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Even the pros get burned mixing money with friendship. The head of a San Jose, California, venture capital firm says he lost $25,000, not to mention a 10-year friendship, after taking a stake in his friend's startup jewelry store three years ago. The problem, he says, was that nothing was in writing. "Because he was my friend, I didn't feel comfortable going through all the paperwork," says Scott Axelrod, 42 (whose name has been changed here to protect his privacy). "I didn't want to push it."
According to experts, investing in a friend or relative's business is one of the riskiest investment moves. "It's hard to take the emotion out of it," says Sam Sezak, senior associate at New Vantage Group, a venture fund management firm. But with proper planning and the right execution, it's possible to ease risks, make a healthy profit and keep your friendship intact. The key is to approach the investment as purely business.
1. Know your role. "Investors need to be clear about their motivations," says Axelrod, who admits he invested too hastily. Decide to take an active role in the business or take the back seat. Do you care how decisions are made? Do you wish to have a say in the management or marketing of the business? Does it matter how the money gets re-invested? Axelrod, who provided close to a third of the jewelry store's initial funding, began to doubt his involvement when the friend used his $100,000 to purchase a new car. "He was not spending according to the plan we had," says Axelrod. But, then again, Axelrod's role was never clearly defined.
2. Do your due diligence. Review the friend's business plan and examine the market size, competition and exit strategy. For more insight, reach out to other friends or business contacts who work in that same market. What do they see as barriers to entry? What do they struggle with? What are the opportunities? The resource centers at local libraries may also offer helpful market reports.
Next, review the business's financial model. For this, you may need to call colleagues in that industry or contact a SCORE counselor for advice.
Finally, find out who will manage the business. The friend might have great ideas but may not have the decision-making skills to run the company efficiently. "It could be a good friend, but if you don't trust him worth a dime, that could be the deal-killer right there," says Sezak.
3. Look at the number of investors. The more people jumping in on the investment, the better. It's a good sign if several people, not just you and your friend, believe the business will thrive. Bank loans are also a solid indicator. Most important, make sure the friend is digging into his pockets for at least 10 percent or 20 percent of the investment. "That's the only real test of whether it's a reasonable deal--if they're writing their own check," says Phil Gross, an angel investor.
4. Set the terms. Once the decision has been made to invest, put it in writing. To avoid tension, Gross recommends having a third party--preferably another investor who's not a friend--draft the terms and play mediator. Have a lawyer take a look at the deal as well. The National Venture Capital Association offers free samples of legal documents, such as term sheets and investor rights agreements.
Braving the formalities involved in investing in a business isn't always easy for friends--but it ensures that the friendship will endure, even as businesses come and go.Farnoosh Torabi is a correspondent for TheStreet.com TV.