When carrying debt makes sense

By Lisa MacColl | June 11, 2013 | Last updated on June 11, 2013
3 min read

The experts

Barry Gekiere, Managing Director, Investment Accelerator Fund, Toronto

Rhonda Sherwood, CFP, FMA,

Client profile Katerina, a 33-year-old serial entrepreneur living in Waterloo, Ont., wants to invest in her friend’s tech start-up, which uses cloud technology to sync files between Windows and Mac OS. Katerina meets the OSC’s accredited investor definition.

The situation

As a teenager, Katerina ran her own concession stand outside a baseball stadium. In university, she formed a tech start-up designing integrated audio and home-security systems. She sold that company for $1 million. Her next start-up designed a system that changed password encryption; she sold it for several million and currently runs a consulting company that targets young entrepreneurs. She earns $200,000 per year.

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A friend’s approached her to place $250,000 into a cloud-computing start-up. To provide that funding, Katerina will have to liquidate assets, but could earn a significant return if the company is successful. Should she borrow to invest?

The issues

While still a student, Katerina used the proceeds of her first business sale to buy a house near the University of Waterloo and rented it out. That income covered the mortgage and property taxes. The property value has since skyrocketed to half a million dollars, and she continues to collect about $30,000 yearly in rent.

Katerina borrowed to start her previous companies, and wants to do the same for this tech start-up, rather than risking her own money. She has a high income and is intrigued by the opportunity to write off interest costs.

Planning for retirement isn’t a priority. She has no dependants, and her consulting business funds her living expenses. She has disability insurance, and a life insurance policy that names her favourite charity as beneficiary.

Comfortable with risk, her $1.3-million portfolio is 80% equities for maximum wealth accumulation, but has some dividend-paying stocks to lower the overall risk. She’s maxed out her TFSA and RRSP room, and has a $50,000 cash emergency fund. She lives in a modest two-bedroom condo with a nominal mortgage payment.

The start-up has approached Katerina to join its board. However, while the concept of syncing Mac and Windows files is good, most people don’t use both systems simultaneously and Katerina is concerned about the market base.

The solution

While Katerina meets the definition of an accredited investor, that doesn’t necessarily mean she has enough knowledge to choose investments of this type on her own.

The $150,000 threshold hasn’t been adjusted for inflation (if it were, it would have topped $265,000 in 2011). And, unless the advisor does a thorough suitability assessment, there’s no proof she can sustain the loss.

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“Pre-venture capital investment has the greatest risk,” says Barry Gekiere of the Investment Accelerator Fund. “Investors typically don’t recoup their investments until the company is sold or goes public, which can take three-to-seven years. If the capital runs out before the product has been developed, the angel investors could be washed out.”

As well, board members can be held personally liable if the company ceases to operate. “Having the company purchase directors’ insurance would mitigate the risk, but the premium can be expensive. It’s better to stipulate in the investment agreement that certain expenditures or actions by management need to be pre-approved, and the investor can have observer status on the board without assuming liability.”

Katerina has only borrowed to invest when she had control over the venture. When her advisor pointed out she would have no say unless she joined the board, Katerina was less enthusiastic.

Rhonda Sherwood of ScotiaMcLeod says the tax deduction benefits of borrowing to invest are nice. But “If the business fails, [and] you lose your investment, you still have to pay back the loan.”

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Client acceptance 6/10

Instead of investing in the start-up, Katerina’s advisor suggested she offer technical expertise until the company is established. Katerina compromised by investing $50,000 of her own money—she did some tax-loss harvesting by selling some failing equities—and provided business coaching.

Lisa MacColl is an Ontario-based financial writer.

Lisa MacColl