Ask These Questions Before Investing in a Startup – Episode 99

Have you ever thought about investing in a startup? If you haven’t already, someday you’ll be approached to fund the next big thing. And maybe it’s the next Amazon.com. But before you hand over your cash, you’ll want to understand exactly what you’re getting into. In this episode of Dentist Money™, Reese & Ryan walk through the steps of startup investing and provide a list of factors every dentist should consider before jumping in.

Show notes:
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Podcast Transcript:

Reese Harper: Hey everyone, it’s Reese Harper and thanks for listening to the Dentist Money Show. Today we’re going to talk about investing in start-up businesses, and give Dentists a framework they can use to evaluate the right opportunities.
It’s a conversation that comes up a lot with our clients, and unfortunately, there’s not a lot of good opportunities out there. If you haven’t already, all of you will be approached at some point in your career about participating in a start-up. We’re going to explain how start-up investing works and what to look for if you’re thinking about doing it. It should be a really helpful topic for all of you as I’m sure you get approached quite often about this.
As I mentioned last week, the Dentist Money Show is the official podcast of this year’s Greater New York Dental Meeting. We’re going to be at the show recording interviews on-site November 26 through the 29th and we hope you’ll stop by and see us while you’re there. For registration details go to GNYDM.com.
Also check out the Dentist Money Show YouTube channel where we’re now posting video of each podcast. Finally, if you like what you hear from us, and you think you’re ready for your free consultation, visit dentistadvisors.com and click the link at the top. You’ll schedule a time on our calendar that works for you, and then we’ll have a discovery call to assess your overall situation and show you how we can help build wealth faster. You can also give us a call anytime at 833-DDS-PLAN.
Thanks again for joining us, we really appreciate all of our loyal listeners. Enjoy the show.

Speaker: Consult an advisor or conduct your own due diligence when making financial decisions. General principles discussed during this program do not constitute personal advice. This program is furnished by Dentist Advisors, a registered investment advisor.
This is Dentist Money. Now, here’s your host Reese Harper.

Reese Harper: Welcome to the Dentist Money Show where we help dentists make smart financial decisions. I’m your host Reese Harper here with my trusty old, rusty old co-host, sir Ryan Isaac.

Ryan Isaac: Getting rusty. You get near 40 you get rusty. You go from trusty to rusty. It’s gonna be a T-Shirt, from trusty to rusty.

Reese Harper: I’ve got a great story for you today that I think you’ll be interested in.

Ryan Isaac: Yeah, I want to hear this.

Reese Harper: This week we’ve had a lot of… we had an unusual amount of requests come in from people to invest in start-up companies.

Ryan Isaac: Mm-hmm (affirmative).

Reese Harper: And I thought this would be a good time to kind of talk about the start-up landscape and how it works, because a lot of people don’t really have… They hear these terms like series A, seed funding,

Ryan Isaac: Yeah.

Reese Harper: Adventure capital, private equity, what does all this stuff really mean? How’s it work and what role does it play in the life of a dentist? You know. And I think one way that I thought would be interesting to go about this is telling one of the best start-up stories of our time.

Ryan Isaac: Dentistadvisors.com

Reese Harper: Besides dentistadvisors.com.

Ryan Isaac: Oh, dang it. Okay.

Reese Harper: That story’s

Ryan Isaac: That’s for episode 100.

Reese Harper: We have a storied past, it is episode 99 today but we’re going to save that for episode 100.

Ryan Isaac: The story.

Reese Harper: In 1994, between a series of friends and family money, Jeff Bezos raised his first seed round of funding for Amazon.com. And a seed round is typically what people call that first round of funding that gets something off the ground. We’ll talk about that more a little bit.

Ryan Isaac: Yeah, we’ll get to it.

Reese Harper: He raised about a million dollars, and he didn’t interview just a little while ago, it was a presentation he did at a Vanity Fair kind of annual conference and he talked about the story a little bit. Business Insider reported on this a few months back and so a lot of the statistics that I’m getting are from that report. I didn’t do my own direct research by going and talking to Jeff himself.

Ryan Isaac: He’s mean these days.

Reese Harper: An interesting fact: when he started the company, it was actually cadabra.com.

Ryan Isaac: Cadabra?

Reese Harper: Yeah, and Jeff actually mentioned that because his parents were the first people that gave him money, and he always says they invested in what later became Amazon.com. Because it wasn’t Amazon initially. I think a lot of businesses take shape over time a lot more than people realize. The idea that Jeff had in his garage when he started wasn’t the same idea that he was raising money from four years later.

Ryan Isaac: That’s crazy.

Reese Harper: But anyway, on average, that first million, it was raised between 20 and 22 people.

Ryan Isaac: That’s so spread thin.

Reese Harper: It was quite a few people for Cedar Round.

Ryan Isaac: Half were dentists.

Reese Harper: All of them were dentists. I’m kidding, no he had his parents who put in a few hundred thousand, and then most people put in between like 30 and 40, I think there were some 50 thousand dollar investments. If you add it all together, he said it was between 20 and 22 people, at a million bucks it’s going to be around 50 grand a piece.

