5 Simple Steps for Evaluating Private Investments With Family And Friends
We’ll give you a simple process to follow whenever anyone approaches you for an investment along with key questions to ask
Are you thinking about investing your hard-earned money in a private company with a friend or a family member (yes, this includes adult children…)?
While it can be an exciting adventure, it's also important to be smart about it. Investing in private companies is very different than buying stocks in public companies like Apple or Disney. Not only is it more time intensive as an investor, its more emotionally challenging when money and relationships are involved.
But don't worry, we've got your back! In this post, we'll walk you through five easy steps (with examples) to help you make a wise investment decision. We will also give you a list of 10 questions you need answered before agreeing to part with your hard earned money.
Let’s get started!
Step 1: Understand the Difference Between Public and Private Companies
First things first, let's clear up the basics. Public companies, like the ones you see on the stock market, have their shares available for anyone to buy.
But private companies are a bit more secretive – their shares are usually owned by a select group of people, and they don't trade on the stock exchange. These companies by nature are typically harder to vet because there is not as much information readily available and it is not as easy to sell you investment.
Example: Think of a public company like a big, famous theme park that everyone can visit. A private company is more like a secret club: limited memberships, could be great/or could be sketchy.
Step 2: Do Your Homework
Given that its harder to get information on private investments, it’s time to dig deep. We would start by asking your friend or family member the 10 questions below, and remember the famous saying, “trust, but verify.”
Research the private company you want to invest in as much as possible. Find out about their products, financial health, and their plans for the future. If the company is already doing business— talk to customers, visit locations, or try the product yourself.
If they have not started yet, do some work around their potential market size and opportunity. Does your research match up with their financial projections and aspirations for the business? Do you have faith in the people leading the company?
Example: If you're thinking about investing in a private tech startup, learn about their innovative products and try them out for yourself. Talk to current customers and find out if they are making a profit or not. If they are not yet, do their plans to make a profit make sense? Ask around and try to get a sense of the competition.
To help you get started we have come up with a list of questions you can ask:
What is the specific business idea or what does the business do, and how does it solve a problem or fulfill a need in the market?
What is the target market for the business, and how well-defined is it (i.e. are they targeting a specific type of person)?
What is the business plan, including revenue projections, expenses, and growth strategies?
What is the level of experience and expertise of the individuals involved in the business (if others besides your family member or friend), including any relevant industry experience?
What is the competitive landscape like, and what sets this business apart from existing competitors?
What is the proposed timeline for launching the business or achieving profitability (if not currently profitable)?
What is the financial structure of the business, including investment requirements of me and potential returns as you see them for investors?
What are the potential risks and challenges associated with the business, and how does the team plan to mitigate them?
How transparent and open is the communication between the founders and potential investors, and what level of involvement can investors expect in the business?
What legal considerations, such as ownership structure, liability, and exit strategies, have been addressed or planned for in the business?
Step 3: Evaluate the Risks
Private investments can be riskier than buying shares of a public company, so this is the part where you have to really be honest with yourself (and trust your gut).
After you have done your research and asked the questions above, it’s time to really think carefully about all of the risks involved. List out everything you think could go wrong that would make them not achieve their goals.
Finally, answer for yourself if you would be comfortable in a negative scenario losing some or all of your investment.
Remember, deciding to invest with a friend of family member can change your relationship with that person. This is not a financial risk, but one that is equally important to consider.
Example: Imagine you want to invest in your friend's “always sold out” bakery. If their secret cookie recipe gets leaked by a disgruntled employee and they lose their edge against the competition, down goes the demand for their no longer special cookies.
Step 4: Set Clear Terms
Supporting a friend or family member in a business venture can be exciting, but it's crucial to set clear terms from the get-go.
How much will you invest? What happens if the business struggles? What ownership will you get and what does that mean for the value of the company? Having these conversations upfront can prevent disagreements later. And make sure everything is in writing.
Example: If I invest $1,000 this means I will own 1% of the business. Is this business really worth $100,000? what happens if I want to pull my investment?
Step 5: Be clear on the exit strategy
This is the one part most people forget when making a private investment, but it is perhaps the most important. How are you going to get your money back?
Whether the company hopes to sell itself one day, go public through and IPO, or pay you back with cash from the business as it grows, you need to have a clear picture in your mind of how you will be paid back and milestones along the way to help you see that you are moving toward this goal.
Example: If I invest $1,000 today and your plan is to sell the business in 5 years, how much should the business be doing in sales by then? And who would be looking to buy this business
Final Thoughts…
If there is one thought we can leave you with when it comes to personal investments it would be: don't put all your eggs in one basket.
Even if you're excited about your friend's business idea, it's a good idea to spread your investments across different types of assets. This way, you won't lose everything if one investment doesn't work out.
Many people lose money in private investments. According to a study, around 60% of small businesses fail within the first three years. So, it's super important to be cautious and do your homework.
Remember, investing should be fun, but it should also be smart. By following these five simple steps, you and your friend can make informed decisions, reduce risks, and hopefully, grow your money together.
