Investing with a Friend

Anyone who can rub two nickels together has probably been asked by a friend or relative to invest in their business.  I am not to keen on the idea in general, but I think there is a lesson to be learned for investing in general.

In both of the following scenarios, you are the only source of capital, it’s your equity and the cousin’s sweat equity.

Scenario A: You decide to invest $100,000 with your cousin, Scott.  You have looked at Scott’s financials and see that he will generate enough cash to pay you back in two years.*  Your proposal, therefore, is to structure the investment as a loan to be paid back over a reasonable time within the first 3 years with a commensurate interest rate, let’s say 10%.  Your inclination is that Scott is a good guy, but you want your money back as quickly as you can get it.

Scenario B:  You decide to invest $100,000 with your cousin, Susie.  You look at Susie’s financials and see that she will generate enough cash to pay you back in two years.  However, in this scenario, you structure the investment as an equity investment to be a part-owner of Susie’s business.  Just like Scott, Susie will be able to generate sufficient cash to pay you back in a reasonably short time, since her business is generating a high return on its capital, approximately 50% per year.*  But in this scenario, you want to share in the continued growth of the business.

I don’t want to take the analogy too far, but if you are making an investment, the feeling of wanting to get paid back as soon as possible, is for me a warning sign that I don’t trust the underlying business.  Money will surely be made by people who invest with the Scotts of the world.  But, I do think it is easier to invest and sleep at night (a winning combination) if you are not worried about how quickly you will get paid back.  To put it more directly, if Susie it generating 50% return on capital*, you shouldn’t want to get the money back, but instead figure out how to invest more.



*Admittedly, these return rates are rather absurd, but it makes the math a lot easier for the example.

More to Explore

Returns for Great vs. Bad Businesses

Munger and The Cattle Rancher

Munger’s ability to find great businesses is directly related to his ability to consistently discard bad businesses. He is excellent at inverting, and discarding the bad businesses as quickly as possible.

The Abominable No-Man and Bad Management

Some investors think a business is good, but know that management is bad.  These investors justify the investment based on the idea that the great price of the business is worth the bad management. This is akin to marrying a supermodel who is going to yell at you all day.  Whatever pleasure your eyes may derive from the marriage, your ears will endure a greater amount of pain in the long run. The pocketbooks of those partnering with bad management are likely to see a similar 50%+ decline in their net worth.

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