Ryan Isaac: Mm-hmm (affirmative).

Reese Harper: So we’re going to say 50 thousand dollars was kind of that original investment for most people. If you look at Amazon’s what you call market capitalization today, or the value of Amazon today, we’re in October 26th 2017 today, and Amazon’s trading at about 470 billion dollars this morning. So that’s the value of the company, it would be $470 billion. So let’s just round it up to an even 500 billion.

Ryan Isaac: Let’s do it.

Reese Harper: Which could happen by the end of the day. So one person that invested 50 thousand dollars has now grown their money over the past 23 years to an even, you know they’ve gone from 50 thousand to where their 1 percent is worth 50 billion. So the initial 50 thousand dollar investment was worth around 1 percent of the company and if that 50 thousand dollar investment grew to 5 billion dollars today and it wasn’t ever diluted by any future rounds of fundraising, and the investor never sold it in the public market when it went public…

Ryan Isaac: Which is kind of like, when you see your 50 thousand go to like 100 thousand out of your son’s garage company, Cadabra.com or whatever, you’re probably like, “I’m going to sell that.”

Reese Harper: That’s good enough.

Ryan Isaac: I doubled my money. Come out.

Reese Harper: Yeah so it’s unlikely that seed investors usually maintain their- we call it undiluted ownership all the way through til a company’s public and they keep holding it. There’s just a lot of life events that come up and a lot of future investors are aggressively wanting to get what they call a cap table, or the table that all the investors that are in there, sometimes there’s too many and it’s kind of not clean.

Ryan Isaac: And want to reduce it.

Reese Harper: Yeah so they’ll clean it up and buy people off and people usually can’t pass up on a good offer to take their money off the table. So either way, let’s say his parents held their-

Ryan Isaac: That’s the real story I’d really like to know. [crosstalk 00:06:42]

Reese Harper: And either way that 1 percent of Amazon would have grown to 5 billion dollars over 23 years so I bet people are wondering what kind of return is that right? So I’m going to grab my trusty old calculator here.

Ryan Isaac: Punch in some numbers.

Reese Harper: And if over 23 years you put in 50 thousand dollars of money and it grew to- let’s do it the accurate way, four point seven billion dollars as of this morning. Your annual compounded return would be about 64.52 percent. That would be 64.52. Now-

Ryan Isaac: Decent return.

Reese Harper: That return doesn’t sound quite as cool, let me give you a few other ways I could express that that would be a little more fun. And sound a lot like a lot better return. Cause you say 50 thousand goes to 4.7 billion, that seems like an insane amount.

Ryan Isaac: Like a 1000 percent return.

Reese Harper: That’s a great return.

Ryan Isaac: Yeah.

Reese Harper: Right? But one way to reflect it is I could take my 4.7 billion dollars and I could divide it by my original investment of 50 thousand and I could say I made 94 thousand X return. I invested 50 thousand I got 94 thousand times my money.

Ryan Isaac: I’ll take that.

Reese Harper: That way of reflecting sounds really great. I could also add up the return of 54 percent a year, times it by 23, and I could say I got a almost a 1500 percent return over my investment lifetime. My point of doing this little side note here caveat is depending on how I reflect the return to you, you might feel different about your investment.

Ryan Isaac: Which is really kind of an interesting point that I think will lead into what we’re going to talk about today when dentists are approached with opportunities, numbers get thrown around a lot. And I guess what you’re saying is, you could’ve told that return three different ways to make it sound however you wanted to.

Reese Harper: And you’ll see that magazine articles and websites, they will never report an annual compounded return because it’s the least exciting way to reflect a return. They’ll usually do it like the Business Insider article. It was written a few months before, written prior to this podcast and they had had like a 74 thousand X return. Today it’s even more, it’s 90+ thousand X, you know. And that’s how they chose to express it. Usually you’ll see them express it in a total return over the holding period so it’s in the thousands of percent return.
But the difference to give you a little context, let’s say it was a normal investment that his parents made in the overall US Equity market. Okay? And let’s say it grew at 10 percent a year for the last 23 years. If that were the return, then they would have only earned 437 thousand dollars.

Ryan Isaac: Weak.

Reese Harper: So you know their 50 thousand would’ve grown to 450 if they would’ve gotten a normal market return.

Ryan Isaac: Yeah.

Reese Harper: And like the difference between those two outcomes is so dramatic.

Ryan Isaac: Massive.

Reese Harper: But when you say one was let’s say a 40 percent return versus the 10. You probably wouldn’t think that that… or a 60 percent return instead of a 10, like in this case, you might not assume that that would be the difference between billions.

Ryan Isaac: No, think about.

Reese Harper: As soon as that thing was worth a billion, and you got a 60 percent return that year, you just added a lot of money, and then when the dollar amounts get big.

Ryan Isaac: Yeah.

Reese Harper: That’s why I mean it’s kind of a side note, but that’s why we encourage people to start saving as early as possible because as soon as you can get those dollar amounts, just the raw dollars to be big in an account, those returns are meaningful.

