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Should you invest in a friend’s start-up? Four tips to avoid disaster

Thursday, 23 May 2013 | By Briana Everett

Your friend is smart, talented, trustworthy and successful (no bias, of course) and they've come up with a brilliant idea for a new business. Their innovative venture shows all the signs of a winner and you can't wait to see them pull it off.

But there's one problem. Like many start-ups, your friend doesn't have the cash they need to get it going.

So, should you invest in your friend's start-up?

For Laura Menschik, a financial planner from WLM Financial, the short answer is 'no'. Investing in a friend's business poses a number of risks, the obvious one being that it could ruin your friendship.

"If your friend can't pay you and you desperately need the money for your next holiday or to pay off your mortgage, they might all of a sudden start avoiding you because they haven't paid you or they're too embarrassed, and that breaks up the friendship," she says.

"And there's the stress that comes with it. The emotional and financial stress that could follow."

But if you're going to do it, despite the risks, Menschik says you need to be very clear about what you're getting into, right from the start.

"If someone was to invest in a friend's business, they should only do so because it's a good proposition for them and putting their money in that company will give them a good return – not just the principal, which is very important, but some form of interest or dividend," she explains.

Fred Schebesta, the co-founder of Hive Empire which owns Finder.com.au – a website that operates online financial comparison sites – emphasises the importance of treating the decision as an investment one, first and foremost, and to avoid blurring the lines between wanting to help your friend succeed and making a sound investment.

"Fundamentally, it comes down to whether or not the business is a good investment and whether or not you both have what I call an 'aligned horizon of investment'," says Schebesta, who has previously gone into business with a friend, only to lose that friendship due to a disparity between their investment goals and strategies.

"You may be friends personally, but in a business sense you may disagree on strategies and investment decisions."

Secondly, anyone thinking of investing in their friend's business needs to establish whether they're going to lend them money (financing) or whether they're going to buy into the business (ownership).

"You have to understand whether you're lending them money or actually giving them money and investing it in the business for a share of the profits and income and a share of the business," says Menschik.

"Understand what you're actually doing, what your friend is asking you to do and what you would get back, or not get back, over a period of time."

Whether you're simply lending your friend money in the short term or you're buying into the business with the aim of sharing some of the profits, Schebesta suggests writing down your investment goals and to establish an exit strategy.

"If I put this amount of money in, how am I going to get my return back? Is it through dividends or selling the company? What is the way in which this money is going to come back to me?" he says.

"Sometimes friends can agree on something but they never actually write anything down on paper or they don't finish it. If that is left unfinished or is left open, that can cause problems down the line and it can get messy. I would strongly encourage finishing that paperwork and making sure it's finalised and done upfront."

How to avoid a friendship meltdown:

  1. Ensure your investment horizons are aligned. Agree on the investment and business strategy upfront, write it down and make sure everyone is clear on what each party contributed and what each person's role will be.
  2. Establish an exit strategy.
  3. Separate your friendship from the investment decision.
  4. Get professional advice. Although it will cost money, it's a good idea to get professional advice before you make a decision to protect yourself and your friend. Your friend may have a very good idea, but they may not be great at running a business.

This article first appeared on Women’s Agenda.