Risky investment with a "guaranteed" principal return

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IFKC
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Risky investment with a "guaranteed" principal return

Post by IFKC »

Hi everyone,

This is a bit of a multi-facted question, about possibly the riskiest investment out there...a restaurant.

The facts are as follows: I've been approached to provide almost 100% of the startup capital for a restaurant with a side business. The restaurant has unique characteristics that could work in the area, or, of course, it could flop. The side business could be a huge flop, but it has the potential to have big returns. One of my two potential partners, due to his other successful side business, has the opportunity to vertically integrate (sorry :) ) the side business, thereby creating sort of a pipeline of clients.

Now for the more interesting part. While I would front 100% of the startup cost, I would be silent partner and only get 10% of the return. *BUT* the principal is guaranteed (or as close to a guarantee as it can really be) by my partners. He/she is willing to reimburse the capital out of his other successful business. Whether the restaurant succeeds or fails, they are asking for a 5 year term. Both of the partners have successful business experience (one of them owns 5+ stores in another industry, the other owns 3 restaurants (though none of this type)). I have a decade long relationship with one of the partners, and only recently met the second.

A family member and I are considering splitting the capital, which would equate to roughly 7% of my portfolio and 15% of my family members. I'm relatively young, and my family member is nearing the end of his/her career.

So there it is: a risky venture with a "guaranteed" principal return. :) I know this is a fiscally conservative forum, so I look forward to hearing your thoughts.

Thank you!
A happy father and tepid lawyer, trying to do the right thing
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cheese_breath
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Re: Risky investment with a "guaranteed" principal return

Post by cheese_breath »

You are right to put "guaranteed" in parenthesis. Your title admits it's a risky investment, and you say the "guarantee" is "as close to a guarantee as it can really be" which means it's not really a guarantee. If (s)he can "reimburse the capital out of his other successful business" why does (s)he need your money? And why do the need you to fund almost 100% of the new business if they're so well off? And why you? Why don't they get a bank loan? How is their credit? Even though both partners have been successful in other enterprises you say neither has experience in this type of restaurant. Do they claim to be doing you a favor by allowing you in to this great opportunity? Don't let the fact that you "have a decade long relationship with one of the partners" cloud your judgment. It's a lot easier to scam someone you've had a long relationship with than someone you just met.

I don't know. Maybe this is legit, maybe not. But it's more risk than I'd want to take, especially with the money of a family member nearing the end of his/her career. Maybe this will be a great success, but if it was me I'd run the other way. My two cents worth.
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in_reality
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Re: Risky investment with a "guaranteed" principal return

Post by in_reality »

10% of the return? How is that calculated? Are they writing off 20% of startup capital each year? Are they taking a big salary? Are they buying supplies from a cousin at high cost? Do you know or care? Oh it looks like restaurants are under a 15 year amortization http://www.irs.gov/pub/irs-pdf/p946.pdf#page32 So for sure I think 33 of the total will be written off in the first 5 years. You won't be getting 10% of that.

How long does it typically take to build up a clientele? Are they going to have heavy advertising/promotion expenses? What if they just beak even? Have they laid out a plan?

Also, what does "willing to reimburse" mean from a legal standpoint if things go bad and it fails. They have an obligation or it was a verbal commitment meant to reassure you of their commitment but in fact if they had really meant it, that the contract would have been drawn up along those lines.

Obviously they are looking to reduce their cost of capital by getting financing from you. I don't have a good idea of what it will generate in the first five years. Do you? Is that a good use of your money? Return of principle and 10% of profit doesn't seem reassuring to me because I don't have enough information.

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Re: Risky investment with a "guaranteed" principal return

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Re: Risky investment with a "guaranteed" principal return

Post by nisiprius »

Are you yourself desperately interested in either the restaurant or the side business, willing to involve yourself in it many hours a week almost job-like hours--and do your partners want you to do that? How often will you be physically on site? How often will you be attending meetings?

I think "restaurant and side business" sounds dangerous. Divided attention.

And do your partners have a desperate interest in these new businesses, in addition to the eight that they already own?

I understand some of it is caginess, but it seems to me that your post is so much about the money arrangements and so little about the business... but I do you have the "fire in your belly" for the business itself, or just for the investment opportunity?
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IFKC
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Re: Risky investment with a "guaranteed" principal return

Post by IFKC »

Thanks for the responses. Some interesting points. Thanks!
cheese_breath wrote:You are right to put "guaranteed" in parenthesis. Your title admits it's a risky investment, and you say the "guarantee" is "as close to a guarantee as it can really be" which means it's not really a guarantee. If (s)he can "reimburse the capital out of his other successful business" why does (s)he need your money? And why do the need you to fund almost 100% of the new business if they're so well off? And why you? Why don't they get a bank loan? How is their credit? Even though both partners have been successful in other enterprises you say neither has experience in this type of restaurant. Do they claim to be doing you a favor by allowing you in to this great opportunity? Don't let the fact that you "have a decade long relationship with one of the partners" cloud your judgment. It's a lot easier to scam someone you've had a long relationship with than someone you just met.
It's certainly not a government bond guarantee, or even a large corporate bond guarantee, it's just a written guarantee secured via the other small, successful businesses. As for why no bank loans, roughly 90% of restaurants do not receive bank funding, often times due to the risk (which seems to be somewhat mitigated here because of the security via the other businesses).

