High risk investments in your portfolio?

[ESRBob]

Lightspeed, the bigger question has to do with the actual venture you're being invited into -- how risky is it?
I happen to think investments in private companies are a great form of diversification and a great way to build wealth, but you have to understand and be able to manage the risks.

We made our ER 'wad' mostly through selling a company I founded. But I founded several and only two were reasonably successful, and one has made money. The rest were "tuition payments" for learning about private investing.

I think 5% -10% of an ER portfolio can be in private investments, (plus more in commercial real estate, hedge funds etc -- say 20% in risky or illiquid stuff overall). That to me feels like good diversification away form the simple traded stocks and bond securities.

But if you are younger, building up your savings (as opposed to taking out a safe withdrawal amount each year), and actively involved in something you know about, I think you could reasonably put more of your eggs in one basket.

Before investing, it is worth trying to speak to angel investors, people in the same industry, maybe some venture capitalists etc etc to try to make sure your investment passes some of the obvious due diligence screens. Local angel networks are all over -- ask local accountants or lawyers who work with this sort of company for leads to others who can help you start to fill in some of the gaps in your knowledge.
Good luck with it!

 

[Meadbh]

It's generally recommended that investors keep high risk / alternative investments to a maximum of 10% of the portfolio. These can include hedge funds, art, and venture capital, private equity or "angel" investments. Googling "angel investor" or "private equity" will generate plenty of information. While most sites are aimed at entrepreneurs, do check out the National Angel Organization and download the NAO-RBC Angel Primer (PDF file). Chapter 2 on Due Diligence is essential reading.

I have ~1% of my portfolio in VC, specifically, in a biotech startup whose business plan I am impressed with. (ALWAYS read the business plan!) I'm pleased to say that things are going well. I know my investment will be tied up for at least 5 years, until the company has an IPO or is bought out by Big Pharma. I would not make any such investment with nondiscretionary capital.

 

[two4theroad]

Risk vs reward

One must take risk to build great wealth and reduce risk greatly to keep it.
(or something like that)
DH and I took a risk investing in company stock for years when it was undervalued. By cost basis we have about 10% of our invested money in it. Due to greatly increased value it is now over 60%. We are getting out of it now but it is not something you can do overnight. When we were working it felt OK but now it feels chancy. We would like to get back down to 10% by next year.
2fer

 

[kcowan]

The other reason to reduce your holding is likely that future growth is going to be much less than past growth. What about volatility?

 

[lightspeed]

This investment I'm considering would be at most 2% of my net worth, and is a silent partner opportunity in a food start-up (as I understand, most of these fail), but it is founded by people with a proven successful track record in the same industry. Furthermore, I know and trust the founders, and have what I consider a great concept. The 4 founders have put in 250K of their own money, and are going to keep an 80% share of the company. They are selling 20% of the company in increments of $50K for 2% ownership. The investment is not likely to be liquidable until they get bought out, but the partnership agreement calls for paying the silent investors back their full investment before paying the founding partners. Do these sound like typical terms to any venture capitalists out there?

 

[kcowan]

This investment I'm considering would be at most 2% of my net worth, and is a silent partner opportunity in a food start-up (as I understand, most of these fail), but it is founded by people with a proven successful track record in the same industry. Furthermore, I know and trust the founders, and have what I consider a great concept. The 4 founders have put in 250K of their own money, and are going to keep an 80% share of the company. They are selling 20% of the company in increments of $50K for 2% ownership. The investment is not likely to be liquidable until they get bought out, but the partnership agreement calls for paying the silent investors back their full investment before paying the founding partners. Do these sound like typical terms to any venture capitalists out there?

This makes the company worth $1 million for 100% (ignoring sweat equity). Unless they have proceeded to generate some further value, that makes $50k worth 5%. If all four are active in the company, then you need some control over salaries and perqs that could prevent any ability to pay back their investors. Finally, you need a timetable and an associated valuation formula so that if you get paid back in two years, you get e.g. $150k not just $50k. After 3 years, you get $200k etc.

