How to structure investment?

[seabourne]

I'm considering investing with a couple that I have worked with for about 8 years. They have been (successfully) running a charter business over that time - I was the first employee, they sold the first two boats and have upgraded in size significantly. They are currently considering purchasing an additional large vessel to start a similar operation in another city.

I have two options - I can invest a substantial amount (~33% of my net worth) an become a minority partner, or I can invest a lesser amount (5-10% of my net worth) and become a 2nd tier lender (behind the seller financing from the bank which owns it currently). I'm flying out to inspect the vessel in a few weeks. Subject to the boat being what I expect it to be I have a couple of questions that I'm hoping for some suggestions for.

1. I can withdraw from Roth accounts to about 10% NW, which would be sufficient for this investment, but that would forgo the tax free protection.

2. I can borrow (will begin speaking to banks to find out what rates would be) up to 10%, so that if I lose it all, I can still cover the loan even if I should lose my job.

3. I can borrow a greater amount and become a larger investor (20% NW), and expose myself to the possibility that I can't both lose my job and the investment and pay off the loan quickly without paying withdrawal penalties for other retirement accounts.

4. I can go whole hog, borrow 20% NW, withdraw 10% from Roth, and become partner. The potential would exist for me to draw a salary from the new company, though less that I make as an engineer probably.

They have said that they are willing to secure the loan to them with both the new company and the old, which vastly reduces the risk of lending. My intent is to try to negotiate a fixed + % profit proportional to the investment on the loans, with the fixed greater than my borrow rate should I do that. Right now,depending on what a bank is willing to lend to me at, I'm inclined to option 2. Additional potential would be to approach friends to participate to either reduce my investment exposure to 5% NW or to increase the participation and the risk of any other investors stirring the pot (Assuming that I'd represent our investment group). I suppose that I could also approach friends for a direct loan (contracted, etc - investment loan not a "cause I'm your friend loan") at fixed rate and take the extra investment risk/return personally.

There could be a lot of moving parts and uncertainties with this, but as personal potential. If I wanted to semi-retire soon to running the new operation for a few years, this would probably be a good way to do it - higher risk, but a lot of personal control and payback for sweat invested.

Thoughts and recommendations? Cynicism welcome. I've avoided direct numbers, but if anyone knows roughly what I'm likely to obtain as a rate for $100k or less loan from a bank with high credit rating, only debt mortgage <2x salary, I'd very much like to know prior to talking to banks so that I have a reality check.

Thank you all in advance.

Seabourne

 

[sailor]

It's hard for me advise you the level of involvement you'd like to have with the new company.
But - how far away from FIRE are you?
How much would you need to work longer if you lost 33% of your NW?

On the rates:
Any chance you could secure money thorough mortgage or HELOC (really cheap rates these days - I'm just refinancing to 2.5%).
For comparison our local Wells Fargo offers business loans at prime+6.50%, you can probably do better than that.
For non commercial boats you can get loans @ around 4% with 80-90% LTV (the boat is the collateral)
I don't have any experience with commercial boat loans though.

sailor

 

[Nords]

Thoughts and recommendations? Cynicism welcome.

Let's assume that the charter boat & operation is fully insured for boat casualties and other passenger liabilities, with the company (not you) on the hook for the deductibles.

The worst situation would be having the boat sitting pierside waiting for some sort of approval-- Coast Guard inspection, EPA certs, business license, or other red tape. How long could the company handle that dragging on? A few years ago a Hawaii startup tried to operate a controversial high-speed interisland ferryboat. It was tied up in legal & environmental lawsuits before it even arrived, and then it was blockaded several times from pulling into port. It also had to cancel a number of runs due to weather.

The next-worst situation would be having the charter operating at a loss in a vicious market that's undercutting the cost of goods & services. The company could suspend repayment, or let the interest accumulate while they've suspended repayment, or just declare bankruptcy.

I can't tell if you're planning to make a withdrawal from a Roth IRA (with or without penalties) or if you're planning on investing it as a self-directed IRA. In the latter case you're going to have to find a custodian who'd agree to this sort of investment in the first place. Usually the custodian's zeal for proper due diligence equates to dragging the owners through documentation hell. That may be a good idea, but it will certainly test the strength of your relationship with them.

You need better advice than us. You need a lawyer.

 

[GrayHare]

No pun intended, but this sounds like a sink or swim venture. More risk than I'd want to take on, unless I had enough funds to FIRE even if the business goes under. Additionally, if the couple are friends, note that a business failure could end the friendship.

 

[Tyro]

Not to be negative, but just realistic and practical, what happens if you want to get out of this business for any number of reasons? It's not like stock where you can sell your interest in an open market.

In the option where you are a minority partner for 33%, are the other 2/3 by any chance owned by the couple (1/3 each)? What happens if they divorce?