As to the scam issue, that was indeed my first concern. 100% was higher than the partner originally asked for. Once he "guaranteed" the principal return, my spidy-sense starting tingling. :) But the more I thought about it, the more it sort of made sense to me. It's hard to get bank financing, and then you are starting off from an interest rate hole. Most finance for restaurants comes through loans outside of financial institutions. They never tried to sell me like they were doing me a favor, and they said they fully understood if we didn't want to do it. They further said that if we didn't, it wouldn't happen as quickly, but that they would eventually go forward with other financing, so no pressure to "make it happen for us."

in_reality wrote:10% of the return? How is that calculated? Are they writing off 20% of startup capital each year? Are they taking a big salary? Are they buying supplies from a cousin at high cost? Do you know or care? Oh it looks like restaurants are under a 15 year amortization http://www.irs.gov/pub/irs-pdf/p946.pdf#page32 So for sure I think 33 of the total will be written off in the first 5 years. You won't be getting 10% of that.

How long does it typically take to build up a clientele? Are they going to have heavy advertising/promotion expenses? What if they just beak even? Have they laid out a plan?

Also, what does "willing to reimburse" mean from a legal standpoint if things go bad and it fails. They have an obligation or it was a verbal commitment meant to reassure you of their commitment but in fact if they had really meant it, that the contract would have been drawn up along those lines.

Obviously they are looking to reduce their cost of capital by getting financing from you. I don't have a good idea of what it will generate in the first five years. Do you? Is that a good use of your money? Return of principle and 10% of profit doesn't seem reassuring to me because I don't have enough information.
.
Most of these answers come from a business plan, operating agreement, and contracts. They agreed to reimburse us as required by a written contract drafted by our attorney. The operating agreement has yet to be drawn up, but could include limitations on salaries, suppliers, etc.

As for whether its worth it financially, that obviously depends on how much profit it would generate. I have an estimate right now that I'm trying to see how it was generated and how it would compare to a 7% growth by just leaving it in the market. I was given an estimate of $2 million in annual sales (again, not in the first two years), and I've seen that profit margins range from 7-30 %. If these numbers were right, investing would make sense. However, I'm investigating all of these numbers further.
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chocolatemuffin
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Re: Risky investment with a "guaranteed" principal return

Post by chocolatemuffin »

I look at it as you are investing not in a business, but in your friend and the relationship between you and him. Since he's the one actively managing the business, and that it sounds like he's much more knowledge-able in this business than you are, he has complete control and can screw you over if he wants. You don't really have much leverage in this situation. The difference between investing in a public vs private company is that in the case of a public company, it's well regulated and provide many protections for its investors.

My advice is that you should only consider investing in this if you truly believe in your friend's competency and good-will, otherwise don't even think about it.
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Re: Risky investment with a "guaranteed" principal return

Post by retiredjg »

It appears you could afford for this whole thing to go belly up. But your relative is nearing retirement and this is a larger portion of his/her portfolio.

It might boil down to this. Can the relative afford to lose this money? If not, the relative should not venture into this investment.

Never loan or gamble money you can't afford to lose.
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IFKC
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Re: Risky investment with a "guaranteed" principal return

Post by IFKC »

nisiprius wrote:Are you yourself desperately interested in either the restaurant or the side business, willing to involve yourself in it many hours a week almost job-like hours--and do your partners want you to do that? How often will you be physically on site? How often will you be attending meetings?

I think "restaurant and side business" sounds dangerous. Divided attention.

And do your partners have a desperate interest in these new businesses, in addition to the eight that they already own?

I understand some of it is caginess, but it seems to me that your post is so much about the money arrangements and so little about the business... but I do you have the "fire in your belly" for the business itself, or just for the investment opportunity?
I'm not interested in running a restaurant, nor, by the expected operating agreement, would I be entitled to. I'd be a silent partner; my interest here is in $. The other two (actually one, with the other as his backup) would run the business, and they desperately want it. Both of them have wanted something like this for years, and neither expected they would be able to do it for many more years.


@retiredjg: Thanks, I think that's spot on.

@chocolatemuffin: Kind of. I'm investing in the business, not him or my relationship with him, with the idea that they know what they are doing. Given the limited knowledge I have about the business and industry, stuff seems to jive. And I know the city and area, and it makes sense too. Coupled with a contract reimbursement for the principal, it's much more than just investing based on a relationship.
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Re: Risky investment with a "guaranteed" principal return

Post by aquifer »

A written guarantee secured via the other small successful businesses....Do you know what you're saying here? Is this a legal guarantee secured by the assets of the other companies? Have you done lien searches to see if a bank or other creditor is ahead of you? Or is this just a document that basically says "yeah we'll pay you back"?

All I'm saying is just make sure you know what you're talking about. A written guarantee is meaningless without the teeth of a legally collateralized guarantee in first lien position. Not saying you shouldn't do this but again, just make sure you have what you think you have so you aren't relying on something that isn't the case legally.
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Re: Risky investment with a "guaranteed" principal return

Post by Valuethinker »

retiredjg wrote:It appears you could afford for this whole thing to go belly up. But your relative is nearing retirement and this is a larger portion of his/her portfolio.

