Small private business investments offer potential profits and perils for both clients and advisors.

The client was experienced in business, all right. A self-made, successful entrepreneur. Sophisticated, relatively. Still, advisor Mike McCabe wasn't enthusiastic about the gentleman's intention: to invest $150,000 in a friend's start-up. "The client fully understood what he was getting into," says McCabe, a principal at WNA Investment Programs Inc., in Hinsdale, Ill. But it was a mistake.
The venture failed soon after start-up, done in by a combination of faulty legal advice and a zealous ex-employer hellbent on enforcing a noncompete contract. The company's shares became worthless, vaporizing client wealth, not to mention assets under management. "My client doesn't hold a grudge against the guy, but it was a lot of money to him and losing it hurt," McCabe says.
Stories of gritty entrepreneurs emerging from garage workshops, backed only by the prescient capital of their faithful inner circle, are the stuff of legend. And sometimes these bets do hit. "We have had clients come out of deals [get] paid very well for their participation," says Daniel B. Roe, a principal at Budros Ruhlin and Roe in Columbus, Ohio. Some of his clients invest from $50,000 to $500,000 in small, private companies in return for minority equity stakes. Given the illiquidity, lack of management control, other risks and five- to ten-year time horizon that's typically involved, "the expected annual compound return on an individual deal should be at least 20%, and probably more like 25% to 40%," Roe says. "You're looking for a big payoff."
But all too often, the investment goose eggs. The outcome suffered by McCabe's client is hardly rare. You can almost hear James Taylor sing, "Sweet dreams and flying machines in pieces on the ground," every time a client brings up this type of investing. Yet more than just his interests are on the line when the topic is broached.
"If you are an NASD-registered representative, helping someone make an investment decision about an unregistered security could be considered selling away, which is prohibited," says Richard Stumpf, principal of Financial Benefits Inc., a registered investment advisory firm in Wichita, Kan.
Like many practitioners, Stumpf is also a registered rep. So he has to be careful. "When my clients are approached with these deals, I merely give them some basic questions to ask in evaluating any business proposition, like whether their liability is limited to the initial investment. Advising as to whether it's a good investment or not gets into dangerous territory," Stumpf says. Your errors-and-omissions policy might also have something pertinent to say about such activity.
Occasionally, the client doesn't want advice but rather a graceful way to decline the solicitation. Here, the advisor plays the heavy, says Herb Daroff of BayState Financial Planning in Boston. "We have written letters for clients suggesting that it might not be a good idea to make the investment right now because of liquidity, taxes or other concerns. Then the client can show the letter and we, not the client, look like the bad guy," Daroff says.

Paid To Dissuade
But when regulatory proscription is not an issue, and the saucer-eyed client truly wants your take on the deal-or worse, doesn't want it-what should you do? Search for good reasons not to invest. Deals are packaged to appear attractive. That fuels greed and hence the motivation to participate.
So you need to play devil's advocate and challenge every assumption. "If a deal can pass numerous hurdles, then it is probably worth some amount of investment and it is up to you to advise how much," Roe says.
The psychological side is where James Holtzman, a shareholder at Legend Financial Advisors Inc. in Pittsburgh, starts. He asks the client why he's considering the "opportunity." Usually buried in the reply is something about wanting greater returns, which sometimes leads to a candid discussion about reassessing the client's risk profile. "Maybe we get riskier with a portion of his portfolio, but that might still be safer than holding a solitary illiquid investment," Holtzman says.
Also worth probing early is how much the client wishes his relationship with the other person to remain intact, "because it probably won't," says Atlanta business attorney John Jeffrey Scroggin. Joining forces in business routinely busts friendships and strains family relations, he says. "If you invest in your sister's company and it goes under, Thanksgiving dinner could be awkward," Scroggin warns clients. Success, meanwhile, produces friction when participants don't think they're getting a fair slice of the pie.
Next, pound home just how risky this kind of investing is. Perhaps you point out that it's riskier to invest in a single private company than a diversified private equity fund. But you must get across the concept that the entire investment could be lost and therefore only expendable dollars should be used, says veteran advisor David Diesslin in Fort Worth, Texas. "Even when I am optimistic about the business's prospects, I always tell clients in both conversation and letter, 'You have to be able to walk away from this capital,'" Diesslin says.
Sharing the ill fates of other clients who traveled similar paths is one way to illustrate the danger. Explaining how illiquidity factors in is another. "It's not like the company gets in trouble, the stock drops 20% or 30% and you decide to get out. You can't," Roe tells would-be financiers. "If the company blows through all the cash before developing a product or getting it to market, they close up shop and it's over." Or face dramatic dilution if the business manages to obtain another round of financing.
Of course, the client might insist that that won't happen in his situation. That's your chance to put the deal under the microscope, or to at least get the client asking intelligent questions. What about taxes, for instance? If the business is set up as a pass-through entity, such as an S corporation or most limited liability companies, the investor could owe income tax on business profits he didn't receive if management chooses to reinvest everything for growth. Then the client would have to cough up additional funds to support the investment. Gotcha!

Due Diligence
The legal aspects are extremely important. If the client ultimately invests, he'll obviously need an experienced attorney to represent his interests. You may as well engage the lawyer now to get a view on the deal's reasonableness. Is the percentage of ownership received for investing appropriate? Should the client demand pre-emptive rights, the right to maintain proportionate ownership interest in the business?
When a private company begins showing signs of success, Scroggin says, "the majority shareholder sometimes dilutes early investors' ownership by bringing in family members or hiring managers and issuing them stock options." Pre-emptive rights help manage that risk. What about future similar deals? If the business is successful and expands, does the investor have a right to participate?
Scrutinizing the individuals behind the venture can be a touchy subject when they are the client's friends or family. Nevertheless, a record of success, preferably in a similar business, and unimpeachable integrity are desired qualities that private investigators can help gauge relatively inexpensively. Bankruptcy. Crimes. Pending lawsuits. "Sometimes it's surprising what you find," says Roe.
Also make sure the principals' interests are aligned with the client's. "You want it win-win, lose-lose," Diesslin says. That means you want the organizers to have money at risk, but you don't want them to have multiple ways of profiting if the client only has one. "In restaurant deals, for example," Roe warns, "the principals sometimes manage the restaurant as well as manage or own the property it's on."
How much help to give the client in assessing the operation's chances of success is a decision each advisor must make individually. Even when evaluating business plans is part your skill set, it can be very time consuming. "Sometimes we review with the client the due diligence questionnaires we use when interviewing hedge fund managers, so he knows what to ask," says Legend's Holtzman.
Here are some things to look for: start-up cost projections, operating budgets, pro forma financials and an actual business plan based on realistic assumptions, not just a sexy idea with a wild scheme for spending money.
The decision to invest ultimately rests with the client, of course. If he proceeds with it against your better judgment, try to limit the risk. For example, counsel him against personally guaranteeing any of the business's debt. "That can prove to be an open-ended liability," Scroggin says.
"Put in the minimum amount to kick the tires," Holtzman urges clients. "I flat-out tell clients when I'm not comfortable with an investment," he says, "but I also say, 'I'll work with you as best I can.'"
Part of assisting involves determining which assets are best to use for the investment. Some of McCabe's clients prefer retirement money, even though that can create numerous tax and other complications that are beyond this article's scope. Still, one man who invested $50,000 in his son-in-law's biotech insisted on using Roth IRA funds. That way, says McCabe, "if he hits a home run, it will be a tax-free home run."