Should I Invest In My Friend's Business?
By AJ Ayers, CFP®
So we get this question a lot: Should I invest in my friend’s business?
It goes like this: You've got some money, you've done well for yourself, and you're kind of bored with your investment portfolio. I always like to say, “You can't throw a party in your diversified portfolio.”
So you’re a little bored with making money the old-fashioned, traditional way of stocks and bonds (btw it works pretty well) and want something a little sexier. Maybe it’s a friend’s bar, maybe it’s a cool boutique hotel in that cool town in Portugal you went to last summer, or an exciting new start-up idea from a business school friend. Whatever the ask is, it’s usually something awesome that you’re actually excited about. And it probably comes with a fancy, well-designed presentation with lots of very convincing financial data that says you’ll make your money back quickly and even make have some upside!
So how does a financial advisor react when our clients ask us to review these types of investments? Well, I usually say NO, don’t invest, and then I’m ignored and they make the investment anyway. But that’s life!
So why is it almost always a no? Because the type of investors who have available cash to invest in these types of EXTREMELY RISKY ventures are already financially independent. So they have already taken into account the risk and assume that they will never ever recoup their money - but it won’t be but a tiny dent in their portfolio. While many of our clients ARE financially independent, it’s often not so secure that one large failed investment COULD actually disrupt their financial security.
So to me, the decision-making process is fairly simple.
Should I invest in my friend's business?
Am I financially independent?
Do I have enough money to take care of myself and my family now and in the future without changing my lifestyle?
If the answer is NO to that question, unfortunately, you can't really afford to drop off an extra $5,000 or $25,000 or $100,000 into an investment that is pretty risky.
But how risky? The stats are a little shaky but we expect about 60% of restaurants to fail in the first five years. Generally, one in four busineses will fail. So just to reiterate, there is a 25-60% chance you will lose all of your money and never see a penny of it ever again.
You want to support your friends but, at the end of the day the simple answer is sorry, I have to take care of myself first before I can afford to make this investment.
I hate to be the queen of darkness, negative Nancy, whatever you want to call me, but I'm willing to take on that role (literally a role I have degrees in), but it's almost always a no from me.
But there are exceptions to every rule, of course! Let’s look at when it might be a YES.
Your friend or family member really needs the money, and you love them and want to support them. Tread carefully but sometimes love conquers all, even your financial security.
It’s not a LOT of money and you get some intangible benefit to this investment. For example: investing in a new bar down the block that offers $500 monthly tabs to investors is a pretty sweet deal. If you live on the other side of town or in another state and can’t benefit from this, don’t do it!
And just remember, the moment you complicate your financial life, you also complicate your taxes. Investing in businesses usually results in you waiting around until September 15th for the business to issue you a K-1. Any accountant can help you report the income with no problem, it’s the waiting that sucks.
So let’s dive into it.
Weighing the Risks: Investing in Friend's Business
Understanding the High Risks of Personal Investments
Investing in a friend's business can be more than just a financial decision; it often involves personal relationships, which can complicate matters. The high risks associated with these investments stem from several factors. Firstly, startups have a high failure rate, with statistics showing that a significant percentage don't survive past the first few years. This means that the likelihood of losing your investment is considerable. Secondly, personal investments often lack the rigorous due diligence that professional venture capitalists undertake before investing. Without this critical analysis, you may overlook potential red flags or challenges the business could face. Lastly, mixing friendship with finances can strain relationships, especially if the business doesn't perform as expected. It's essential to recognize these risks and evaluate whether the potential rewards justify taking the chance on your friend's business venture.
Evaluating Your Financial Independence
Financial independence is the cornerstone of making sound investment decisions, especially when it comes to personal ventures. Before considering an investment in a friend's business, assess your financial health. Do you have a robust emergency fund, are your retirement savings on track, and is your debt under control? If an investment went south, would it compromise your lifestyle or financial goals? It's crucial to ensure that you're not putting essential financial milestones at risk, such as funding a child’s college plan or securing your retirement. An investment should not jeopardize your ability to maintain financial stability. Remember, investing in a friend's business should come after your financial needs and responsibilities are met. If this isn't the case, it might be wise to decline the investment opportunity and instead focus on building a buffer that secures your financial independence.
The Emotional Cost: Supporting Friends vs. Financial Security
When Friendship Interferes with Investment Decision
The emotional ties in a friendship can cloud judgment and lead to investment decisions that are not financially prudent. When a friend pitches a business idea, the desire to help can override critical thinking about the viability of the venture. It's important to approach such proposals with the same scrutiny as any other investment. Ask for a business plan, understand the market analysis, and consider the competitive landscape. If the business doesn't seem sustainable or the plan lacks substance, it's okay to say no. It's also helpful to set clear boundaries from the start, clarifying that your financial decisions will be based on the same strategic considerations you apply to all investments. By doing so, you can maintain both your financial security and your friendships without allowing one to unduly influence the other.
Practicality Over Sentimentality: Saying ‘No’ to Friends
Saying no to a friend's investment proposal requires a delicate balance between preserving the relationship and protecting your financial interests. It's essential to approach these situations with practicality over sentimentality. Always communicate your decision with respect and transparency, explaining that your investment strategy must align with your financial goals and risk tolerance. It's helpful to offer support in other ways, perhaps by providing feedback on the business plan or making introductions to potential investors whose investment strategies are more suited to such ventures. Remember, true friends will understand and respect your decision to prioritize your financial security. By choosing practicality over sentimentality, you ensure that your friendships can endure regardless of business outcomes, and you safeguard your financial future against decisions driven by emotion rather than sound investment principles.
The Opportunity Cost: Other Ways to Utilize Your Money
The Power of a 529 College Plan
Investing in a friend's business might seem enticing, but considering the opportunity cost is crucial. One powerful alternative is a 529 college savings plan. This investment vehicle is designed specifically for education savings and offers tax advantages that can significantly enhance the growth of your contributions over time. By directing funds that you might have invested in a friend's business into a 529 plan, you're investing in your child's future and the promise of higher education. Unlike the uncertain outcome of a startup, a 529 plan provides a structured path to achieving a specific, impactful goal: covering college expenses. Additionally, the benefits of a 529 plan often include state tax deductions, tax-free withdrawals for qualified education expenses, and high contribution limits. Hence, when evaluating where to allocate your resources, the long-term rewards of a 529 college plan can outweigh the immediate appeal of a personal investment with a higher risk profile.
Smart Money Moves for Future Security
When you're faced with the decision of investing in a friend's business, consider other smart money moves that can bolster your future security. Building a diversified investment portfolio, contributing to retirement accounts, and paying down high-interest debt are all examples of financial strategies that often yield more predictable and stable returns than a risky business investment. Prioritizing these moves can help you achieve financial independence, providing peace of mind and a solid foundation for your financial future. It's also wise to consider establishing an emergency fund that covers several months of living expenses, which can protect you against unforeseen financial hardships. By focusing on these smart money moves, you are taking proactive steps to ensure that you and your family are well-prepared for whatever the future may hold, without the added risk of uncertain business ventures.