It might boil down to this. Can the relative afford to lose this money? If not, the relative should not venture into this investment.

Never loan or gamble money you can't afford to lose.
Excellent analysis.

But not complete. If OP loses money *now* he/she loses the chance to invest that money long run in say Vanguard TSM, returning say 7-8% pa. 30 years time, that is *8* times the money invested.

I am reminded that Warren Buffett says the worst investment decision he ever made was quite early in his career. After a fight with a major shareholder of Berkshire Hathaway itself (a textile company) he bought back the other shareholder's stake in BH (I think it was BH). He did not need to. Compounded until now, the cost of that 'investment' was billions. As Buffett said, his pride and spite made him do it, and it has cost him more money than any other bad investment he ever made.
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Re: Risky investment with a "guaranteed" principal return

Post by Valuethinker »

I think if the other party is prepared to give a written guarantee and one with meaning, ie first lien over an asset, then it's not at all clear why they would do this as opposed to just borrowing from a bank (who would be happy to lend with such guarantees) and paying 5-6% interest rather than diluting precious equity.

I would walk away from this one: too complicated. A lesser alternative is to offer less money for the same stake, but no guarantee *or* bigger stake for the same money.
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Re: Risky investment with a "guaranteed" principal return

Post by IFKC »

Thanks for the responses everyone.
Valuethinker wrote:I think if the other party is prepared to give a written guarantee and one with meaning, ie first lien over an asset, then it's not at all clear why they would do this as opposed to just borrowing from a bank (who would be happy to lend with such guarantees) and paying 5-6% interest rather than diluting precious equity.

I would walk away from this one: too complicated. A lesser alternative is to offer less money for the same stake, but no guarantee *or* bigger stake for the same money.
I'm not sure the banks would lend. The lien itself is of limited nature: the other businesses, save for the restaurants, have little physical value (they are service oriented, rented space, etc. that produce regular capital but have minimal tangible assets).

But what do you mean bigger stake for the same money? A larger profit share?
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Re: Risky investment with a "guaranteed" principal return

Post by Valuethinker »

IFKC wrote:Thanks for the responses everyone.
Valuethinker wrote:I think if the other party is prepared to give a written guarantee and one with meaning, ie first lien over an asset, then it's not at all clear why they would do this as opposed to just borrowing from a bank (who would be happy to lend with such guarantees) and paying 5-6% interest rather than diluting precious equity.

I would walk away from this one: too complicated. A lesser alternative is to offer less money for the same stake, but no guarantee *or* bigger stake for the same money.
I'm not sure the banks would lend. The lien itself is of limited nature: the other businesses, save for the restaurants, have little physical value (they are service oriented, rented space, etc. that produce regular capital but have minimal tangible assets).

But what do you mean bigger stake for the same money? A larger profit share?
Ahh.. Would the banks not lend if the founders were prepared to guarantee the loan with equity in another business? As they are prepared to do with you?
In other words, a personal guarantee against a line of credit? That's how startups normally get bank funding.

I mean equity -- so if the thing is set up as a company you get more shares, more voting rights, a bigger percentage of any dividends, and more of the sale price if it is ever sold.
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Re: Risky investment with a "guaranteed" principal return

Post by Streptococcus »

It's a terrible idea. Remember what Warren Buffer said about the rules of investing: First rule, do not lose money; second rule, remember rule number one.
If you get into this business, you are not investing, you are gambling. ANd gamblers most often lose.
A few points:
1. If you invest 100% of the business you will have more to lose than them. Furthermore, putting 100% and being a silent partner is a recipe for disaster. If I put 100% of my money in something, I want to be the boss.
2. You cannot put 100% and only have 10% in return. A better deal would then be to put that 100% in the stock market and you might be likely to have more in return with less risk.
3. Are you sure that the business that they put as a guarantee is a really successful business? how do you know that it is not full of debt? did you check the papers or do a research to verify that what is being placed as a guarantee is worth it?
4. Keep in mind that investing is not gambling. When you put your money somewhere, especially when you are the sole investor, you need to be able to trust, but verify, supervise and monitor. otherwise you put yourself in the gambling spot.

This is just my 2 cent
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Re: Risky investment with a "guaranteed" principal return

Post by archbish99 »

Streptococcus wrote:2. You cannot put 100% and only have 10% in return. A better deal would then be to put that 100% in the stock market and you might be likely to have more in return with less risk.
This is what makes me question the proposition. They're fronting none of the money, why should they have a share in the ownership? Fairer would be to say that you're the 100% owner, and they're employed by you as management. Their salary could be performance-based, as a percentage of profits, for example. If the goal is for them to eventually own the business, give them the right to buy you out in part or in whole.
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Re: Risky investment with a "guaranteed" principal return

Post by On the way »

Streptococcus makes very good points. I have watched several episodes of "American Greed", and was surprised on how easy it is to run a scam. Be very careful, it could be legit, but once you are in, and it is not, the money is gone.
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Re: Risky investment with a "guaranteed" principal return

Post by Bidwell »

Okay, you invest big bucks in something risky, then become silent partner at 10% ROI. This is just nuts - Not a business, a minefield. Too much ego involved here.
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Re: Risky investment with a "guaranteed" principal return

Post by Jack FFR1846 »

Look into the % of restaurants that succeed past their first year in business. Hint, it's the same as the return they're promising you.
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Re: Risky investment with a "guaranteed" principal return

Post by Raymond »

"Look around the poker table; if you can’t see the sucker, you’re it."