Because you are taking a risk of 100% loss, you need to expect to get 10x your money back in 5 years.

 

[clifp]

This investment I'm considering would be at most 2% of my net worth, and is a silent partner opportunity in a food start-up (as I understand, most of these fail), but it is founded by people with a proven successful track record in the same industry. Furthermore, I know and trust the founders, and have what I consider a great concept. The 4 founders have put in 250K of their own money, and are going to keep an 80% share of the company. They are selling 20% of the company in increments of $50K for 2% ownership. The investment is not likely to be liquidable until they get bought out, but the partnership agreement calls for paying the silent investors back their full investment before paying the founding partners. Do these sound like typical terms to any venture capitalists out there?

In my Angel investment group we'd look at this company
as having a pre money valuation of 1.0 million and
a Post money valution of 1.5 million
with $100K getting you 4% of the company.

This doesn't seem unreasonable on the surface, but they are lots of caveats.
1. Is this just a concept or have they done a lot of work? In general you don't want to overpay for a ideas or concept
2. What will the involvement of the founders be. If they are going to work full-time a low salary this a much different deal than if they are going to hire a manager to run the operation.
3. What will their additional capital needs be and how do they intend to get them.
4. Finally you need to understand the exit strategy. If there only strategy is to be acquired. They need to provide you with as much financial details as possible of similar companies that have been acquired by Megacorps. I.e. what were there revenue, profits, locations before being a acquired.

The smartest guy in my Angel group, likes to be the last guy to invest in any round of funding not the first one. So if they have cashed 7-8 other guys $50K check then give them yours.

 

[clifp]

To answer the initial question. I have 3% on a few Hawaii starts-up which will probably increase in 5% in the next year or so. It isn't as risky as sounds, because I get close to a 100% state tax credit (not deductions) on these investments. I also have 1% in microcap stocks, that I bought based a AAII stock screen (all the companies are selling below book value.)

Oh and I lost 2% investing in my friend software company... So I am going to draw the line at 10% of risky investments.

 

[Delawaredave5]

This makes the company worth $1 million for 100% (ignoring sweat equity). Unless they have proceeded to generate some further value, that makes $50k worth 5%.

If partners put in $1million for 80%, that values company at $1.25million.

$50K should be worth 4% (if my math is right...) - so you're paying 2x per share than partners are paying.

Regardless, I'm also looking at some "local private equity" deals also - would be a couple percent max of portfolio. Some are passive, some have some active participation.

What I am looking at: what is the maximum, out-of-pocket, after-tax hit that I would take if the investment became worthless.

If there's an investment credit involved (like clfp's) and/or ability to draw a partial salary as a 1099 employee -- these could substantially reduce your "total tank" maximum loss - possibly below $20K on a $50K investment - in which case the upside potential might be worth it.

 

[pedorrero]

30% of your worth in a single stock? Sounds a bit concentrated to me. I guess there are special cases: a couple shares of BRK? Wal-Mart (if you were one of the early shareholders? -- Your last name is "Walton"...) Seems quite dodgy to me...look up "Enron" in your history lesson book if you would like to know why....

 

[ESRBob]

One metric that has been used over and over, at least in tech startups that don't have profits, is to value the company at 2 times sales. This may seem harsh to the earliest stage companies, but then again, if they are looking for outside money at those early stages, they deserve to pay dearly for it, as the risk is extreme.

So if the startup has 500k of revenue right now, they'd be worth 1 million pre-money. Otherwise, it sounds to me like you're overpaying.

Also, if the founders are putting in their 250k now at the same time as you are putting in your money, then the valuation should be the same. If their 250k went in a year or so ago, then you get to decide whether the company has quadrupled in value since.

Think a lot about how you're going to get your money out of the startup. It's like marriage -- easy to get in, hard to get out. Or as the English say, "Decide in haste, repent at your leisure". Little illiquid companies need a clear exit strategy for investors.

If the founders have done all this successfully before, that can be a big help, but every company is different so make sure they can be successful again.