Ryan Isaac: Yeah.

Reese Harper: They add a lot.

Ryan Isaac: They do.

Reese Harper: Because-

Ryan Isaac: So today are we going to help listeners know how to find the next Amazon investment?

Reese Harper: I was just going to say that, we need to insert the little disclaimer voice guy you know when he’s like, “This is not a recommendation to invest in…”

Ryan Isaac: Yeah so I think what we’re going to talk about today is more just an understanding of the landscape and hopefully it’ll help you see how unlikely it is for this to happen. And how in hindsight, you can see some of the factors that contribute to a company having extraordinary growth, but I’m confident that even Jeff Bezos wouldn’t have ever been able to predict the success he was going to have out of his garage and it’s a lot of forces coming together that have nothing to do with things that were in his control.
So let’s jump right in and talk about some terminology just so people are familiar with this investment landscape of start-up companies. The reason I’m taking time to educate people on this is you need to know that there’s a formal, very thoroughly vetted process for raising capital for start up companies. In Jeff Bezos’ time in 1994 when he raised the money, there really wasn’t even a framework. This wasn’t being taught in college, there weren’t textbooks on it, there weren’t enough case studies to understand how it should be done.

Reese Harper: It wasn’t happening in the hundreds all over the world.

Ryan Isaac: It would not be advisable today to raise from 20 to 22 people at 50 thousand dollars a piece. That would not be an advisable seed round. That was just the only way that he could really make it happen at the time. And it wouldn’t have happened that way today.

Reese Harper: Today you’d go to one company and get the money from one person.

Ryan Isaac: Today… Let’s get into the terminology and talk about it a little bit.

Reese Harper: Okay.

Ryan Isaac: This first term that I want people to understand is there’s a time before getting your first round of funding, but that first round of funding is what’s called seed funding. And that’s what Jeff Bezos was getting from his friends and family and acquaintances. And seed funding is basically the point in time where a company that’s set up as a seed fund or individual investors, sometimes called angels, those are wealthy individuals. They get involved in putting money into a start-up company before the product or service has really been… sometimes it may be vetted a little bit, because the business has been running. But in most cases, it’s just an idea. It’s a prototype with some designs, it’s some initial forecast and financial modeling. Maybe some testing that they’ve done in a market, but it doesn’t have like a lot of proven revenue.
After that point, there are several series of fundraising rounds, sometimes they’re given in most cases are called series A, series B, and series C. We won’t go into those details, but just enough to say that as the business matures and achieves certain milestones, and starts to accomplish certain growth goals and scale, other firms and different types of investors actually come in and contribute money at different phases of fundraising.
So a seed fund or a seed round investor is not the same as a series A investor or a series B investor.

Reese Harper: And the company’s not in the same place by a long shot either.

Ryan Isaac: Yeah, and the companies themselves that… it’s very very infrequent that a company actually makes it from a seed round of funding to a series A round. The likelihood of companies advancing through fundraising stages is really low. It’s just kind of like people trying to get into dental school. There’s a lot of applicants and the people that apply or initially, the people that say I’m going to be a dentist, and then they take okay I’m for the first time, as soon as they take O Chem and get through it and they realize that [inaudible 00:14:31] they got hammered. Then they quit and they decide to be a financial advisor.

Reese Harper: (laughs) That literally happened to me.

Ryan Isaac: And so you’ve got that point where you go through O Chem and you figure out that you can hack it, and you actually, you didn’t maybe enjoy it. Some of you loved it, and some of you didn’t like absolutely love it but it was kind of a barrier to entry to getting to the point where you might apply to dental school. And then you apply to dental school and some of you get in and some of you don’t, unfortunately.And after that some of you get into private practice and are successful, and some are not as successful. And you just weed yourself out over time until the people that are left are the people that went through a lot of different hurdles to get there.

Reese Harper: What I will say is the likelihood though, the probabilities of getting to series like B or series C funding is it’s much much much smaller than being successful as a dentist. The probabilities of how many companies get seed funding-

Ryan Isaac: Actually get to that point.

Reese Harper: And then get through, it’s significantly lower than ever.

Ryan Isaac: Getting to the end of that too is near like and IPO where someone’s about to go public.

Reese Harper: Yep. Becoming a public company is kind of the goal of a lot of businesses that start out doing fundraising in this fashion, and very few will make it to that point. And so I think it’s just a good framework to start with is kind of understanding that when someone comes to you- this week I was sent two different emails from dentists about business opportunities that either friends or family or neighbors wanted them to invest in.

Ryan Isaac: Yeah.

Reese Harper: And I don’t think that they realize that these clients that I was emailing and interacting with and talking to, that I don’t think they realized that there is really a formal process of how these companies should be asking for money. And a formal way that they should be presenting their business plan.

Ryan Isaac: Because usually how it happens is what? What do we see normally?

Reese Harper: Well usually what happens is someone will say, “I need money.”

Ryan Isaac: Got this idea.

Reese Harper: I have an idea, and I’ve done a little research, I know it’s gonna be great.

Ryan Isaac: Yeah.