I would pass on this "investment".
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Re: Risky investment with a "guaranteed" principal return

Post by Calm Man »

OP, I am going to assume this is a legitimate post as you sound sincere. Rather than try to understand the soundness of the guarantee, why are you bothering with this at all? Is it a sense of adventure? Looking 5 years down the road and seeing if you get your money back? You have no clue as to the expected return but we do know that you are putting up 100% of the financing and getting 10% of the return. Are you actually considering this? Why?
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Re: Risky investment with a "guaranteed" principal return

Post by IFKC »

Thanks for the responses everyone. I appreciate the perception has been almost universally "no." I think the response would be far different had I posted on an entrepreneurs forum, but I asked for the input from you and I've got some good ideas.

A couple of key take aways and reinforced thoughts:

1) I'm getting a business plan (if it's wrong, I walk away totally)
2) I'm getting financials on the other companies
3) I'm asking for higher return

For all of that, thank you.

With that said :),
Calm Man wrote:OP, I am going to assume this is a legitimate post as you sound sincere. Rather than try to understand the soundness of the guarantee, why are you bothering with this at all? Is it a sense of adventure? Looking 5 years down the road and seeing if you get your money back? You have no clue as to the expected return but we do know that you are putting up 100% of the financing and getting 10% of the return. Are you actually considering this? Why?
I think some of you are probably a bit more conservative than I: I'm young, stable job, and my investment represents 7% of my portfolio (the bigger risk comes to my family member). Even at a mere 10% profit, average returns on a $2 million dollar operation of this type of restaurant would ridiculously outpace 7% annual returns in the market. The marriage of personnel with opportunity offers an intriguing opportunity: why would I not consider this?

Why do I have "no clue" about expected returns? I'm certainly not just hoping to get my $ back: I would expect to gain a significant return.
modelamike wrote:Okay, you invest big bucks in something risky, then become silent partner at 10% ROI. This is just nuts - Not a business, a minefield. Too much ego involved here.
It might be nuts, but maybe not. It partially depends on the security of the principal right? If you were me with the characteristics above (young, stable job, 7% of my portfolio), had a high likelihood of getting your principal returned after 5 years (not saying I do, but I'm proceeding on that notion will need to investigate further), had a 30% chance at massively better than market returns after 3 years, PLEASE tell me why you wouldn't take a shot?
archbish99 wrote:
Streptococcus wrote:2. You cannot put 100% and only have 10% in return. A better deal would then be to put that 100% in the stock market and you might be likely to have more in return with less risk.
This is what makes me question the proposition. They're fronting none of the money, why should they have a share in the ownership? Fairer would be to say that you're the 100% owner, and they're employed by you as management. Their salary could be performance-based, as a percentage of profits, for example. If the goal is for them to eventually own the business, give them the right to buy you out in part or in whole.
Might be on to something... Its a solid idea.
Streptococcus wrote:It's a terrible idea. Remember what Warren Buffer said about the rules of investing: First rule, do not lose money; second rule, remember rule number one.
If you get into this business, you are not investing, you are gambling. ANd gamblers most often lose.
A few points:
1. If you invest 100% of the business you will have more to lose than them. Furthermore, putting 100% and being a silent partner is a recipe for disaster. If I put 100% of my money in something, I want to be the boss.
2. You cannot put 100% and only have 10% in return. A better deal would then be to put that 100% in the stock market and you might be likely to have more in return with less risk.
3. Are you sure that the business that they put as a guarantee is a really successful business? how do you know that it is not full of debt? did you check the papers or do a research to verify that what is being placed as a guarantee is worth it?
4. Keep in mind that investing is not gambling. When you put your money somewhere, especially when you are the sole investor, you need to be able to trust, but verify, supervise and monitor. otherwise you put yourself in the gambling spot.

This is just my 2 cent
You raise a number of good thoughts here; I need more information about the other businesses, and I intend to get it. I disagree with your gambling characterization though. Not to sidetrack the issue (which I'm sure this will... :)), but you are most likely a silent partner in every business in the stock market (ever try to execute your voting rights?). The primary differences between TSM and this are liquidity, diversification, and and stability, not control. No doubt, the former is far better to as your foundation, which is why 93% of my portfolio would be that and bonds.
Valuethinker wrote:
IFKC wrote:Thanks for the responses everyone.
Valuethinker wrote:I think if the other party is prepared to give a written guarantee and one with meaning, ie first lien over an asset, then it's not at all clear why they would do this as opposed to just borrowing from a bank (who would be happy to lend with such guarantees) and paying 5-6% interest rather than diluting precious equity.

