By now, you’re probably pretty familiar with blatant money scams. Nigerian princes, for instance, never truly seek to resolve their short-term financial problems by reaching out to random Americans via email. Who knew? But what can really trip people up are the financial situations that are gray areas — the sort of money traps that are mutually beneficial in the right context but involve unacceptable levels of financial risk in others.
These sorts of deals are tricky because while they can be worthwhile, they’re just as often fraudulent or something just short of it. So, here’s a look at a few financial decisions that are worth rethinking. Study up to avoid these common money traps.
Mirror wills are an easy way married couples can save on legal expenses. They basically set up identical wills that leave the entirety of the estate to the surviving partner regardless of which of them passes first, then everything is passed along to their children when the surviving partner passes.
However, there’s nothing stopping that surviving partner from changing the will, and the children don’t really have any legal recourse to stop them. If you have a mirror will, your widow or widower could remarry, make out a new will leaving their estate to their new spouse and ultimately leave nothing to your children.
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What To Do Instead
Clearly, for some families, a mirror will really is a great way to save on legal fees. In many cases, just having a conversation about your wishes with your partner is going to be all you need, and that won’t cost you $100 or more an hour. But it’s also worth noting that when you know you won’t be there to ensure your wishes are carried out, it’s often worth being extra cautious.
One possibility could be a mutual will. Like a mirror will, it will combine your end-of-life wishes and your partner’s into a single document. However, unlike mirror wills, they can’t be altered by the surviving partner after one of them has passed. So, if there are parts of your estate you want to be sure will end up with specific people, this could be one way to make it legally binding.
An annuity is a contract with an insurance company in which you pay a certain amount in exchange for the promise of future payments. Typically, their most common use is in retirement planning. If you’re worried that your assets won’t stretch far enough, you can buy a fixed annuity to ensure regular payments for the rest of your life, whether markets are up or down.
The problem is, the insurance companies are armed with detailed actuarial tables to ensure that you probably won’t get a good value for the lump sum. And if you die prematurely, in many cases the company that issued the annuity just gets to keep the remainder of the money you’re owed. It’s part of why annuity sales plunged after the Department of Labor made rule changes in 2016 to require brokers to act in their clients’ best financial interests.
What To Do Instead
Clearly, some annuities are actually perfectly fine investments. That’s especially true for someone with a very risk-averse approach. If you’re okay with giving up investment returns for the relative certainty of an annuity — particularly if you’re extremely uncomfortable with managing your money — that choice could be the one that makes you happiest in the long run.
However, the important thing is that you should know just how much you’re giving up in investment returns for that relative certainty. Dividend stocks and AAA-rated bonds can also give you regular, scheduled payments that don’t come at the cost of sacrificing all of your potential investment returns. And the right portfolio is only going to have slightly more risk involved than an annuity. Don’t let your fear drive you to overpay for that structured payment if you can possibly avoid it.
The process of an initial public offering can be as long as it is expensive. That leaves many smaller companies interested in going public looking for other answers, and some will turn to the reverse merger. Basically, the private company will “merge” with a shell corporation — i.e., the legal structure of a public company without the actual company — and voila, you’re a public company.
Of course, if you’re listening to that and thinking, “Boy, that sounds pretty iffy,” that’s because it almost always is. If a company is not ready to go public by way of an IPO, it’s probably not ready to function as a public company. More often than not, the object of a reverse merger is really just to give the founders a chance to jettison their private equity stock on public markets.
What To Do Instead
If you’re an investor, you should take a very long, hard look at an opportunity to invest in a company that’s gone public by way of a reverse merger before you consider investing. Unless there’s just an excess of clear, documentable evidence for why this is a unique opportunity, it might just be safer to stay away entirely.
And if you’re a startup, you should probably ask yourself why it’s so important to go public that it’s worth using this method. Whether it’s VC funding, taking out loans or even just biting the bullet and filing for IPO, there are a lot of options to keep your business growing that are simpler and don’t have so many potential pitfalls.
For a long time, it was illegal to sell stock in your company to the general public unless you were a public company. It’s a way of protecting the retail investor from a host of extremely risky investments that are as likely as not to result in big losses. However, the JOBS Act of 2012 opened up a lot of new ways for startup companies to raise money, including one where they can crowdsource up to $1 million a year in exchange for private equity.
On the one hand, this is a powerful opportunity for the democratization of finance, giving entrepreneurs a chance to go straight to the people to raise the capital they need to launch their ideas. But on the other, it also means there’s a ready-made market for bad business ideas that were unable to raise money from any banks or venture capitalists to see if they can’t dupe less sophisticated investors into biting.
What To Do Instead
The thing to know about equity crowdfunding, especially if you’re an investor, is that launching a crowdfunding campaign in this manner is not easy and the payoff is actually relatively small. So, while the rare quality consumer-facing companies might see a big opportunity to raise awareness about their business and raise capital at the same time, it’s also very often the last refuge for business ideas that couldn’t find cash elsewhere. There certainly could be some good options out there, but they’re also probably going to be in there with a lot of investments that will probably never pay out.
