He must have been shocked. We'd never discussed a role for me as an investor. He didn't object, however, and I felt very confident putting my money behind him. I knew that he'd listen to me and let me help him achieve his goals, and that's all I really wanted.
Rule 2
When possible, go it alone
I don't do large-scale, limited-partnership investing anymore, but I used to. During the 1970s and 1980s, I invested in everything from flat-screen-TV technology to glow-in-the-dark toys, usually with groups of 5 to 50 people. I can't recall a single deal in which I made money. In most cases I wound up losing my shirt, or at least a portion of it, and I often had to sue to try to get something back. It was extremely frustrating. I'd see people making decisions that I knew would be disastrous, and yet I had no power to stop them.
There was one deal, for example, in which I helped finance a business that was marketing a new type of toilet seat, called "the American bidet." Believe it or not, it was actually a good product. The problem was that we had seven partners, each of whom wanted to market it his own way. It was like having a ship with seven captains. We kept going around in circles. In the end we wound up selling the rights and the inventory. Of the $35,000 I'd invested, I got back at most about one-third.
By the early 1990s I'd had it with passive investing in groups. The only way I'd ever made any real money was with my own two hands. If I was going to back any more new ventures, I decided, I had to be a player, not a bystander. Somehow I had to make sure I preserved my capital and retained some influence over what was done with it.
The result is that I've wound up going it alone. In all the deals I've done since then, I've been the sole outside investor, and it's turned out better for everyone concerned. Granted, I have to stay away from deals that require more capital than I can come up with on my own, but that's a trade-off I'm willing to make. I'm a headstrong person. I have my own ideas about how to build a business, and they sometimes differ from other people's ideas. I don't mind trying to work out those differences with the person who's running the business, but I have no interest in getting into debates with other investors. Better that we go our separate ways.
Rule 3
Take a majority stake until your investment has been repaid
Most people build their investment strategies around achieving a certain rate of return on their capital. I take a different approach. My number one goal is preservation of capital. Not that I don't want to make money, but I focus first on getting my investment back. Toward that end, I insist on owning a majority stake in any new venture I finance. The deal is that as soon as I've been paid an amount equal to my initial investment, we'll issue new stock, and my stake will shrink to 25%.
Usually, I take 51% of the stock in the beginning. In David's case, however, I took all of it because the restaurant didn't open for business until mid-October, and so we knew there were going to be significant losses in the first year. I wanted to use those losses to reduce my taxes, and I couldn't get the full benefit unless I owned 100% of the stock. Nevertheless, the principle is the same. Once my initial investment is repaid, my share will go to 25%.
I do this for the obvious reason: I want full control of the company while my principal is at risk. I'm careful, however, about the way I exercise that control. I give advice, but I don't interfere. I don't make decisions.
Not that I keep quiet. Early on, David told me he intended to hire a public-relations firm at $1,500 a month. I wasn't thrilled. I generally advise start-ups not to waste their money on PR. We talked about it. He said that in his experience you needed a PR firm to get reviews, and reviews were critical to a restaurant's success. One good review could generate enough business to cover a year's worth of PR expenses.
Who was I to second-guess him? I know business, not restaurants. As long as he had a reasonable rationale, I wasn't going to stand in his way.
David hired the PR firm, and it turned out to be a great decision. Within weeks of the opening, the restaurant's name began popping up all over the place. There were good reviews in the Daily News, the Times, and various city magazines, all of which helped the restaurant get off to a fast start, far exceeding our initial projections.
Of course, I wouldn't hesitate to use my authority as majority owner if I thought the entrepreneur was acting irresponsibly, but I almost never have to. People understand and accept the arrangement, and I always get my investment back, usually in a short period of time. I haven't lost a dime on a venture deal since I began to apply this rule.
Rule 4
Retain the right to force a payout
Nobody invests in a new venture just to avoid losing money. If the business is successful, I expect to make a good deal of money--more than I would make by putting my capital into a bank or bonds or publicly traded stocks. My goal, after getting my principal back, is to earn 33% of my initial investment every year for as long as the business is in operation. Of course, I don't want to bankrupt the company or leave it undercapitalized. Nor do I want to deprive the person running the business of the opportunity to make money as well. So I'm prudent about what I take out.
But I want my partners to understand up front what I hope to earn by putting my capital at risk, and how I expect to get it. Unfortunately, I had to learn the hard way how to keep from being burned.