I would walk away from this one: too complicated. A lesser alternative is to offer less money for the same stake, but no guarantee *or* bigger stake for the same money.
I'm not sure the banks would lend. The lien itself is of limited nature: the other businesses, save for the restaurants, have little physical value (they are service oriented, rented space, etc. that produce regular capital but have minimal tangible assets).

But what do you mean bigger stake for the same money? A larger profit share?
Ahh.. Would the banks not lend if the founders were prepared to guarantee the loan with equity in another business? As they are prepared to do with you?
In other words, a personal guarantee against a line of credit? That's how startups normally get bank funding.

I mean equity -- so if the thing is set up as a company you get more shares, more voting rights, a bigger percentage of any dividends, and more of the sale price if it is ever sold.
Interesting, ok. You may be right about the lending. I'll press on that. Thank you!
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Re: Risky investment with a "guaranteed" principal return

Post by KyleAAA »

I wouldn't do it for 10%. The reason they are approaching you to do this instead of a bank is because it's in their best interests to do so. If the business succeeds, 10% is no big deal. If it fails, they can pay you back at their leisure without any interest expense. An important point is that they seem to be promising to pay you back OUT OF CASH FLOW from their other businesses. It doesn't appear they are backing the loan with equity of the other businesses, though. So if they default, what is your recourse REALLY?
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Re: Risky investment with a "guaranteed" principal return

Post by sport »

If the banks would not take this risk, why would you? Banks are the professionals at lending money. You are an amateur. If banks would not consider lending for this venture, I would trust their judgment.
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IFKC
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Re: Risky investment with a "guaranteed" principal return

Post by IFKC »

KyleAAA wrote:I wouldn't do it for 10%. The reason they are approaching you to do this instead of a bank is because it's in their best interests to do so. If the business succeeds, 10% is no big deal. If it fails, they can pay you back at their leisure without any interest expense. And since you don't have the financial heft of a bank, they probably don't have to worry so much about legal action in the event they are slow to pay.

What happens if they default? What recourse do you have other than the personal guarantee?
I'm the litigious type!

Seriously though, the issue isn't whether I could or would pursue recourse (I could and would). The issue is whether there's anything worth pursuing. That's what I intend to find out.
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in_reality
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Re: Risky investment with a "guaranteed" principal return

Post by in_reality »

IFKC wrote: I'm the litigious type!
Well then do the investment. You seem to like the contractual aspect of it. It seems you have a sense of where things might go wrong and how to look out for them. I hope you are sharing your deepest and darkest worries about the investment with your relative. I suspect they are trusting you to get them into a safe investment.
They never tried to sell me like they were doing me a favor, and they said they fully understood if we didn't want to do it. They further said that if we didn't, it wouldn't happen as quickly, but that they would eventually go forward with other financing, so no pressure to "make it happen for us."
This means nothing I think. I would expect even a scam artist, and I am not suggesting they are that because I do not know, to have read enough reactions to know how to make people comfortable with them. They read you reading them and learn over time how to get the reaction they want. I think you have to establish the legitimacy of the investment by looking into it as you say you are. OK you have known them for 10 years...and you seem to be getting the agreement in good order. Have you really known about the health of their business for 10 years?

Why are you putting up less than your relative? They can afford to lose more?
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Re: Risky investment with a "guaranteed" principal return

Post by windhog »

Question: How do you make a million dollars in the restaurant business?
Answer: Start with 2 million.

Sorry, I could not resist posting this. Good luck.
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johnz1001
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Re: Risky investment with a "guaranteed" principal return

Post by johnz1001 »

IFKC:

Reading your responses, it seems that you want to invest in the business despite all the qualifications and questions of board members. But, what would make me, if not think twice, but run, would be that you're being guaranteed 100 percent return of principal but the guarantors are not putting in any money up front. If you can defend how someone can't have any liquidity to put skin in the game with you other than guarantees to repay you 100 percent, defend it. That doesn't even make any sense.

Given that your co-investor is nearing retirement, I would be very cautious about bringing them along for the ride, and I would ask either for the guarantors of your principal to put skin in the game or get another investor.

Take the risks for the adventure of it and the prospect of making a lucrative investment, only be willing to concede that reasoned business acumen would tell you not to. You may come out way ahead, but I wouldn't take a family member along for the ride. That could be a long term disaster...
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retiredjg
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Re: Risky investment with a "guaranteed" principal return

Post by retiredjg »

IFKC wrote:....PLEASE tell me why you wouldn't take a shot?
If you were single, I don't think it would hurt you in the long run to do this. You might lose your money, but I think you would recover.

But you are not single and my guess is that your spouse is not on board with this idea. Perhaps if this is "your" money instead of "our" money....but there are problems with that approach as well considering that you have a huge amount of student loan debt (which affects the whole family) that needs to be repaid.

Yes, it is true that many of us are older that you, but we have something you don't have. We've had your experience. We can see the world through young eyes. But you have not had our experience, have you? There are reasons that people seem to become more conservative as they age. It's because we've all learned the hard way from doing stupid stuff at some point in the past. We have a better sense of what should be avoided. You see that as being "conservative", but it might be better labeled "wisdom".

