Investing in a start-up company can be the way to turn a little money into a lot of money. By getting in right at the beginning you can get a significant percentage of a company with a minimal investment. It is definitely not for the faint of heart, however, and it is not really investing. It is buying a lottery ticket and hoping things turn out in your favor. More often than not they will turn out badly and you’ll lose your investment. Here’s my personal experience with buying a start-up:
Back in 1992 I met with a friend, Bob Ferris, at Mama’s Pizza next to the campus of the University of Arizona. We were both students in the engineering department and I knew Bob from the Engineering Student Council. Bob had the idea to start a virtual reality company and was looking for people to help finance his vision. I could tell that he was passionate about the business – this was what he wanted to do with his life. He knew that I was an investor, even in that day (my parents had started me with a starter portfolio to pay for college and get started in life rather than paying for my bills like most students) and he needed someone to provide him with enough money to get things going. He talked about using virtual reality as a way for architects to see the buildings they were designing and surgeons to learn their craft through realistic simulations.
A few months before we’d had a virtual reality company come to the university bookstore and set up a system, charging $5 per experience. I had seen people line up around the block to pay their money and use the system. They had a screen setup that was displaying what the people wearing the VR helmets were seeing to the crowd waiting – very cartoonish, 2-D images with very little detail. Computers were considerably slower at that time than they are now so there was not enough horsepower to recalculate a complex scene and redraw it as you turned your head, so the simulations needed to be simple. Yet people were eager to use the system because it was new and exciting. As Bob was talking, I pictured the students lining up at a virtual reality center near campus and all of the revenue that could be generated. This steady stream of cash would allow the company to start other virtual reality centers at other universities, malls, and other locations. It was an ideal business plan since operations would generate a lot of free cash flow to fund expansion. Perhaps going out for a virtual reality experience would be as common as going out for a movie in a few years.
Bob originally proposed selling bonds in the new company – a loan that he would repay over several years. I convinced him that selling equity – stock in the company – was the way to go. I wasn’t interested in a loan since the risks were too high to justify the return I would get. I wanted the chance to have a big payback if the company took off like I thought that it could. A bond would also put undue pressure on him to get profitable results quickly and take cash away from the company when it needed it to grow.
A few months later Bob called me and arranged another meeting at Mama’s pizza. He had set up the company as an S-corporation named “Ferris Productions” and was ready to issue shares. I brought my checkbook and after dinner we walked to his apartment a few blocks away. It was about midnight when we got there. He showed me the virtual reality helmet he had bought and we talked about plans for the company. I agreed to buy 2% of the company. Bob pulled out the certificates he had gotten, filled one out, and handed it to me. For a few minutes I was the only shareholder in the company until he filled out certificates for himself and his family, giving 15% shares to each family member and probably a 50% stake for himself. I joke with him off and on that while I was the only shareholder in the company I could have just grabbed the helmet and left.
I soon learned after the investment that Bob had different ideas for the company than I had. I thought he would setup virtual reality centers for entertainment and sell tickets for revenue. Bob’s vision was that he wanted to build systems and sell them to other people and companies that would setup up virtual reality centers and use them for other purposes. That’s when I learned the first lesson of investing in start-ups:
The founder’s vision of the business may be different from what you expect and there is little you can do about this.
As time went on Ferris productions began to operate. Bob brought in another individual to help with the company who also bought a stake. They would do small things, including setting up a booth at the University carnival, “Spring Fling,” in 1993. The booth at the carnival was very popular with constant lines. To keep people from standing for hours waiting for their turn, tickets were issued with appointment times at which they were to return. Things looked good.
Then things began to stall. After I graduated and went off to grad school I would call Bob about once a year and talk to him about how things were going. I always said that someday I would call and someone else would answer the phone. At that point I would know that he had made it. They were building systems and selling a few here and there, but nothing big. (Systems costs between $25,000 and $150,000 since each one was custom-made, so there weren’t a lot of customers with the needed money.) They had started a booth at a Six Flags location that apparently was doing all right, but the results were nothing spectacular. I would get a 1099 form each year from the S-corporation with a loss that I would be able to use to offset my taxes if I’m remembering correctly (at this point, you really need an accountant because the tax rules are tricky). Because it was an S-corporation, it was nearly impossible to sell out if I wanted to. I would need to find someone else who wanted to buy my shares and negotiate a price like selling a used car. I was pretty much locked in for the long haul. This was the second lesson I learned:
You will probably not be able to sell your shares for a long. long time because there is no established market.
To be continued. In the next post, I’ll tell about what happened as the company was bought out by a Texas company and became a C-corporation. Was this my big break?
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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.