Don’t Fall For Scams: Part 3 – Business Opportunities

Co-produced with Philip Mause

Before beginning Part 3 of this series, we should note a recent development that underlines one of the concerns expressed in Part 2. Two of the largest non-traded REITs, Blackstone (BX) and Starwood (STWD), implemented caps on withdrawal requests for their non-traded REITs: BREIT and SREIT.

Both managers are very well-regarded, and this doesn’t fall under a “scam” category. However, as we pointed out in Part 2 concerning private deals (including private REITs), liquidity (or the ability to convert one’s holding into cash quickly) is almost always a potential issue. In contrast, holdings of a publicly traded REIT can be sold on the market and converted into cash quickly. To be sure, that conversion may occur at a discount to net asset value in a down market. But at least there is a path to liquidity. Before entering into a private deal of any kind, an investor should examine the path to liquidity or exit and should determine whether the unavailability of the funds involved will create a problem for him.

Some Definitions

For the purposes of this 3rd Part, “business opportunities” will include offers to participate in a business venture in which the investor is requested to put up funds on the front end as well as to engage in work or effort to further the venture. Situations in which only funds are required are covered in Part 2 as “private deals.” Situations in which only work (and no funds) are required are essentially “jobs” or “gigs” and will not be covered in this series.

Multi-Level Marketing

Multi-Level Marketing (“MLM”) is best understood as a marketing scheme in which products are sold directly by a large number of distributors. It is, thus, part of the “direct sales” industry; the sales force consists of a large number of participants selling directly to friends and acquaintances or even door-to-door. MLM distributors pay an upfront fee for a distributorship and pay for an initial amount of inventory. The new distributor then earns some (in some cases, almost all) of their income by selling new distributorships to new distributors who are then considered to be in their “downline”. In turn, the sales of products and distributorships completed by these new distributors also generate payments to the distributor or distributors with respect to whom the new distributors are in a downline. On paper, this can look attractive. Images are conjured up of distributors relaxing on a yacht paid for by the hard-working distributors in their “downline.”

A completely “naked” MLM set up with no products but only distributorships being sold is sometimes called a “pyramid scheme”. One example of this is a “chain letter”. In a chain letter fraud, a victim is induced to send an amount of money (say, $100) “upstream” to an unknown recipient. The victim then sends letters to 20 acquaintances (or names out of the phone book) requesting them to send similar amounts to a different individual and – in each case, send out 20 more letters requesting that the recipients send similar amounts to the initial victim. If this works, the victim will send out the $100 but will soon receive $40,000 (from the 400 victims two levels down from him). Instructions are prepared which make it clear that new victims are to follow the same drill and the process appears to be self-sustaining. Everyone will pay $100 and receive $40,000. Sometimes, there is a suggestion that anyone who “breaks the chain” will be plagued by bad luck.

Naked pyramids are generally illegal because they are considered to be inherently fraudulent due to the finite number of people on the planet (and more importantly the much more finite number of people able to part with $100) and the inevitable losses that will occur as (and usually long before) the “victim pool” is exhausted.

MLMs can be legal if there is an actual product being sold by the various distributors and if the sale of the product is the primary source of income in the system. There are a number of MLMs that have been in business for decades. Probably the most famous is AMWAY but there are a number of others. Periodically, there are complaints and civil actions taken against some of them.

As a general rule, there are usually a much larger number of distributors who never earn enough to offset their initial distributor fee payment than distributors who become successful, but this can vary considerably among different MLMs. On the other hand, there are almost always some individuals who acquire distributorships and thrive.

A potential investor is cautioned to:

1. Determine whether the sponsor is reputable, stable, and likely to continue in business – a search of complaints, FTC and state legal actions, etc., is necessary
2. Carefully calculate exactly what he will have to produce in terms of product or distributorship sales in order to earn back his initial distributorship fee and whether this is reasonably foreseeable
3. Investigate any evidence of the experience of other distributors
4. Become familiar with the products that he will be trying to sell.

No investor should devote a large percentage of his or her net portfolio to distributorship fees as there is an inherent risk in this setup.

A couple of other points. In some MLM systems, courses, materials, and other items are sold to distributors – so money may need to be spent even after the distributorship is acquired. Again, the investor should take care before parting with funds in these situations.

Another source of possible confusion, this section dealt with the issues associated with buying a distributorship in an MLM system. There is a completely separate question about whether or not to buy the STOCK of an MLM sponsor. A few years ago, there was a big controversy about the shorting of the stock of an MLM system sponsor. We are not opining here on the investment merits of these stocks.

Franchises

Franchises are very popular in the United States, and many investors in franchises have done very well. They are best defined as business opportunities in which the participant gets to use the name and trademark of an established business and is expected to conform to certain business standards. In many cases, the franchisee is required to purchase products or equipment from the franchisor.