But again, I think the question revolves around the relative. It appears you can't do this without the relative and if the relative is nearing retirement and only has twice as much money as you, it appears the relative may already be in serious danger of facing financial ruin even without losing 15% of his/her nest egg. In the long run, I doubt you would be very proud of yourself if you were involved in making that situation worse.

Right now you are too involved in defending the plan that you are not seeing the full picture. Put this idea on the back burner till you can see it more clearly.
Valuethinker
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Re: Risky investment with a "guaranteed" principal return

Post by Valuethinker »

retiredjg wrote:
IFKC wrote:....PLEASE tell me why you wouldn't take a shot?
If you were single, I don't think it would hurt you in the long run to do this. You might lose your money, but I think you would recover.

But you are not single and my guess is that your spouse is not on board with this idea. Perhaps if this is "your" money instead of "our" money....but there are problems with that approach as well considering that you have a huge amount of student loan debt (which affects the whole family) that needs to be repaid.

Yes, it is true that many of us are older that you, but we have something you don't have. We've had your experience. We can see the world through young eyes. But you have not had our experience, have you? There are reasons that people seem to become more conservative as they age. It's because we've all learned the hard way from doing stupid stuff at some point in the past. We have a better sense of what should be avoided. You see that as being "conservative", but it might be better labeled "wisdom".

But again, I think the question revolves around the relative. It appears you can't do this without the relative and if the relative is nearing retirement and only has twice as much money as you, it appears the relative may already be in serious danger of facing financial ruin even without losing 15% of his/her nest egg. In the long run, I doubt you would be very proud of yourself if you were involved in making that situation worse.

Right now you are too involved in defending the plan that you are not seeing the full picture. Put this idea on the back burner till you can see it more clearly.
Endless wise words.

We really ought to put this in the wiki somewhere.

Wisdom = youth + the experience of making mistakes and watching others make ruinous mistakes

Mistakes are a much better teacher than successes. This is why it is so dangerous having 40-something CEOs in this world.

The involvement of the other relative is to me a total deal breaker.

One (good) description of venture investing has been described to me as 'invest in the business OR

put your money on the table. Cover with lighter fluid. Light a match' ;-). My own experience with startup investing mirrors that.
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Re: Risky investment with a "guaranteed" principal return

Post by Valuethinker »

IFKC wrote:
KyleAAA wrote:I wouldn't do it for 10%. The reason they are approaching you to do this instead of a bank is because it's in their best interests to do so. If the business succeeds, 10% is no big deal. If it fails, they can pay you back at their leisure without any interest expense. And since you don't have the financial heft of a bank, they probably don't have to worry so much about legal action in the event they are slow to pay.

What happens if they default? What recourse do you have other than the personal guarantee?
I'm the litigious type!

Seriously though, the issue isn't whether I could or would pursue recourse (I could and would). The issue is whether there's anything worth pursuing. That's what I intend to find out.
Civil litigation is generally immensely time consuming and stressful. It's hard even for those who 'win' to feel that they have really won. And if it gets to the court room *anything* can happen. There's a huge time opportunity cost in litigation.

When I have been involved in litigation, I don't regret settling for a percentage (probably less than 50%) of what I theoretically might have won.

Of course, we have a plaintiff pays tort system here.
Streptococcus
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Re: Risky investment with a "guaranteed" principal return

Post by Streptococcus »

IFKC wrote:
I think some of you are probably a bit more conservative than I: I'm young, stable job, and my investment represents 7% of my portfolio (the bigger risk comes to my family member). Even at a mere 10% profit, average returns on a $2 million dollar operation of this type of restaurant would ridiculously outpace 7% annual returns in the market. The marriage of personnel with opportunity offers an intriguing opportunity: why would I not consider this?
OP, I can relate to you as I'm young, I have a secure job and I'm very business oriented. But you are making a common mistake investors and entrepreneurs make. You focus on returns and disregard the risks. As you know, the two are related: the greater the risk, the greater the return. But there is a point where the risk becomes too high in relation to the return; this is where an investment becomes gambling.

A few points:
1. Keep in mind that over 70% of new businesses disappear within 5 years. When you assess a business, you should always evaluate the risk first. start pessimistic and work your way up to optimism if you can check the appropriate boxes. And I feel like you started out optimistic, that's why you write guaranteed principal without even verifying if what they put as a guarantee is actually worth it.
2. We are not a conservative forum but a diverse one. I personally have 85% of my portfolio in equities. This is not what I would call a conservative approach. So please don't take our advices as though we cannot relate to you.
3.You cannot be the one with the most to lose (you put 100%) and on top of that you are just a silent partner. That increases the risk to intolerable levels. You wrote that we are all silent investors of our equities. Well, Bogleheads are silent investors of the global economy: thousands companies. It's a pretty good place to be. You will be the silent and only investor of one company which statistically has more that 70% chance to fail over the next 5 years. That's an ugly place to be.
3. You say that you are young and it only represent 7% of your portfolio. Is that a reason to lose it? 2 quotes: Do not lose money; another one, by another wise man was "treat your money as though you will never earn it again if you lose it." If you lose your money, you will probably earn it back over time, but you may not. Don't take it for granted.