Reese Harper: And I don’t want to see- this happens every time but quite often, they have gone to several places to get money for their idea. They have talked to several people and they have not had a lot of success. And sometimes the dentist that is approached in the process is one of the only people that is saying yes to the idea.
And that’s kind of my worry is that if there are other…like if you have a good idea, and you have what’s called a pitch deck when you’re raising seed round funding. You have to explain your team and every single cost of your business and where your marketing budget’s going to go and all of your financial forecasting and what your product is-

Ryan Isaac: Yeah.

Reese Harper: And the size of the market you’re going after, the technology you need to build or buy, the people you’ve got to hire.

Ryan Isaac: Who’s your customer and what do you know about them and what pain are you solving, what’s the real problem that they are feeling that you are going to solve. It’s a real formal process, there’s many books that have been written on it. And a business who’s really got that story down can get funding from a lot of professional firms. If you have a good story, and you have a good pitch deck, and your business has been well thought-through, there’s a very active market for seed funding.
Most seed funds or seed companies while they know that they want to throw say 500 thousand dollars at a business anywhere from 100 thousand to maybe as much as a million dollars in a seed round. And that round of funding, they’ll know that for every 20 investments they do, probably only one or two of them are really going to do really well. And so they don’t really care if all of them are excellent, they just have to be good, logical, possible, executable-

Reese Harper: These are deep pockets that have seen, they see these things, they see these pitch decks, they see these details all the time.

Ryan Isaac: All the time.

Reese Harper: And so if a dentist is presented with an idea and you are the source of funding, the first thing that for me that says is these people don’t know where to go for money. You could say there’s two things that could happen here. One is you’re really really really lucky because the person asking you for money doesn’t know what they have. They might be just really-

Ryan Isaac: They have an Amazon.

Reese Harper: They have an Amazon and they don’t know it, and they’re bringing it to you. And they’re like give me 250 K and I’ll give you half the company.

Ryan Isaac: I would say that is not likely. Okay? That is not likely that that could be.

Reese Harper: Statistically.

Ryan Isaac: I mean Jeff Bezos was working very successfully on Wall Street in his early 30s when he came up with this idea, and it was very well orchestrated and researched; he knew what he was doing. And it was strategic, and there was a reason why he approached people that were close to him. And it wasn’t just a random smattering of events.

Reese Harper: Yeah.

Ryan Isaac: But most of the time, if you’re getting approached, it means that they’re not approaching the traditional sources of funding, and it’s important that… what I would say if I was a dentist and I got presented with an idea I would say, “Have you pitched this to any seed funds in our area?”

Reese Harper: Okay so that’d be one good question to ask then.

Ryan Isaac: Yeah.

Reese Harper: Where else have you asked for money.

Ryan Isaac: Who have you pitched this to? Can I see your pitch deck? What’s your pitch deck look like? If you want to email me, Reese at dentistadvisors.com or email Ryan at dentistadvisors.com we can send you some sample pitch decks that you know we see or that we’ve been pitched or-

Reese Harper: That would show like the amount of detail and thought that would have to go into something.

Ryan Isaac: Yeah and I’ll probably send a template of what it should contain.

Reese Harper: Okay, cool.

Ryan Isaac: What each page should look like and what you should see. Usually what it is is it’s some like half-baked email with a word document attachment with some claims on it.

Reese Harper: Yeah.

Ryan Isaac: Like “we’re going to grow to this much” and that’s-

Reese Harper: Or there’s like a spiral down thing that they can’t leave behind so there’s one copy of it.

Ryan Isaac: Yeah, the spiral behind the, this is mine.

Reese Harper: I’d be turning it like I can’t leave this with you.

Ryan Isaac: Yeah, so I think that’s probably the first start on the seed funding idea is where else have they pitched this first?

Reese Harper: Okay so the question would be why is it important for a dentist to know where the opportunity is at in terms of funding? Like why would that be important for them to know where they’re at?

Ryan Isaac: Well first of all, from our perspective, this is something that a lot of dentists will do regardless of what I’m about to say so I’m okay with that reality. But a lot of dentists will invest in things like this very prematurely when they don’t have enough stability, or financial wealth, or like just overall wealth and liquidity.

Reese Harper: Mm-hmm (affirmative).

Ryan Isaac: They just take too much risk too early in their careers. And so what happens is both the company and the investor are kind of in a weak situation. A company that starts out, they don’t want a seed fund investor who represents a large portion of their wealth.

Reese Harper: Yeah it’s dangerous.

Ryan Isaac: Because if they don’t have the pockets, and you need more capital.

Reese Harper: Or more time.

Ryan Isaac: Or more time or more patience or more flexibility, you don’t want your investors breathing down your neck because they’re hungry for the money. And most dentist that will do this might… I’ve seen people throw 100 thousand and they might only have 500 thousand liquid. That’s 20 percent of their liquid net worth or I’ve seen people throw 100 thousand when they have 200 thousand available.

Reese Harper: Yeah, uh huh. Or all their money.

Ryan Isaac: All their money, yeah.