If I wanted to semi-retire soon to running the new operation for a few years, this would probably be a good way to do it - higher risk, but a lot of personal control and payback for sweat invested.

...and a lot of frustration if you're "outvoted" on how you are, want to, or think you should be, running the company.

It's your decision, but IME, I've seen many problems & regrets in unconventional business structures.

Wish you the best whichever way you go.

Tyro

 

[W2R]

I'm considering investing with a couple that I have worked with for about 8 years. They have been (successfully) running a charter business over that time - I was the first employee, they sold the first two boats and have upgraded in size significantly. They are currently considering purchasing an additional large vessel to start a similar operation in another city.

I have two options - I can invest a substantial amount (~33% of my net worth) an become a minority partner, or I can invest a lesser amount (5-10% of my net worth) and become a 2nd tier lender

And, your third option which I think you should consider with equal gravity, is to not invest with your friends at all. Do you feel like they would like and respect you more if you invest with them? If they are truly your friends, they won't care one way or another. Don't let this be a factor. Does investing in this give you an ego boost? Think about it and do not possibly endanger your retirement for an ego boost.

100% of people who I have known, who have invested in something with friends like this, have regretted it for financial reasons. Arrangements like this have also ruined many friendships, as GrayHare also pointed out.

My suggestion is to run from this like the wind and instead, invest in conventional investments that you may be able to consider more objectively.

 

[nun]

+1 on the avoiding investing with friends, but from a purely financial perspective I'd plan for the worst case scenario and ask yourself if you could survive if you lost everything you put into the company. If you are retired already I would not invest any more than I could stand to loose. If you are still working it's a slightly more difficult decision as you have the opportunity to earn back what you might loose.

The bottom line is the same with any investment; don't make it if you can't survive it going wrong.

 

[seabourne]

So I've done more discussion and exploration on this. I've excluded the option of becoming a full partner. I believe that I will become a lender to them. Basically, the loan to them will pay me an 8% floor, higher payment based on operational income possible. The loan will be secured by 1. the new firm, 2. the current company they are operating (net income of $450k avg last 3 years) and 3. personally secured by them.

The question now becomes a) how much - range is $50-100k, b)how acquired.

I can borrow up to 50k from my 401k at 4.25% for 5 years. Downside is 30 window to repay if I leave the firm or pay early withdrawal penalties. I'm comfortable with this option - I wouldn't be able to fully top out my retirement accounts, but I would still be able to save for all of the company match, plus some, fill my Roth, and not cut my current standard of living/spending at all.

Other possibilities are 1) I may be able to get a 5% 5 year 100k balloon loan, secured with the purchased debt. This would be the best option. 2)I may offer participation to other people (friends looking for uncorrelated investments) 3)I could do something truly stupid, like take out a credit card loan for the extra amount, loan shark, clean out my Roth, etc. I think that I'll avoid number 3, 1 would be ideal, and I'm on the fence between limiting my involvement to 100k or inviting other people to either directly participate or to lend me money to invest, secured by the assets.

As far as feeling obligated to invest because they are friends, they are friends because we have been in business together for 8 years, so money in this friendship is the start of it, not the end. For respect of the friends, I'm not concerned about it. For potential respect in the industry, it may have value in my semi-retirement career as a professional sailor in the field to be involved with a successful operation. While intangible, that does have some value to me. They also have no problem with me making inspections of the vessel and operation any time I would like - which would include being able to go and stay aboard for a vacation should we desire.

As far a downside impact on my early retirement - at 50-100k, I could lose it all, and it would cost me 1-2 years of continued work, or 3-5 years of carefully living frugally (not the end of the world - could just be traveling light and spending time on the farm). I wouldn't be happy about that outcome, but I can survive it, and it wouldn't break anything in the long run - I'm 33 year old, my wife-to-be is already semi-retired and works her own hours via a laptop anywhere in the world, we can rent out my condo, live on the farm, and travel via working boats for room and board or low pay. If I were willing to live Jacob's "ERE" lifestyle for 10 years, I could retire tomorrow and would be able to live a comfortable middle class spending life afterwards.

That said, the numbers and contracts will still be run in front of skeptical, intelligent people, the ship still needs to be inspected and estimated for insurance, and many other moving parts have yet to be nailed down. It may yet fall through or I will learn something that will cause me to turn tail and run.

Thank you again for the responses, I am listening and appreciate the contributions.

 

[Tyro]

Basically, the loan to them will pay me an 8% floor, higher payment based on operational income possible.
....
I can borrow up to 50k from my 401k at 4.25% for 5 years.

Strictly from an investment POV, that's a net of 3.75% while taking the risk of an 8% investment. That doesn't make sense to me, and I have to wonder how much emotion is involved in this decision and investment.

I'm wondering what kind of interest rate they'd get from a bank, and why they're not going that route -- unless the banks want considerably more than 8%.