So what would I do if I were you? I would negotiate.
If the business in question has good foundations, I would ask them to put half of the money. That is a sine qua non condition. Because if you put no money in a business, you cannot feel the pain when it fails. How do they find the money? That's not your problem. If they are resourceful people, they will find it. This negotiating strategy is a risk management. You decrease your risk of losing money by having them financially involved. If they cannot find the money, you walk out and you don't look back. This would be a good deal for you and your family member because you would only be invested at 25%. That's a good place to be for a silent partner.
The business guarantee thing is useless, unless you are sure and have verified the papers and the numbers that the business that they put as a guarantee is not in debt, is making money and you could actually sell it if you end up with it. Your risk here is to end up with a failed company with a lot of liabilities and employees.
dailybagel
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Re: Risky investment with a "guaranteed" principal return

Post by dailybagel »

What confusing to me is, would your $100,000 be a loan, or would it give you equity in the business, and lead you to own 100%of the business? (I am lumping your family member in with "you.")

For example, let's say the restaurant is a screaming success. Can the operating partner buy you out by simply repaying the $100,000 back? In that case, you are putting up this money, but you won't fully participate in the upside. On the other side, if things go poorly, there may be risk to you. Other posters have discussed the value of the guarantee, and I won't get into that here.

Essentially the same question: if a third party offered to buy the business for $300,000 two years from now, would you merely receive your $100,000 in principle, or would you capture all those gains as a 100% equity holder?

My personal advice would be this: structure the deal so that the operating partner brings money to the table, and all investors would own equity according to the share they bring. The operator could put up $25,000, and you could bring $75,000 to the table. You would then receive 75% of net profits.

If the operating partner would run the business as well, you could pay him -- in his capacity as an employee -- a fixed salary plus a pre-defined percentage of the businesses' profits after taxes.

If he isn't amenable to this more traditional structure, I would pass.
Austintatious
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Re: Risky investment with a "guaranteed" principal return

Post by Austintatious »

IFKC, there's no way for us to appreciate the quality of the guarantee you speak of; however, it's integrity might not survive a bankruptcy. That's one thing you'd want to cover with your attorney. Should things go far south, the borrowers might not have the capacity to honor the guarantee, despite the purest of intentions. Ask your attorney about possible ways to guarantee that guarantee, something that might assure no loss of principal - for example, might some type of surety bond be an option?
Twins Fan
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Re: Risky investment with a "guaranteed" principal return

Post by Twins Fan »

Admittedly I have not read through the replies in this one, so maybe it's already been said...

I forget which book I read it in, but I only have a few Boglehead list books so maybe someone else will know where it's from... When one of them is talking about risk and return the book says something along the lines of, if someone offers you a risky investment with a guaranteed return... run.

Just seemed fitting for the title of the tread and the little of the discussion I did read. :D
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cheese_breath
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Re: Risky investment with a "guaranteed" principal return

Post by cheese_breath »

Streptococcus wrote:
IFKC wrote:
I think some of you are probably a bit more conservative than I: I'm young, stable job, and my investment represents 7% of my portfolio (the bigger risk comes to my family member). Even at a mere 10% profit, average returns on a $2 million dollar operation of this type of restaurant would ridiculously outpace 7% annual returns in the market. The marriage of personnel with opportunity offers an intriguing opportunity: why would I not consider this?
OP, I can relate to you as I'm young, I have a secure job and I'm very business oriented. But you are making a common mistake investors and entrepreneurs make. You focus on returns and disregard the risks. As you know, the two are related: the greater the risk, the greater the return. But there is a point where the risk becomes too high in relation to the return; this is where an investment becomes gambling.
+1 Greater risk has the potential for greater return. But it also has potential for greater loss.
The surest way to know the future is when it becomes the past.
KyleAAA
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Re: Risky investment with a "guaranteed" principal return

Post by KyleAAA »

Where does this 7% return figure come from? A 100% equity allocation (which would still probably be significantly less risky than this venture) would be expected to return something close to 10% per year over the very long term. I don't think anybody is realistically expecting only 7% nominal returns from the stock market. I'm expecting more like 9-10% from equities over the next 30 years. 10% just doesn't seem high enough to be worth the risk, but to each his own. For 13-15% I would probably bite for a small portion of my portfolio.
stan1
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Re: Risky investment with a "guaranteed" principal return

Post by stan1 »

If Steve Wozniak had posted here that he wanted to build a computer in his garage he would have been advised to go to medical school instead (or get a government job with a pension).

Not the place to discuss invention/entrepreneurship.
Last edited by stan1 on Sun Mar 02, 2014 2:46 pm, edited 1 time in total.
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ajcp
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Re: Risky investment with a "guaranteed" principal return

Post by ajcp »

stan1 wrote:If Steve Jobs had posted here that he wanted to build a computer in his garage he would have been advised to go to medical school instead (or get a government job with a pension).
Steve Jobs did not build a computer in his garage, Steve Wozniak did.
stan1
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Re: Risky investment with a "guaranteed" principal return

Post by stan1 »

ajcp wrote:
stan1 wrote:If Steve Wozniak had posted here that he wanted to build a computer in his garage he would have been advised to go to medical school instead (or get a government job with a pension).
Steve Jobs did not build a computer in his garage, Steve Wozniak did.