Reese Harper: And I think most people are listening to this like “I would never do that” well, I think it’s probably true. Most of you would not take all of your discretionary money and do something like this, but the real question is at what point is it proper to even start considering it? I think that’s going to be a hard call because it really does depend on-

Ryan Isaac: It’s really personal in the situation.

Reese Harper: Yeah and the business itself.

Ryan Isaac: Yeah.

Reese Harper: Like how good of an opportunity is this really? And how good of a… It might be really specific to the area of the world you live in and the opportunity that came up that’s right next to you.

Ryan Isaac: Mm-hmm (affirmative).

Reese Harper: I never want to tell somebody don’t invest money in something that comes up.

Ryan Isaac: Yeah.

Reese Harper: Because really, these markets aren’t really efficient and there’s things that happen that can be a good thing for people.

Ryan Isaac: Yeah.

Reese Harper: But it’s rare and more likely than not, you’re part of the statistic that I shared earlier where businesses don’t even make it through that seed round of funding.

Ryan Isaac: Yeah.

Reese Harper: So why should dentists ask the question of have you pitched to someone else? Well it helps someone who’s more experienced, who’s seeing these all day long, probably dozens of pitches every day.

Ryan Isaac: Think of like the Shark Tank.

Reese Harper: Yeah. It helps someone else just evaluate it, and then give feedback.

Ryan Isaac: They’re rehearsing the story in front of people who’ve seen it dozens and hundreds of times.

Reese Harper: Yeah and they’ll get feedback and they’ll have to go back to work and go and improve something in their business that probably wasn’t ready for launch.

Ryan Isaac: Mm-hmm (affirmative).

Reese Harper: Or they might get a really positive feedback and then you’ll see that while there’s some interest here and maybe I’ll want to participate and see if I can participate.

Ryan Isaac: But you could get that validated before you know what you’re getting into.

Reese Harper: Yeah.

Ryan Isaac: And you’ll usually find that these initial presentations or pitches that happen to seed funds, they end up resulting in good feedback to the entrepreneur, good information and then that person will go back and if they’re still excited about the business opportunity, they’ll keep working on it. If they’re not excited about it, then they just quit and you won’t hear from them again.

Reese Harper: Okay.

Ryan Isaac: Because the investor will tell them something that’s really really important for them to know that’ll just make them kind of quit wanting to pursue their business. And you want to know that in advance, so anyway.

Reese Harper: Yeah. And I think that you made a good point though, I mean if you’re being approached for an opportunity and the person approaching you…I mean maybe they don’t know, but if you’re the main investor and you’re taking too large of a chunk of your net worth, you know you’re putting, you’re tightening the screws a little bit on your own cash flow and your own timeframe of when you need the money and someone’s willing to put you in that position in order to get their business started. That could be maybe a red flag of they haven’t done enough homework or they’re kind of desperate to find money anywhere they can get it.

Ryan Isaac: Yeah.

Reese Harper: But they just don’t know.

Ryan Isaac: Yeah. And I think that’s where the more you learn about this kind of stuff, you’re able to at least feel confident in these discussions and not feel like someone’s pushing you around with information.

Reese Harper: Okay cool.

Ryan Isaac: So the point is today we’re going to go through a couple more of these things that are kind of red flags that you can kind of push back on, and at least give yourself a chance to properly evaluate something or decline it politely based on something that’s actually wrong with their pitch, right?
So I think one of the things that I like to look for is how many founders or investors are already involved.

Reese Harper: Okay.

Ryan Isaac: And how much did each of them contribute to the business, was it just intellectual capital that they contributed meaning like hard work and energy and everyone just got like 25 percent of a company to start out [crosstalk 00:26:16]. Or did someone put in some money. Who’s been there the longest? What’s the ownership structure going to look like because the challenge is how is this business going to look in two or three years. You know it’s going to be really important that each of the investors or employees or partners has either for everyone it’s usually either income or equity, and if someone has a really strong income or their income is comfortable, then they might not need as much equity.
If they don’t have as much income coming out of the business, they might need more equity. Like everyone’s going to have to be motivated by something long-term in order to continue to stay involved in the business. But if there’s four partners, and each of them own 25 percent of a start up, and you’re the founding like fundraising partner, I mean the business has to get exponentially larger for everyone to get paid off.
For example, think about Jeff Bezos. He didn’t bring four partners to the table each with 25 percent ownership and then sell 20 percent to investors. It was just him and he only sold 20 percent of the company total to get his first million dollars of funding. That’s very different than if there were four people that came to the table and all four of them raised the million dollars and they sold 20 percent of the company. Because if each of those 25 percent partners sold 20 percent of the total company, they’d each be left with 20, not 25 anymore. Right?

Reese Harper: Mm-hmm (affirmative).

