Here are some benchmarks, litmus tests and key questions to ask before investing in a child’s vision.
A little-known secret of some of the world’s best-known entrepreneurs is that they might never have succeeded without the financial backing from mom and dad. Chipotle founder Steve Ells opened up his first restaurant with an $85,000 loan from his father, and the company has since grown to become a successful international brand.
Of course, not all children who receive financial backing from their parents achieve those results. And with family, there are ramifications beyond just profit and loss. That’s why parents and their entrepreneurial children should approach any sort of startup financing in a professional and businesslike manner.
“All parents obviously want their kids to succeed and do something they’re passionate about,” says Matt Smith, Portfolio Manager for Regions Asset Management. “But you also don’t want to harm family relationships by approaching any kind of business investment in a haphazard way.”
The world of private equity investing can provide some lessons and best practices to help both parents and children work together on a new business, without making Thanksgiving dinner awkward.
Real Investment, Real Risk
From the parents’ point of view, the process should start by establishing that any financial backing they provide is not a gift, Smith says. Rather, it should come with possible consequences for failure, such as a potential reduction in a child’s inheritance. And like private equity investors, parents should expect regular updates and full transparency about how the business is doing.
One way to start things off professionally is by having the child-entrepreneur pitch their business idea first to a business-savvy non-family member. “As a parent, you should introduce your child to friends who are in business so he or she can try to sell the idea to them and see if it passes their ‘smell test,’” Smith says. “If you have them pitch the idea to you first, it can create conflict if you don’t think the idea is viable.”
Assuming the child has a viable concept, the next step for parents is to insist on seeing a thorough business plan. Just like any private equity investor, parents should require their children to explain, in detail, everything from the expected launch costs and continuing expenses to run their business, to the potential market size of the opportunity they plan to pursue, to the margins they expect to achieve. Children should be able to present their growth and revenue expectations on a regular basis and also provide a timeline for when they expect to achieve certain milestones and goals.
“What are the milestones they expect to achieve, and when? Do they think that after year one the business should be profitable, or cash-flow profitable after two years?” asks Alan McKnight, Chief Investment Officer for Regions Private Wealth Management. “You need to have a multiyear plan that says specifically where the business should be in terms of revenue, costs and profits.”
Having a defined multiyear plan with specific milestones helps would-be entrepreneurs formulate a concrete plan for how their business will become profitable. It also provides defined times when parent-investors can expect an update on how the company—and their investment—is performing.
Starting with Clarity
“When it comes to family, the basic principles of investment may not always be there, and people struggle with that,” McKnight says. “You have to do a good job up front of setting expectations about both milestones and remedies, as well as the options that are available if those milestones aren’t met. If you can establish them early on, then parents won’t feel like they’re overstepping their bounds by asking for updates at specific times, and kids won’t feel like they’re not being allowed to run their company.”
Just like savvy private equity investors, parents also need to clearly establish the terms of the financing they provide and what that funding entitles them to. There are a lot of questions to consider, McKnight says. “What is the ultimate goal here? Is it to build a business and pay me back a loan?” he says. “If I invest the first million in your business and you get another $500,000 from someone else, am I a 66% owner? What is your child’s own equity stake as the operator, and is there a point at which they will buy out the parent? These are all questions that need to be answered upfront.”
Parents should also establish early on what kind of return they expect on their investment. It will vary depending on whether it’s a loan or an equity investment. “As with any private equity investment, the risk is high, so the expected return should be equally high,” Smith says. “But you don’t want to penalize the child with an outrageous return expectation, because most families would be willing to accept a lower return for the trade-off of helping a family member and potentially increasing the family’s overall wealth. What’s most important is to codify the expectation, as well as the consequences if it doesn’t work out.”
While there are many important lessons parents can learn from private equity investors, family is still family, and maintaining a strong parent-child relationship requires clear and consistent communication. “Over the long term, communication will keep the relationship in a good place, throughout the ups and downs of starting a business,” Smith says. “Whether a business succeeds or fails matters, but not as much as maintaining a strong family.”
Talk to your Regions Wealth Advisor about:
- Elements to look for in a solid business plan
- What terms and expectations to place on your investment to help mitigate your risk
- Ways to maintain a strong family bond while also managing a business relationship