Edited, but point still valid. :oops:
Warning: I am about 80% satisficer (accepting of good enough) and 20% maximizer
ajcp
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Re: Risky investment with a "guaranteed" principal return

Post by ajcp »

stan1 wrote:
ajcp wrote:
stan1 wrote:If Steve Wozniak had posted here that he wanted to build a computer in his garage he would have been advised to go to medical school instead (or get a government job with a pension).
Steve Jobs did not build a computer in his garage, Steve Wozniak did.

Edited, but point still valid. :oops:
Definitely doesn't change the point, I just think Jobs gets enough credit for work he didn't do, he doesn't need any more :wink:
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cheese_breath
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Re: Risky investment with a "guaranteed" principal return

Post by cheese_breath »

stan1 wrote:If Steve Wozniak had posted here that he wanted to build a computer in his garage he would have been advised to go to medical school instead (or get a government job with a pension).

Not the place to discuss invention/entrepreneurship.
OP asked for our thoughts. Let's not censor them. He's free to accept or reject them as he sees fit.
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Random Musings
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Re: Risky investment with a "guaranteed" principal return

Post by Random Musings »

If the partners have assets that ultimately guarantee your principal, why do they need you? Perhaps, in a best case, they decided the 10% they would give you is cheaper than getting loans through traditional lending channels. And if that is the case, that means that this is riskier than you think.

I would pass.

RM
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Raymond
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Re: Risky investment with a "guaranteed" principal return

Post by Raymond »

IFKC wrote:Thanks for the responses everyone. I appreciate the perception has been almost universally "no." I think the response would be far different had I posted on an entrepreneurs forum, but I asked for the input from you and I've got some good ideas...
(emphasis added)

I'm curious what they would say on an entrepreneurs' forum - have you done so, with the identical conditions as you have stated here (100% of startup capital, 10% of return as a silent partner, etc.)?
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StormShadow
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Re: Risky investment with a "guaranteed" principal return

Post by StormShadow »

I wouldn't touch this with a 10 foot pole.
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Re: Risky investment with a "guaranteed" principal return

Post by Bidwell »

OP, you said tell me why I shouldn't take a shot?

1. All business ventures have some risk. But, You said this is a "risky" venture. Now your job is to measure the specific risk here and quantify it. Then apply that number to the normal premium you would charge for a loan. 10% might, for the purposes of discussion only, be an acceptable loan rate for a non collateralized loan without risk. From an investment perspective, you have loaded this hypothetical without solving the age old equation of a loan's cost factored by risk.

2. This doesn't look like 7% of your liquid assets. If that were the case, I'd say do it for the value of lessons to be learned.

3. Silent partners that do not have operational control have in fact have no control.

4. Your being a litigator won't help you if the business crashes. The time it would take to unwind your investment could be immense.

5. Suggest you take in that show on CNBC on startups.

6. Only since you mentioned it, I'd love to read the responses to your question on the entrepreneurial forum. Been there done that, you better stick to your day job.

In any case, good luck.
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IFKC
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Re: Risky investment with a "guaranteed" principal return

Post by IFKC »

Ok everyone, thanks for the advice.

We've decided to pass. You raised issues I hadn't considered, and I definitely had to give it a better evaluation because of you. I don't think the venture was an empty pit some people seemed to think it was :), but it was undoubtedly risky. When I pressed for better terms they declined, so we walked.

As at least a few of you noted, it's not as big of a concern for me as it is for my family members (@Modelamike: it was indeed 7% of my portfolio, I wasn't fronting 100k). If they weren't splitting the investment with me I'm not sure if I'd weigh it differently. I'd probably try to negotiate some more: the concept was intriguing, and I don't think it's a financial sin to take a chance with that %. But risking (as one of you noted) my relatives financial future just isn't worth it.
A happy father and tepid lawyer, trying to do the right thing
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retiredjg
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Re: Risky investment with a "guaranteed" principal return

Post by retiredjg »

Wise choice. :thumbsup
johnz1001
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Re: Risky investment with a "guaranteed" principal return

Post by johnz1001 »

You may be tempted to doubt your decision to back out, especially if someone else comes forward, and the venture turns out to be a roaring success. But, even if that happens, your decision was still the right one, considering the facts as they were presented to you. I can't think of a good reason why your partners would not give an inch in providing better terms. Couple that with your interest to protect a family member from a potentially poor investment at a critical time before retirement makes your decision a good one, independent of what happens in the future. There will be better opportunities, and now you have a savvy business person's baseline for what you won't accept.

It's my experience that some business people attempt to generate the best terms to protect themselves. If that leaves someone else in the lurch, so be it. But, that's not the kind of business partnership in which I would want to be involved. When two or more people share in the risk that real, that's my kind of partnership.
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Re: Risky investment with a "guaranteed" principal return

Post by Tyler's trust »

johnz1001 wrote:You may be tempted to doubt your decision to back out, especially if someone else comes forward, and the venture turns out to be a roaring success. But, even if that happens, your decision was still the right one, considering the facts as they were presented to you.
True that.

IFKC, Please update us in 2 or 3 years about the venture's progress/ success. I would be interested in how it turned out in the end and what other form of financing your friends end up using.
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