Ryan Isaac: Which means that now each of those four people instead of like in Jeff Bezos’ case where he owned 80 and the investors owned 20 and he still had a big incentive to keep working, well all four partners only had 20 percent ownership and so it’s already a disadvantaged what we call cap table right from the get go where too many people that haven’t proven their value yet are asking for a lot of equity with no-

Reese Harper: They already have…so the problem could be, I’m just thinking of this in terms of dentists you know, let’s say they put in some money maybe a couple hundred thousand into this idea, and it’s a great idea, it’s a good company but if what you’re saying is if there’s too many partners or however many people are involved own too much of the company, you might find yourself in a position where the quarter of a million bucks that you gave lasted two years but you need more money. It’s a great idea, it’s a good business but it needs, now it needs a couple million but the people that could give it aren’t willing to come in and give it because-

Ryan Isaac: There’s not enough upside for them.

Reese Harper: There’s not enough upside, not enough to give them an equity in the company so that either means everyone has to now dilute big time or people are just going to pass and not be interested.

Ryan Isaac: Yeah, dilute means just take less ownership.

Reese Harper: Yeah.

Ryan Isaac: All the original people would cut their ownership down.

Reese Harper: Yeah. So the original investment- there’s a word called a capitalization table, it’s basically just a chart that shows who owns what. And that table of ownership’s really important and there’s a way that you want it to look as your business progresses and there’s a lot of strategy involved in it because in order for you to continue to raise money and continue to grow, continue to expand, it needs to be set up properly and not have- it needs to have room for future investors to be able to have upside. And it needs to have room for employees who are going to be needed in the future.
As the business grows you actually need different types of talent that you didn’t need before. And so if you don’t have equity available for people moving forward then the business can get in a bind and not have the proper incentives to bring on the right talent, and it won’t have the right incentive to bring on the right investors. I see that happen quite often, it’s just people are starting businesses and they have no clue how to structure their–

Ryan Isaac: They’re kind of willing to just say, “I’ll just give you like a huge chunk because I just need the money from you.”

Reese Harper: Yeah.

Ryan Isaac: Okay.

Reese Harper: And they make unrealistic like promises that aren’t really… one of the businesses that I saw pitch a client recently, it was promising like a whole series of commitments to this investor, this dentist, that it couldn’t realistically stick with. Like a certain amount of return every year it was promising, on top of a growing amount of equity and some perks that just aren’t really typical in a seed fund, a seed round of funding.

Ryan Isaac: Mm-hmm (affirmative).

Reese Harper: And so I think it’s really important to kind of gauge the competency of the pitch that’s being given to you by having some other smart people look at it. And if that’s a seed fund great, if you have an advisor or a friend who knows this type of work, might be an MBA that you’re friends with that’s raised money for their own business. Float something like this by somebody who’s done it a few times, because you’ll see in this initial round it kind of tells the story of the sophistication of the people you’re about to work with.

Ryan Isaac: How much thought’s gone into it, how much people even know. Sometimes you just don’t know what you don’t know.

Reese Harper: Yeah. Now here’s one caveat note and then I think we can move on to a different section is sometimes you knowing more than the company puts you in a situation where you feel like you’ve got an advantage over them where you might know something they don’t or maybe you feel like you’re getting a great deal and it’s just because you’ve got money and they’re desperate. And so you want to take advantage of that.

Ryan Isaac: Yeah.

Reese Harper: In most cases, that’s not really a great investment to make because you’re still going to depend heavily on those employees and those owners to make your investment actually come true.

Ryan Isaac: They should be smarter than you.

Reese Harper: Well they should be smarter than you, and even if you know a little bit more than they do, if they don’t have enough upside and once they find out that it wasn’t a good deal for them, and once they find out that it was one-sided and that you kind of took advantage of them, they’re going to be demotivated and stop working and be frustrated at you and it’s going to be a really bad culture.

Ryan Isaac: Interesting.

Reese Harper: So business in my mind, I don’t believe in one-sided transactions, like I don’t believe in our firm as financial advisors, I don’t believe in a fee schedule that if clients because you know dentists don’t know exactly how to compare financial advisory fees across the industry really easily. Last week we did an episode on it to try to help them with that so they could understand it better.
But it’s not easy for a dentist to sort of compare 50 different options and decide which one’s the best for him in terms of what’s fair, but I think of our pricing or our fee structure in a way where I go if a dentist had the knowledge that I have, and they knew everything I knew, how would they want to be charged? Like how would they want to pay for the service?

Ryan Isaac: Yeah, that’s true.

Reese Harper: And I think the same thing you want to do when you’re investing in a business is if these founders knew as much as I did, how would they want this scale to be structured? Because they’re going to find out eventually, about how inequitable the deal was or how good the deal was, and you need to make sure that every deal is fair for both the shareholders of the company that are the investors and the founding partners and I think that’s usually not something that dentists think about. A lot of times when I talk to a dentist it’s that they don’t know what they have or I know that this thing’s going to be big, and in some cases they feel that they know a little bit more than the-

Ryan Isaac: Mm-hmm (affirmative).

Reese Harper: Because they have more money, sometimes that translates to them feeling like they know more. And in some cases they do.

Ryan Isaac: Yeah.

Reese Harper: But that doesn’t necessarily mean that the deal should be one-sided.

Ryan Isaac: Okay. Anyway.

Reese Harper: When people come to you Ryan and ask you about investments like this what are some of the risks that come with investing in something like this?

