You’ve just been granted the business opportunity of a lifetime, and it’s your daughter’s.
She has style and savvy. She wants to start a small accessories company, selling handbags and other fashion objects she designs. Her friends think she’ll be the millennials’ answer to Kate Spade. Do you, as a proud parent, help finance her startup company?
“My first advice is, don’t!” said Allan Garber, an accountant and tax specialist for Parker, Garber & Chesney LLP in Richmond Hill, Ont.
He was half kidding, but only half. “It’s a tricky situation, and as difficult as it is, you’ve got to step back. [Get] emotions out of the way.”
Investing in a friend’s or family member’s business can be enticing. You believe in them. You want to help them. You may feel duty bound. It may even feel more appealing and tangible than investing in stocks.
But there are pitfalls aplenty.
First, you have to ask yourself the cold, hard question, “Would I invest in the idea if it wasn’t my daughter’s?” Usually the answer is no.
Second, is it an idea with a clear business plan, a clear sales plan and a clear goal for when you will see any return on the investment?
If the idea passes these tests – or at least sort of passes them – then you must consider how the business is set up. Consider personal liability and taxes, especially during the crucial, initial period.
These are business basics, but they are the same questions seasoned entrepreneurs and investors have to weigh. Incorporating a company, either federally or provincially, creates a separate legal entity, sheltering the business owners from many personal liabilities.
The flipside is that incorporating can prevent owners from claiming some personal tax credits. So if business expenses are relatively low and liabilities minimal and predictable in the early phase of a business, setting the company up as a partnership may be better, Mr. Garber advised.
“The rule of thumb that people go by is that businessess, when they start up, generally don’t make money for the first three to five years,” he said.
So while they are losing money, and if you’re not just lending money but own a piece of the business, then you want to at least recover some tax costs. If you incorporate, then losses are trapped in the corporation. (If the business goes under, however, you could claim an allowable business loss, Mr. Garber said.)
“And then at the point in time when it becomes profitable, then you want to shelter it in corporate tax, because the rates are substantially lower for a small business,” he said.
It’s complicated. And it can become even more complicated when dealing, for instance, with landlords wanting some kind of personal guarantee when signing a lease for a startup business, Mr. Garber said. “So even if you did incorporate your business from Day 1, you’re still going to have some personal liability,” he noted.
Now, if you’re just lending money to your daughter for her handbag business and not taking an ownership stake, then the structure is different. The loan could be accompanied by a promissory note with interest or a loan fee for tax purposes.
The upshot is that no matter how talented your friend or family member is, they have to understand these kinds of details and decisions, or get help from someone who does.
“Any person being asked or looking to back somebody has to assess the character of the person who’s going to be running the business. That’s paramount to my mind. Do they have the wherewithal to make this a true opportunity?” said Donald Brown, managing director of Catalyst Strategies in Toronto.
“There are a lot of people, particularly in the last five to ten years, who have been given their severance packages, and they’re out looking for something to do. They can’t get a job, so they have to go and buy a job.”
For Mr. Brown, the point about “buying a job” is key. Investing in your friend or daughter’s business isn’t creating a job for them. It’s not merely to give your daughter or friend or family member something to do, or to provide them with a springboard for their talents.
It’s investing in their business. Meaning, all the considerations for setting up a partnership, an incorporated business or a loan are concerned with the potential success of the business, its liabilities and a clear expectation for when investors will get their investment back.
“The entrepreneur has got to understand that there has to be some accountability to the person putting some dough into this. It can’t just be, Thanks very much Dad, or Mr. Brown, or Uncle Jim,” Mr. Brown said.