There are a lot of high-risk-high-reward investment options to try and get in early on, including thousands of small-cap and penny stocks. While these are also very risky, most will probably be a lot less dicey than something you’ll find on an equity crowdfunding platform.
To be clear, private equity is among the most lucrative forms of investing out there, and there are a wide variety of funds and firms that have tremendous success doing so. Private equity simply describes stock in private companies. You won’t find it on public stock exchanges, but it can be bought or sold by certain investors.
However, while there are people making billions by investing in private equity, this is also an extremely, extremely risky pond to be fishing in. These are generally smaller companies with much less documentation and auditing than their public counterparts. Not only that but since the market for private equity isn’t open like public markets, there’s a certain liquidity risk associated with it as well — meaning that even if you decide to sell, you might not be able to find anyone to take the shares off your hand. If you get laid off or need to do some home repairs, you might not be able to liquidate your shares to cover your money needs.
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What To Do Instead
If you have a chance to invest in private equity, make sure you do your research. Know why the opportunity is available to you, what the risks are and be ready to lose any money you put in. And, perhaps most of all, understand that it could be years before you will have a chance to see any return on that investment and there might not be good chances to bail out.
As such, there’s something to be said for sticking to penny stocks on public markets. There, the legal requirement for regular financial reporting means you’ll have a lot more information to work with, and you will also have a much larger, more active market to sell into if your financial situation — or your perception of the investment — changes unexpectedly.
Equity in Lieu of Payment
You might have read about David Choe, the graffiti artist who took Facebook stock in lieu of a $60,000 payment for painting their headquarters and wound up making $200 million on the deal. That illustrates something that’s not an uncommon practice for early-stage companies — trading stock for services while cash is tight. In fact, offering equity in the business is one key way to retain talented employees who might otherwise get poached by well-monied competitors.
However, for every example where giving up cash today for stock tomorrow works out as it did for David Choe, there are hundreds if not thousands of stories of employees or contractors ultimately making nothing for their hard work when things don’t pan out for the company. And even when it does work out, it’s usually going to be a while before you can cash in. After all, David Choe had to wait seven years between doing the work and being able to cash in on his shares.
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What To Do Instead
A contractor like David Choe is obviously taking a huge risk in accepting shares instead of cash. It’s one thing for an employee to take equity compensation, they at least have an inside look at the company’s business model and staff. As an outsider, there’s a lot of guesswork involved for you.
What’s more, it doesn’t exactly scream long-term value when the shares are being handed out to cover bills. Companies with promising traits that really make their stock options enticing are generally much, much more cautious with who gets a shot at equity. Companies suffering money problems, potentially on the verge of bankruptcy are much more likely to start handing out stock to make ends meet.
So, while David Choe clearly made the right choice, it’s generally a good idea to get cash unless you have a very clear reason to think this company’s prospects are really good. Or at least ask for your payment in half-cash, half-stock to ensure you’ll get something even if they go belly up.
When is there a contract when you didn’t put anything on paper? That would be an implied contract, where there’s an implied business relationship based on the actions you take. So, if your neighbor starts showing up every Saturday to mow your lawn, you might assume it’s just an act of extraordinary good will. But if he hands you a bill for his services at the end of the summer, don’t be too shocked — he could make a pretty good argument that you two had an implied contract based on his actions.
And if you’re not careful, it could mean you end up on the hook for a lot more than a bill for mowing your lawn. Plenty of business relationships can muddy the waters when there isn’t a really clear, defined relationship between you and your vendors and contractors.
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What To Do Instead
Some relationships might benefit from leaving certain things left unsaid, but just for safety’s sake, none of those should be your business relationships. Before you end up getting a rude surprise, document relationships clearly and make sure you communicate your expectations transparently. Even if it feels a little awkward here and there, if you’re not entirely clear about the nature of what’s happening, it’s probably worth making sure everyone’s on the same page before proceeding.
Letters of Intent
A letter of intent is an agreement about a business relationship that’s not a contract. They can be a valuable way for people and companies to get on the same page about a potential business relationship before they put it down in black and white, sometimes allowing the early stages to get underway before all the i’s are dotted and t’s are crossed.
However, a letter of intent is a pretty hazy document that can either be too binding or not binding enough. Their relatively ambiguous legal status means that a lot is left open to interpretation. So, you might start work on a large order based on a letter of intent only to have your buyer back out without any consequences. But, you could just as easily sign a letter of intent with a supplier thinking it’s not a sure thing and find yourself on the hook for payment based on the letter.
What To Do Instead
Signing on to a letter of intent can be advantageous when everyone involved already has a working relationship and there’s plenty of trust. However, when you’re unsure of the people you’re getting into business with, that letter of intent could come back to haunt you. So, while a letter of intent can be important, there’s no real substitute for a clear, enforceable contract.
And if you’re a business or contractor that will be put in serious hardship by a deal not coming through, be upfront with the other party about what you’re risking and why you need something more concrete. If they’re unwilling to commit, well, they’re unwilling to commit and you should take that to heart.
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About the Author
Joel Anderson is a business and finance writer with over a decade of experience writing about the wide world of finance. Based in Los Angeles, he specializes in writing about the financial markets, stocks, macroeconomic concepts and focuses on helping make complex financial concepts digestible for the retail investor.