Ryan Isaac: Yeah, I mean one of the- we talk about this a lot, too with the different types of investments. One of the biggest things on the table that you risk to give away in a lot of investments is your own liquidity. That’s what you were talking about this earlier, what percentage of your net worth or liquid investable assets are you putting at risk here? You know, how much of everything that you have access to right now, are you willing to turn over, and not have access to maybe ever again? Or for not a very long period of time.
So these private investments, probably one of the biggest risks that would be on the table for a dentist is that they take whatever amount of money, and however much percent that is of everything they have and what if it disappears or what if you can’t get it for 20 years and you need it in 10, you know? Or even if it’s going to grow a lot, liquidity’s just a big issue if you don’t have access to it and you need access to it then you’re probably just not in a situation to give it up.

Reese Harper: Yeah, I think you’re bringing up a really important point. A lot of times in a sophisticated investor, they want to know exactly how their money is going to be used for growing the company versus paying the people that work there, and how profits and distributions are going to be made. So they’ll and a lot of times dentists won’t realize that they’re investing in a business that really hasn’t clearly stated how money will be used and when profits will be paid out. So for example, if someone’s salary is not transparently agreed upon, then they can pay themselves more or less, or they can pay themselves a lot more, and that would just reduce as an investor, the profits that you might receive one day.
If you don’t have some general understanding in the operating agreement or at least haven’t discussed this,

Ryan Isaac: Of what expenses would be expected to cap.

Reese Harper: Yeah, what are you going to pay yourselves, and when do you get raises? How are you expecting to do that in a fair way?

Ryan Isaac: Or when there is profit, at what point are we not putting it back into the company, when are we not buying more technology or more product or more marketing?

Reese Harper: When are we going to pay a dividend out?

Ryan Isaac: Yeah.

Reese Harper: And that’s a decision that if the founders haven’t really thought through that and modeled it into their business plan, that will be a point of concern and it will come up. At some point down the road and it won’t be easy to decide on it later, something you kind of need to address early on so at least people are on the same page.
Anyway, it’s also important to think about when you’re going to be able to get rid of your stock, how, and who’s the buyer eventually for this. When are they going to come in? What’s the likely exit event? For what industry is this product for? What type of buyer is this service for or technology for? Anyway, I think it’s important like Ryan said to figure out what percentage your net worth should possibly go into it, clarify how all the cash is going to be used, and then really understand when you’re going to get your exit, and how you’re going to get your money out of it.

Ryan Isaac: Mm-hmm (affirmative), who’s going to buy out of that. And the other thing I was thinking about too is you think about the word diversification, we talk about that a lot in understanding how a balance sheet is made up. I was having this conversation with a client this week about forming categories of diversification on a balance sheet. Liquid assets, retirement assets that are tied up in 401K type of stuff. If private business ownership and real estate, or land. And it’s important to know, look at your assets like a pie chart in those four categories. Those are pretty basic general categories.
A lot of dentists, especially early in their career with the amount of money they put into a practice and sometimes buildings and houses and land, how lopsided their assets are on their balance sheet in favor of just private investment, private business investment or real estate. And how little liquidity they actually have. And so I think it’s important to just realize what diversification actually means.

Reese Harper: Yeah.

Ryan Isaac: In terms of your own balance sheet, and your assets and ask yourself if I added another 250 grand, if I took 250 grand out of my liquidity bucket, and I put it into private business bucket, how does that pie chart look? Did that little section just get even bigger and more lopsided and what does that do to me long-term? And if I want to retire in 15 years can I actually expect to get my investment out of that thing in 15 years or how am I going to get paid along the way and replenish the liquid bucket that I took from.
So understanding diversification on your own personal balance sheet and understanding where these opportunities fit in and how they contribute to either more balance or less balance I think is really important too.

Reese Harper: Yeah. I think the final note I’d like to make is that this asset class of private business interests is something that you already have invested in heavily as a dentist, like Ryan said. And you don’t need to invest in it in order to have a really successful financially independent life, and so for most people I’d say you probably shouldn’t do this unless it’s so compelling and the pitch deck is so organized and you respect the people so much, and you’re fairly advanced in your career, with quite a bit of liquidity, and it just seems like it’s been thoroughly vetted and you’re the right partner.

Ryan Isaac: Mm-hmm (affirmative). You’re not just the only person that they knew with some disposable income.

Reese Harper: Yeah.

Ryan Isaac: You’re actually the right investor.

Reese Harper: You’re the right investor because you get along with the person, and you have a lot of money to bring to the table and they want a partner that they just like, that’s a perfectly acceptable position, or you’re a person that has some knowledge about the thing that this business is going to do and you can offer some unique insight. That’s usually a good sign that if you are one of those two, meaning you’re highly liquid, and you’re able to contribute money at a quantity that other people probably can’t, or you have unique knowledge. Maybe you are a good investor candidate.
Otherwise what you’re probably getting pitched is a business that hasn’t thought through anything. A pitch deck that’s prematurely trying to get money. Founders that don’t know what they’re doing, and they’re going after an investor in you that is the only person they can find to give them money.

