As an active investor in search funds (7 deals in 2020), I often talk to individuals interested in investing in search or searchers raising money from investors on deals. In general, I recommend focusing on taking money from professional investors or minimally individuals who are used to investing in alternative assets (direct real estate, startups, etc). However, there are times when you may want to take friends/family money and they might be interested in supporting you.
Before taking friends/family investment, here are five cautionary tips I'd make sure your friends/family investors are aware of:
1) Need to Be Accredited Investor - First things first - your friends/family have to be accredited investors (read the rules but individual net worth $1M+ assets or $200k+ individual salary last two years) and they'll have to go through a process to prove it (provide documentation direct or use a service like Verifyinvestor.com)
2) Need to Understand it's Illiquid - Many friends/family haven't invested in alternative assets and are used to investments like mutual funds where you can get your money out directly or with a penalty in case of emergency (401k, 529, etc). The downside of search investments is the investment is illiquid and could take 5, 7, or 10+ years to get their money back. Basically you want to make sure they won't ask you every Thanksgiving for 7+ years how their investment is going.
3) Need to Provide Their Bank Account Information - If you are going the self-funded route and getting an SBA loan, your investors will need to provide two months of bank account statements to the lendor. It feels weird and invasive (most people don't feel comfortable sharing how much in their bank account) but it's just how it works. Make sure your investors are willing to do that and can turn it around quickly vs debating the issue.
4) K1s Will Complicate Your Taxes- if you've never had alternative investments, you may never have received a K1. A K1 is issued in all LLC or S Corps to report each partner's share of the partnership's earnings, losses, deductions, and credits. Basically, as an investor, you need to pay taxes on your % of the LLCs profit. If the company made $1M and you owned 1%, you are responsible for $10k (1% of $1m) of the profit and need to pay taxes on it. And you are on the hook whether the company actually pays out that distribution or not. As such, on investment, you'll hear of tax distributions which are earnings passed on to cover investor tax implications that are different from preferred return distributions (which are true distributions).
5) K1s Will Delay Your Taxes - Some friends/family love getting their W2s and 1099 by end of January and filing early February every year their taxes. These folks will get annoyed about the timing of K1s. Generally, K1s take time to get out especially if you are a small company. As such, investors may not get their K1s until March or even April. Often, you may need to file an extension on taxes from the April 15th until all the K1s come in. You want friends/family investors who aren't bugging you each year multiple times on when the K1 is coming.
Bonus - remind them - it's risky. These are small businesses that are highly leverage (~50% in traditional search, 80-90% in SBA loans) and they sit 3rd in line in terms of getting their money back if things go sideways (1st - bank gets their money, 2nd - seller note paid off). It's a risky investment so friends/family shouldn't invest if they need the money back soon (or worried about when it will be returning in future)*
What do folks think - what am I missing?
Entrepreneurship is stressful so it can be great to have friends/family being supportive and part of your journey. But like most things in life - it's always good to make sure folks know what they are getting into.
As always, let me know if I can help (DM or --@----.com ). Sign-up for my monthly musings at bit.ly/etamusings
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