledgeable in their field. After all, most founders and CEOs are impressive and charismatic. And most inventors think their patent will be granted “any day now,” when the timeline might actually be five to seven years. Ask for a well-researched, long-term plan that includes conversion rates and contingency plans. And when you meet, if the entrepreneur can’t answer your third or fourth layer of questions, don’t hesitate to ask them to go back to the drawing board. This will ultimately help them hone their pitch for other investors and also understand the level of accountability you expect if you become an investor.
Know that it’s okay to say “No.”
It’s perfectly acceptable to say “no.” In fact, a quick and decisive “no” can be a useful gift to the entrepreneur. By being upfront, you’re saving them time and energy rather than leading them on with no actual intention of investing. You’re also helping them refine their ask while protecting your relationship from complications down the road.
But how to let them down easy? Simply cite any of the investment factors above, positioning your financial advisor as the gatekeeper. You might also add that saying “no” now doesn’t mean forever, and that you might be interested if circumstances warrant it. With any luck, word will get out that you are an investor who requires significant due diligence, not someone who is open to being pitched at a cocktail party. Cocktail parties can be great for a lot of reasons, but complicated investment decisions shouldn’t be made halfway through your martini.
Written by Teague Sanders, Senior Vice President and Senior Portfolio Manager at Whittier Trust, where he serves on the Investment Committee, is responsible for analyzing Consumer Discretionary companies for the core equity strategies, and serves as the co-manager of Small Cap and SMID investment strategies.
If you’re ready to explore how Whittier Trust’s investment services can work for you, start a conversation with a Whittier Trust advisor today by visiting our contact page.