Q: I'm currently working for a startup company and they gave me an opportunity to become a shareholder. I like to grab the opportunity to invest in the business since I'm also working hard to make the company profitable. Can I borrow money from bank or any financial institution to buy my shares in the company? – Glenn J by email
A: It may not be a good idea to borrow money to invest, especially if the company that you intend to co-own is just starting in the business. Borrowing money from the bank entails monthly interest expense on your part which will tend to increase your total accumulated investment cost overtime.
Since the company has yet to become profitable, the dividends that you expect to earn from your investment will be highly uncertain. It may take some time before you begin to receive cash dividends from the company. For the meantime, your interest payments will continue to drain your cash flows.
Borrowing money to invest is not a bad strategy in itself. In fact, it is a powerful tool to leverage borrowed money to generate profits. You only borrow when there is reasonable certainty that your investment will produce immediate returns.
For example, if you are in trading business and you need to buy merchandise inventory to sell next month but you are short of cash, you can borrow short-term loan to acquire your inventory and pay off the loans immediately the following month once you have sold your merchandise in the market.
Another example is if you are investing in real estate. You can borrow money to finance a condominium for as long as the monthly rental of the unit can cover your amortization immediately. In this way, you do not have to cash out so much as the cash flows from the rental can cover your loan repayments.
But in this case, you are planning to borrow to invest in something that will not give you immediate returns. Can you afford to pay the interest that the bank will charge you for the investment? How do you plan to repay the loan in case you are not able to recover your investment?
The fact that your company has no track record of profitability yet, you need to be extra careful in evaluating your risks. How well do you know the owners of the company? How competent and trustworthy are the members of the management team? How competitive is your industry? How much are they selling you the shares?
These are just some of the questions that you need to ask yourself when you are getting to know the company. Your answers will define how risky your investment is assuming things do not turn out as expected.
If you do not know the owners well, how sure are you that you will get your investment back in the future? Your company may become profitable but there is no assurance that they can give you the dividends you expect. The majority owners have the right to declare how much dividends they want to distribute regardless of the amount of profits the company earned. They can argue that the company needs to reinvest it for expansion.
If management is not trustworthy, how will you be assured that there is no mismanagement of finances? There are many ways management can siphon cash off from the company. Much as you want your voice to be heard on how the company should be managed, your ability to influence is limited because you are just one of the minority shareholders.
Before you invest, make sure that you manage your risks by knowing the company well and the people behind it. Study the terms of the investment. How much are you buying the shares? Normally, employee get to buy company shares at a discount. Understand the dividend policy of the company. How often will you get dividend? Try to check if there is any way for you to sell back the shares to company just in case you need to cash out.
As a rule, when you invest, you only risk the money that you can afford to lose. In this case, you have nothing. You are borrowing your future income for the present. This means that if you fail in this investment either because the company simply closed down or due to mismanagement, you will end up paying the loan for nothing and may take months or years for you to completely settle it. It is important that you make some feasibility first since you are borrowing to finance your investment.
If you do not have the cash to buy the shares, the other way you can do is to negotiate with your company to allow you to earn option shares. For example, you can come up with a deal wherein you can get option shares for every six months you spend in the company. You can also get extra option shares for every revenue generating project you can deliver. There are many things you can propose to the company wherein the value that you can give can be exchanged for option shares.
An option share allows you to invest in the company at steep discount when you have the money to invest. There is no hurry to own the company. It only gives you an option when you want to exercise it. In this way, you will have all the time to evaluate the company and see if it will be worth your investment. You will also have the opportunity to save money just in case you decide to be shareholder.
In the future, if your company become very successful or a bigger company buys them out or your company get listed in the stock exchange, you can always exercise your option shares and cash in on your profits immediately.
Henry Ong, CMC, is president of Business Sense Financial Advisors. You can follow him at@henryong888 or email hong[at]businesssense.com.ph.