 

[haha]

You have your mind made up, but only God knows why. This is all risk, tightly capped reward. Why don't they borrow the money they need from a bank?


Ha

 

[mystang52]

You have your mind made up, but only God knows why. This is all risk, tightly capped reward. Why don't they borrow the money they need from a bank?


Ha

+ 1 million

 

[sailor]

So let's say you are risking 50k (and to the lesser extent taxes & 10% penalty on it, if for some reason you would be unable to repay 401k loan) for a potential to earn $1875+ annually.
Even if the new company operational income doubled your income/dividend to $3750 (how you are going to structure this agreement/note btw?), for me the risk would be too concentrated, but I understand that for you it's not a purely financial decision.

OTOH a lot of us made some marginal financial decisions, which turned out fine, and if loosing it means only 1 year of additional work @ your age - maybe we worry about it too much for you

 

[seabourne]

I think that, as far as stretching to make it happen at 100k, I'm going to listen to intelligent people here and elsewhere, and agree that it would be pushing too hard. I will see if any friends are interested, and structure it as pass thorugh - they get the same security I do, get to go in eyes open.

If i use the 401k loan, it would change my allocation to be ~10% in this loan. Probably high, but I am comfortable with that exposure. Above that, I'm putting it in the "too hard" question catagory, and will no longer consider it. the advantage to taking the 401k loan is that 1)it reduces my stock market exposure 2)it is pre-payable, so it doesn't obligate me to continue paying the interest indefinately 3)it allows me to maintain my Roth accounts and cash liquidity for emergencies 4)from the investment perspective of the 401k, 4.25% fixed return is not bad.

I know that I am comfortable investing in this at some level. If it were 25k, I would do so immediately, and while I'd probably take a 401k loan to manage cash flow, I would have it paid back within the year. At the 50k level, I can pay the 401k loan without changing my current budget - just redirect taxable account savings. If other people are interested in investing alongside me, at levels where they are comfortable affording a complete loss, I may be able to reduce my share below 50k.

Thank you all for the help, and I don't mean that so as to close the thread - things are not yet fixed in place, but I think that people here and elsewhere have convinced me that borrowing from anyone other than myself to make this would be a poor risk/return. Leverage may get me where I want faster, but I'm in good enough shape early in life that I don't need to gear up to get where I'm going in an acceptable time frame. Slow and steady.

 

[Newventurer]

2)it is pre-payable, so it doesn't obligate me to continue paying the interest indefinately

This may be true for you, but my experience is exactly the opposite. I was told that if I repay my 401k loan early the interest is not recalculated for a new payoff. The total payoff stays the same, including all interest regardless of payback date.

 

[Tyro]

If other people are interested in investing alongside me, at levels where they are comfortable affording a complete loss, I may be able to reduce my share below 50k.

Risk of a complete loss for a return of 8% (3.75% in your case)‽

8% for venture capital is cheap (usually 12-25%); I can see why they want your participation, but I'm skeptical you'll get any takers. It wouldn't be unreasonable for you to insist on a more reasonable (i.e. fair) rate of return, and I'd be surprised if they could get financing anywhere else for less, so why should you?

It's your money and your life, and I (sincerely) hope it makes you rich, but it's looking far more like gambling than investing.

 

[MasterBlaster]

Why wouldn't they finance through a bank ? Like a normal business would ?

Why do the couple want you as a partner ?

 

[seabourne]

Risk of a complete loss for a return of 8% (3.75% in your case)‽

I don't think that I agree with your calculation - the return is not 3.75% (which would be borrow at 4.25%, invest at 8%). It would be investing 401k money at 8%, 4.25% of which is required to be paid back to the account, 3.25% which will remain outside the account (both less taxes owed).

 

[Sun456]

What would someone have to say to talk you out of this? It is a very bad idea.

 

[seabourne]

Why wouldn't they finance through a bank ? Like a normal business would ?

Why do the couple want you as a partner ?

They are financing the majority of the purchase with the seller, probably below what a bank would give them.

As far as wanting me as a partner, it is partly because my professional network in the industry - we've identified key employees and a pool of potential employees that the business would pursue, and I've been able to reach out and find people with personal knowledge of and experience with this boat as well as another boat that was build on the same plans a few years earlier operating elsewhere. We have been talking about doing something along these lines for about 5 years, but when they purchased the previous vessel, I wan't comfortable with the needed level of commitment and my level of liquidity. That firm has been successful, and will also serve as security for this loan.

 

[Tyro]

I don't think that I agree with your calculation -

That sounds like a bit of a straw man; the calculation is secondary, so I'll concede that point - I'm not familiar with the rules regarding borrowing from a 401K.

8% is still way too low a return for venture capital and the risk of complete loss. You may actually have a negotiating advantage here if they can't get financing anywhere else without paying a considerably higher rate.