Do you find the stock market stodgy? Or traditional investments tedious? There’s always the allure of the startup world and the creations of clever entrepreneurs. It’s easy to see why: The success stories of Google, Facebook and eyeglass maker Warby Parker have captured headlines and imaginations. But if someone asks you to invest in their revolutionary idea because you’re a friend or family member, what are the chances you’ll hit it big in, say, a year or so?
Maybe you should visit Vegas instead, and bet it all on red at the roulette wheel.
“The first item you need to know — not consider — is that you may never see this money again,” says Mike Foguth, principal of Foguth Financial Group in Howell, Michigan. “So ask yourself the question, ‘What can I afford to lose?’ If you can’t afford to lose anything, then the conversation shouldn’t continue. People should never risk their future on someone else’s dream.”
“Startup investing is the exact opposite of a ‘get rich quick’ proposition,” adds Chris Tsai, co-founder and CEO of Celery, an e-commerce platform that helps startups sell their merchandise. “Ninety percent of startups fail, and any startups that survive will likely lock up your capital for an extended period of time.” He adds: “The average venture-backed IPO takes seven years.”
Still, the potential returns can be enticing. When Robert Wiltbank of Willamette University led the largest study to date of angel investors — affluent individuals who supply capital for a business startup — he found that angels made more than 2.5 times their initial investment. Still, the odds of a positive return in any single investment were less than 50 percent.
That said, Wiltbank released his landmark study in 2007 — the year the first iPhone was introduced — so it’s hard to gauge how much the odds have improved, if at all. Even startups making what’s called “the ask” have lots of questions they learn to answer along the way.
“Since we’d never entered the fundraising space before, we really didn’t know what to expect,” says Joey Gabaldon, founder and CEO of Ascenergy, an oil and gas company that works through creating a diversified portfolio of drilling sites. After encountering high fundraising costs through traditional routes, “we reached out to friends and family for our initial fundraise period. This experience was invaluable, as it taught us where our [business plan] materials were unclear and other lessons that helped us improve the quality of the offering,” he says.
Ascenergy raised $900,000 in less than a year, which put it in an ideal position to solicit funds in July 2014 via three crowdfunding equity platforms (Crowdfunder, EquityNet and Fundable). As of May, it has raised more than $3.7 million, and the team hopes to complete its current round of funding by June 30.
Even when success comes in the marketplace, patience is still the watchword for the friends-and-family investor. After four years in development, Chicago-based Parce Rum experienced a huge stroke of good fortune in March. It captured five top honors at the acclaimed San Francisco World Spirits Competition, including a Double Gold Medal and Best Rum for its 12-year-old liquor.
Festival organizers recognized it as an unprecedented success for a new product. But Parce is just starting to grow in terms of nationwide distribution. Meanwhile, Parce co-founder Jim Powers would be the first to encourage due diligence by investors in any startup.
“Our experience has been there are no shortcuts to success in anything, ever,” Powers says. He adds that startups and their backers alike should “plan on years until critical mass: three years absolute minimum, probably five.”
Looking to increase the odds of turning your friends-and-family investment into finance and fortune? Consider these expert tips:
1. Look at the team before the dream. Startups come to the table with enthusiasm and emotion, but potential investors need stay cool and sidestep hype. “All the data about early-stage investing suggests venture capitalists are no better than you or I at picking out the next ‘unicorn,'” says Melinda Moore, chief marketing officer of Crowdfunder. “The most important factor, statistically speaking, is the quality and experience of the founding team.”
2. Do lots of startup homework. All investors should research where they put their money, but with a proposition from a friend or family member, take added imperatives to look closely. “Look at the one-year, three-year and five-year business plans,” Foguth says. “Is the business going to be sustained on quick results? What are their growth strategies? Have they allocated dollars for slow months or market downturns?”
3. Does the product or service fill an unmet need? Warby Parker exploded from humble roots because the co-founders saw a need for high-quality eyeglasses at an affordable price. “Evaluate the market potential,” Tsai says. “Are there early signs of traction that demonstrate real market demand?”
4. “Grit” is it. Grit involves perseverance and passion for long-term goals and came to the fore in 2007 when University of Pennsylvania psychology professor Angela Duckworth identified it as a major predictor of success. “There’s lots of research now that shows that you should look for grit,” Moore says. “Early-stage companies face many obstacles along the way, and you want to invest in founders that you know aren’t going to quit. Great entrepreneurs figure out ways to become profitable, even if they run out of investment capital.”
5. Maybe your kid is ahead of the curve. There’s a fine distinction between someone pitching a “great idea” versus a techie who’s up on great innovations — and that could be a teen who spends lots of time on screens. Tsai cites a simple litmus test to help you spot new tech trends: “Ask your 15-year-old sister or daughter about which apps are the most popular amongst her friends.”
And from Foguth comes this parting word of caution, which boils down to this timeless truism: Friends are more valuable than money.
“From my experience, a bad business deal can end a relationship, especially if the investor truly didn’t have the money to lose,” he says. “If you value the relationship, I would think very long and hard about making this kind of commitment.”
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Friends, Family and Startup Fundraising: Risky Business? originally appeared on usnews.com
