What would you do if a friend asked you for money to start a business? Would you make a loan, become a shareholder? How would you get your money back out? Listen as I answer these questions for a West Coast viewer.
Oh hey there everyone it's Dave Barnett once again from investlocalbook.com. I got a question from a viewer about making an investment into a startup business and we had a brief exchange of emails back and forth but I thought it was a great example of a potential situation that some people out there may be looking at and I thought I would make a great video so I am going to share it with you.
Now the viewer individual was out on the west coast of the United States and he basically emailed me and he said that he has a friend who is looking at doing a start up and has a business plan all put together and has been told by a bank that he has been approved for a loan, but the friend needs to have a certain amount of cash on his own in order to get the loan. So this would be some kind of equity requirement. Now in the email, the viewer, the potential investor, said that what they are talking about a $15,000 investment. So the business start up entrepreneur has asked this viewer for $15,000 and he is basically giving him 2 options. Number 1- Lend me the $15,000 or invest $15,000 in my business and the viewer wants to know the pros and cons of each and how would he then get his money back out?
So in my book invest local, I actually have a whole section in there about why you don't want to be a minority shareholder in a small business and the reason for that is that as a shareholder in a business you get dividends, okay and dividends are controlled by two different things. Number one is the net income of the business. So it there is a net income the business can then have a dividend but the board of directors basically decides how much that dividend is going to be, when it's going to be paid out, the amount of money. So you could have an incredibly profitable business for example and the majority owners who control the board could decide not to issue any dividends. And as a minority shareholder you are not going to get any money, you are not going to get any return on your investment.
The other thing that can happen is that a business owner could manage the business so that there is no net income. So for example you know you see this all the time in companies like the construction business where the owner who is going to drive around in a pickup truck all day, instead of buying a $15,000 pickup truck will buy himself an $80,000 pickup truck. Now if that's his business and he owns it that's fine it's his business he can do has he wishes. But if you own 10% of the company and the reason there is no net-income is because all of the money that would normally be available is going to lease payments on this fancy truck, then you're going to start to feel a little bit abused because basically he is sucking up all the profits, they are not ending up on the bottom line which means that there is no money left to declare dividend with. So that's why I am not a big fan of being a minority shareholder in a small business.
Now the other option was to loan him the money. So we don't have a couple of the key details if somebody I knew approach me and said ‘Dave I have a business ready to go, I need a certain amount of equity you know from the banks point of view, I am short could you lend me $15,000?’ My first question would ‘ what's the total equity position you need to have?’ Because if somebody told me I need to put up $90,000 Dave and I am short $15,000 that means they are in for $75,000 of their own money. That's a completely different scenario than if somebody says I have no money and I would like to get $15,000 from you that I can then put in the bank and pretend that it is mine so that the bank will then lend me more money. Because in that scenario we were talking about someone who has no skin in the game, I would much rather be in business or make a loan to someone who has got $5 or $6 invested for everyone of mine, because it means they are going to fight like hell to make the business work.
Now the viewer also asked, now what sort of interest rate should I look at if I am looking at making a loan? And my advice to him was first of all, if you can at all if it's at all possible, you want to have some sort of collateral on any loan that you do. One of the reasons why the investments that I describe in the book Invest Local are so relatively risk free is because they always include some sort of security, something you can go put your hands on if the deal goes bad. So if there is security, if the guy owns a car or an RV or something that has no debt on it, and he can offer that to you as security, then you might want to look at doing this deal because there is a plan B. If the business fails there is a way for you to get your hands on some money. You can take that asset and sell it somewhere.
The other question is if there is no security at all, what sort of interest rate would you be looking at? Let's consider this from the point of view of a banker. So if I walk into a bank and I said, Mr. Banker I would like to borrow some money. There are 2 different vehicles that a bank might use to lend me some money. They might do a line of credit for instance, so in a line of credit there is probably an underwriting process. They might ask me to provide details about my assets and liabilities and might examine my net-worth. So they are getting a good picture of my overall financial position. And then they might come back and say we are going to give you an interest rate on this line of credit of prime plus of so many points, Prime plus 2, prime plus 3 for example. And many of you out there may have been in the situation where you have this line of credit.
The other way that a bank might lend you some money is by providing you with a credit card. Now when you apply for a credit card, and you can do it in many instances online now-a-days, you fill out an application form; they check your credit bureau. It shows your debts and your history of payment but it does not show your assets. So you could be technically insolvent, you could be bankrupt and if you pay your bills on time every month, you could have good credit score and that credit card could get approved. So the difference though from the bank's point of view is they haven't done the same level of underwriting for the credit card so the risk is greater for the bank but the reward is also greater because they are not charging prime plus 2, they are charging 19%, 21.9%, 23% so the interest rate is much higher and that's what compensates the bank for the fact that they haven't done a full underwriting. So I recommended to this viewer, if you are going to make an unsecured personal loan to this guy then you need to start thinking about the types of interest rates that a bank might do. You're basically being a credit card to this guy, no security, no collateral, a personal loan, we already know that he is going to use the money and represent it as equity to bank so he can borrow more money so he is going to take on even more debt and while the business plan may look good.
Business plans do look good, often business plans are not written to determine whether or not a business makes sense. Often they are written as a sales document to convince a banker to make a loan. So yeah, they often do look great on paper, everything should work out. But we know because of small business failure rates that often times it doesn't work out and we need to have a plan B. That said, I have got experience doing these deals, I would probably not do a $15,000 unsecured loan to someone who is starting a business, If it was a good close friend of mine I might say to him, look you know I believe in your project, I believed in you, I would like to help you out but with no collateral it's a little risky for me. How about I consider doing a $5,000 loan, if you can find two other people to come in with me and basically 3 of us will provide the $15,000 that you need. Now he has got to convince not just me but 2 other people to get involved in the same deal.
So I hope that was an interesting story for you guys, I know in this exchange with the viewer I went back and forth a few times and gave him some ideas about the way he should think about this deal and help to understand just exactly what the risks are. Because really it is a very risky proposition because you are talking about making a loan potentially to someone where there is no collateral available potentially. Who is then going to take that money and use it to borrow even more so the person is going to be in a highly leveraged state which means that more than ever the business has to be successful in producing the correct amount of cash flow to make sure that it works.
Anyway if you want to learn more about doing local investing deals then you should read my book Invest Local which is available at investlocalbook.com or from Amazon stores around the world and if you want to do a deal of your own you should invest in education and take my course on how to do small local investing deals which is available at localinvestingcourse.com and we will talk to you next time.
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