Number One Son recently asked my opinion of a potential investment opportunity – a startup business looking for funding.

“These guys are friends of ours from NY,” he told me, “and they’re building a members-only kids gym/bar, with the eventual goal of franchising. The idea is that you can put your kids in the gym, and monitor them while having a beer. Interesting, yes?

“J and I will likely put about $10K into this because we want to support our friends. But also because we think the business has potential. They’ve so far secured $75K of $375K, I think, and are currently valuing the business at $1M. High, I know. But I’m not sure how one would go about setting a valuation for a business like this.”

“What do you think?”

What to Do When a Friend Asks for an Investment 

After taking a look at his friends’ business plan, this is what I told him:

“I love how every new startup with no sales – forget profits – has a minimum valuation of $1 million. And these people have never even run a business before.

“Yeah, it’s a long shot at best.

“Here’s how I look at new business ideas: The most important facts about making any business a success are not those that are visible from the outside. You can see a lot about a business from the outside (from research). But there are always things that fall into the category of wisdom (derived from experience) rather than knowledge (obtainable through study) that end up being crucial.

“To discover those things, you have to be inside the business.

“This proposal is very well done from an outside perspective. It’s logical. It addresses all the usual subjects. It evinces assiduous research. But it doesn’t indicate that they have any understanding of the business’s inside secrets of success.

“And since I know nothing about that kind of business, I have no way of knowing whether it will – or even could – work.

“So that’s one reason I wouldn’t normally invest in it.

“The other is the issue of valuation. The era of digital startups has skewed the logic of traditional valuations. And so I’m sure these guys feel their proposal is fair. From my point of view, it’s absurd.

“What are they offering for sale? Not a business. Just an idea for a business. And the idea is not even proven. It’s speculative. What is that worth? Absolutely nothing. The value in an unproven business idea rests solely in the capital used to start it.

“Think of it this way. A reasonable reply to this proposal would be, ‘I tell you what. I’ll fund 100% of the business and I’ll keep 100% of the equity, but I’ll pay you guys a fair compensation for starting it and running it. Plus, I’ll give you 10% of the profits as an incentive to make it work.’

“That would be an offer they would be smart to consider.

“I’m not suggesting that you’d be doing anything wrong by investing $10K in this business… unless you have expectations of making your money back. These are friends of yours. You like them. So you’d be buying $10,000 worth of lottery tickets as a favor to them.

“It is, of course, easier to say no if you don’t know the people asking for the money…

“I have a number that I stick to when a friend asks for an investment. It’s my limit. It means, ‘Okay, you’re my friend, so I’m doing this. But I don’t believe I’ll get back one cent and I’m okay with that.’

“If 10 grand is your number, go for it…

“You don’t want to lose a friendship over an investment.”