I don't have to graphically describe how a leg trap works, but it suffices to say chewing an appendage off to escape is a horrible exit plan.
When it comes to investments, I consider most investments in private companies to be human leg traps. Why? In most cases the only way to escape is by "sacrificing" the part that's invested (or in this case trapped). Let me explain.
New companies are always looking for investment capital. Business owners often have lots of ideas and no money, so they look to private investors for capital. Most of these arrangements give the investor a stake in the company by way of common non-voting shares that have the potential for growth. It's not unusual for these shares to come with a number of promises.
For example, the company is going to go public one day, or, once the company gets established, it's going to be sold to someone else, or that they will begin paying dividends. What they never seem to provide is an exit strategy. In order for you to get out of the investment, someone has to purchase the shares that you hold, which puts them in your exact situation.
I'm not referring to angel investors in Silicon Valley, or buying into large established companies before they go public. The "leg traps" I'm talking about are targeted towards the average investor who is looking to diversify their holdings and are often proposed by a friend of a friend (who in turn receives a referral commission).
While I am not a supporter of many of these private investments, the worst of these leg traps are the ones that allow you to use your RRSP money to invest. Here's why: Let's say you're thinking about investing in a private brewing company. They give you the option of investing $25,000 in cash or transferring $25,000 from your RRSP. You decide that transferring the money from your RRSP sounds like the way to go, so you sign the necessary papers and you're now a shareholder of "Leg Trap" Brewing Ltd.
When "Leg Trap" Brewing Ltd goes out of business (which it probably will), you lose your $25,000 and you can't take a deduction for tax purposes, nor can you replace the $25,000 in your RRSP.
If you keep the investment in the company until age 71, you either have to transfer it to a RRIF or you're going to have to take it into income the next year. In either case, what value do you place on this investment? If you paid $25,000, is it still valued at $25,000? How do you know? "Leg Trap" Brewing Ltd isn't going to do a valuation on the company just for you. So how does one determine the value? Isn't fair market value defined as what a buyer is willing to pay? Yes, but here is the kicker: There is no willing buyer because "Leg Trap" Brewing Ltd isn't going to buy back your shares (unless they can benefit), because nothing requires them to do so. So how do you get rid of these shares in your RRSP? As far as I can see, you do one of three things:
a) Find some other unfortunate soul to buy them from you.
b) Purchase them from yourself by taking cash and replacing it for the share certificate (this can be extremely difficult because it usually has to be facilitated through the issuing company).
c) Ask the company to write a letter to CRA confirming the fair market value or that the company is insolvent.
What if you transfer your RRSP to another institution after you make the investment? Since these are private shares not listed on a public stock exchange, the new RRSP carrier will not be able to record a cost base (beginning market value) or current market value. Fast forward to age 71, when you want to convert your RRSP to a RRIF, and the problems outlined above in #2 are further complicated by a recorded value of $0 on the investment.
It is extremely easy to buy into private companies; they will be more than willing to use your money to fund their ideas and aspirations. It is very difficult for the average investor to successfully "invest" in private companies, since success requires some type of return. I'd rather sit back, enjoy a beer as a customer, and consider some other investment options.
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