If an upfront franchise fee is imposed, the franchisor is generally required to make certain disclosures by a complex set of FTC regulations. These disclosures are generally contained in a long and confusing document.

Some states limit the ability of the franchisor to terminate franchisees or to restrict the transfer of a franchise to a new purchaser. These are important issues, and investors should be very clear on exactly how these terms of a franchise agreement work before entering into a deal.

As a general rule, any investor considering entering into a franchise should examine the situation very closely, as these investments may require a significant expenditure of time and effort.

Some of the issues to focus on are:

1. The stability, integrity, and management quality of the franchisor
2. The experiences of other franchisees
3. Whether the franchisee is being granted an “exclusive” territory or other mechanisms to limit the degree to which he will face competition
4. The terms under which the franchisee can be terminated
5. The ability of the franchisee to transfer the franchise if he wants to retire or otherwise cease working at the business
6. Any legal actions or complaints against the franchisor.

If there is a franchise disclosure form or document, it may help answer some of these questions. Although it may be tedious, the investor should read this document very carefully.

Becoming a franchisee can be a major investment and career step, and all of the above questions should be examined closely before making the decision. Many franchisees have invested large amounts of their personal money, only to discover that the franchisor provides little to no support.

Other Business Opportunities

Investors can be offered other business opportunities – in some cases, partnerships in businesses in which both work and money will be necessary. In other cases – opportunities to take courses that are designed to lead to gig work or the ability to set up a new business. In these situations, all of the questions discussed above must be asked and analyzed carefully.

There are certain visas (including EB-5 visas) now being offered to individuals and families seeking to enter the United States, which are contingent upon making an investment that qualifies under the applicable regulations. Individuals considering this should probably retain an immigration lawyer to be sure that the proposed investment actually qualifies. Even if it qualifies, the investor should examine the merits of the investment to determine whether it is prudent and likely to be successful. The financial merits of the investment are a separate issue from the question of whether it qualifies to obtain the necessary visa.

Finally, investors may find themselves in the position of being offered opportunities to buy an ongoing business outright. This can be a great opportunity or a disaster, and it requires considerable due diligence. To some extent, it involves many of the considerations associated with private deals that involve buying shares or limited partnerships in ongoing businesses.

In assessing an opportunity to buy an ongoing business, it is absolutely essential to be sure of exactly what you are buying in terms of land, structures, equipment, accounts receivable, inventory, etc. In addition, you need some kind of agreement from the seller that he will not compete with you. In some cases, this concern can be alleviated by structuring the payment for the business over a period of time with the payments conditioned upon an agreement not to compete. Most important is an examination of the performance of the business and its current working capital. Recent year tax returns are essential.

In a significant transaction, you should definitely seek representation by a lawyer with experience in the area. In a large deal, you should seek advice from an expert capable of providing an appraisal of the business to determine if you are buying at an attractive price. Many businesses have rules of thumb for appraisal based on multiples of cash flow. In the real estate industry, there is the concept of Cap Rate, and knowledgeable professionals can provide guidance on currently prevalent cap rates for various types of properties.

Conclusion

Business opportunities can be great gateways to success and fulfillment. However, investors should be cautious and ask the questions outlined above before plunging in. MLM distributorships produce a large number of disappointed investors. There have been some nasty surprises for some franchise investors. On the other hand, some investments of these types work out well. With respect to all of these investments, even if the questions above are explored in detail, there is always the potential for loss, and investors must bear this in mind in determining how much of their portfolio to put at risk this way.

Bearing in mind the risks and considerations associated with other kinds of investments, for most investors, it makes sense to invest in the stock markets, such as “dividend stocks”, which provide immediate liquidity and a higher level of checks and regulations.

In the U.S. stock market, the presence of active and aggressive regulations minimizes the risk that a risk will blindside an investor due to a blatant misrepresentation of a material fact.

Yet I understand the desire that many have to continue working after retirement. Sometimes for the extra money, often for the challenge and stimulation. Many underestimate the sheer amount of time that they suddenly have available when they retire, so they decide to pursue a new business or buy a franchise. Their 401k provides an amount of capital that was previously locked up. Faced with a lump sum of capital and ample free time, it is easy to see why retirees get swept up in the notion of owning a small restaurant or shop.

It is almost always more prudent to invest in reliable listed stocks, including dividend stocks which produce a nice stream of cash flow and (in some cases) the potential for price appreciation. Ensure you are providing a base of income that you need to cover your expenses. Then if you wish to pursue a business opportunity, you have the freedom to do so without putting your lifestyle at risk.

At High Dividend Opportunities, we focus on publicly traded high-dividend stocks that offer recurrent income for investors through a model portfolio yielding +9%. A well-diversified portfolio of high-dividend stocks can provide you with a large yield and help you secure recurrent income whether the markets are up or down. This will give you the freedom to pursue your dreams.