Ryan Isaac: Here’s a person they know who has a lot of income.

Reese Harper: Yeah, and you don’t want to be in that position. Doesn’t mean that that’s the case every time, but more often than not it is the case.

Ryan Isaac: Yeah, yeah it’s really common.

Reese Harper: And I just don’t like to see people get taken advantage of because as a dentist let’s just say an average makes between 250 and 300 thousand a year across the US-

Ryan Isaac: The average dentist.

Reese Harper: The average dentist. And that their disposable income on an annual basis that they can actually do something with is somewhere around, at that level it’s seven to eight thousand a month. Maybe as much as, it’s five to eight, maybe five to nine thousand a month. So over a calendar year it’s 60 to maybe 100 thousand at most. For the average dentist and if it takes you three years to save up enough money to be able to invest in a private business like this and you do it at the early end of your career where your liquidity is primo important right? And it just disappears on you. Then really what you’ve given up is not just three years of work, because that’s one way, you gave up three years of work but you gave up all of the growth that would come from that money in a more standard retirement account over 20 to 25 years, and that could result in as much as six to seven years of extra work that you have to put in at the end of your career.

Ryan Isaac: Yeah that’s a good point.

Reese Harper: To just make up for it. Now if you do it at the end of your career, and you have financial liquidity, and you’re financially independent, you’ve got your retirement taken care of, and you lost 300 thousand dollars, it probably actually doesn’t hurt that bad.

Ryan Isaac: Yeah.

Reese Harper: Because you already have the compounding growth of the money. It’s still painful.

Ryan Isaac: Mathematically, it’s just not as [crosstalk 00:42:41].

Reese Harper: It’s not as consequential later on because you already have this big pot of money that’s compounding, you’re just reducing the size of the pot a little bit. But man when you do it at the beginning of your career, it’s just super costly. So my advice would be if you’re going to do something like this, continue to listen to the podcast, and listen to other shows that kind of help you understand entrepreneurship, and find the right business opportunities later in your career when you’ve already built up enough liquidity and know what type of business you want to invest in, what you’re comfortable investing in, and do it with an amount of money that won’t hurt your future.

Ryan Isaac: Okay. So let’s just recap a few of those points then so point number one would be understanding what phase the business is currently in. What role you play as an early investor? Are you the first person are you the only person?

Reese Harper: Yeah.

Ryan Isaac: What phase are they in? Two would be you want to understand really clearly the inner workings of the company and that comes- you talked about pitch deck.

Reese Harper: Yeah.

Ryan Isaac: And again, you could email us Reese at dentistadvisors.com or Ryan dentistadvisors.com and we can email you like a sample like an example of how thorough something would need to be for you to feel good about these people have thought through this enough.

Reese Harper: Yeah.

Ryan Isaac: And the financials, too. Where’s all the money going to go?

Reese Harper: Yep.

Ryan Isaac: How’s it going to be spent?

Reese Harper: And in that pitch deck, one of the sections will be financials.

Ryan Isaac: Okay. A third one would be understanding who else is involved, what other investors, what other partners have been involved, what equity did they have, what have they brought to the table, what is their role, what are their expectations, what kind of situation they’re in. Four would be understanding your own personal goals, how does this fit into your own balance sheet and diversification? What percentage of your total liquidity are you thinking about using? What’s your own time frame for when you would need this money back?
And then you’d want to know that this idea or this business has been in front of other people. Like you mentioned, other seed funds or people who give money to businesses that have seen it a lot of times.

Reese Harper: Yeah.

Ryan Isaac: You’d want to know the business has been in front of those people, that have it vetted too.

Reese Harper: Yeah you can find in your community and in your neighborhood, there will be people that market themselves as angel investors and they’ll be kind of well known in the entrepreneurial community, and there’ll be a seed fund. It depends on what state you’re in, certain states have really active entrepreneurship communities, and others are just not as healthy but if you look around the country right now it is… This segment of the market is growing like crazy, and it’s becoming more of a standard way to invest capital. It just needs to be…There’s a right and wrong way to do it and there’s a right and wrong time to do it.

Ryan Isaac: Okay. All right well again we have a new YouTube channel so you can find the Dentist Money Show on YouTube and we also want to remind everyone that we’re going to be the official podcast of the Greater New York Dental Meeting, and that happens on November 26th through the 29th 2017 this year, it’s right after Thanksgiving. So stop by, say hi if you’re in the area, for registration details you can visit GNYDM.com, it’s Greater New York Dental Meeting GNYDM.com. We’ll put the link in the show notes as well. If you feel like you’d like to speak with us, you feel like you’re ready for a consultation, have a conversation you can schedule that consultation if you just go to dentistadvisors.com, click the link at the top of the page, you’ll pick a time that works for you, and then we can talk about your specific situation and how we can help you build your net worth faster. Or if you like, you can just call us. 833-DDS-PLAN. It’s 833-DDS-PLAN. And we’d be happy to chat with you. Thanks guys, thanks everyone for listening.

Reese Harper: Carry on.

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