Investment Club is Making Progress

A couple of years ago, a coworker of mine decided to start a lottery pool at work, to try and win it big and retire early.  I cringed when I heard this, and considered taking what would be the one dollar per person per week dues and make a pile of one dollar bills on my desk, slowly building, showing my coworkers the money they wasted on the lottery.  Instead I considered the cost of joining ($1 per week) and the risk of not joining (being the only person in my department left to ensure nuclear fuel performance), and decided to go in with the other nine participants.  I still was bothered by the obvious money suck I had just joined, so I put together a spreadsheet to track the payments from members, the money we won (lost), and a table of what we could have purchased if the lottery money had been put in a drawer and not used to buy lottery tickets.

The spreadsheet for our lottery pool tracked the normal stuff: How much people have paid, how much
the pool has won, and when a game was played, as well as the not-so-normal: net winnings
(gross winnings - total paid in), and what could have been done with that money instead of
buying lottery tickets.

Two years later, I was something like $100 down, and the group was, obviously, around $1,000 dollars down.  I decided I had finally had enough, and quit.  It felt good to get out of that money hole, but I still wanted to do something with my money as a group.  After some discussion amongst my coworkers, it was decided that we should start an investment club.  It doesn't have that instant emotional rush you get from winning (or losing) the lottery, but there is the actual chance of making some money in the process.

Starting an Investment Club is Not Simple

I am not, nor are any of my colleagues, very knowledgeable in investing.  I know how the system works, and I understand the value in it, but what we don't know is what to look for when choosing stocks.  For that knowledge, I have tried to glean as much knowledge from my good friend and personal investor, Joshua Kennon.  While Josh is not providing us with any specific advice, his approach to investing and his methodology are what we are attempting to emulate.

We quickly realized that starting an investing club is far more complicated than a lottery pool.  There are many different variables as well as legal aspects to deal with, including taxes, legal entity creation, club voting rules, investment strategy, buy-in amount, recurring member contribution, buy-out/member leaving rules, and a number of others.  An investment club is not something to start on a whim.  I again turned to Josh for his expertise on creating a legal entity for the club as well as structuring the club properly, who supplied me with an excellent overview of what it takes to form an investment club. If you are interested in forming an investment club of your own, I highly suggest reading this post.

Investment Club Rules: Rough Draft

Since then, the member list has been mostly ironed out, and rules have been developed to manage the club (although they are still up for review at this point).  I do not want to get into specifics about money, because while I do not really care who knows how much money I have put into the club, other members might.  The rough-draft of structure are as follows:

Making the Club a Legal Entity

First and foremost, the club itself has to exist in a legal sense, because there are multiple people investing their own money, and taxes and fees must be paid.  Based on the information provided by Josh, we are more than likely going with a limited liability company (LLC) with the taxes passed through to the individual members via an IRS Form K-1.  This seems like the easiest way to structure the LLC, and that way the club itself doesn't have to pay taxes of its own.  The LLC still needs to file a tax return, but no money has to be paid by the club itself.  Since each club member is paying their own personal taxes every year (I hope!), it is just one extra form that is required to be filed along with the rest of the tax return.

Club Ownership

There are two things I want to be sure are not compromised by the rules of the club.  The first is the ability for any member to pay any amount they want per month, as long as that payment is greater than or equal to the monthly minimum.  There is no reason why every member has to have the same ownership stake; the amount of ownership is just based on the amount of their initial investment plus the monthly payments.  If one or more of the members really likes what the club is doing, I see no reason why they can't put in thousands of dollars a month and own 90% of the club.  That would just mean they would get 90% of the earnings should they decide to leave the club, as well as 90% of the dividends paid out.

The second is detaching ownership stake to voting rights.  The entire point of the club is to have the group learn more about investing, and if the member in the example above owned 90% of the voting rights, the other members would just be along for the ride.  To avoid this, we are looking to issue separate voting shares, one for each member, regardless of investment.  If a member cannot afford to invest as much as another, they shouldn't lose their voting power, because this is going to discourage membership and the club would eventually whittle down to a couple members.

Stock Ownership

To make this process as simple as possible, no member will own any shares.  Each member will own a percentage of the club based on total money paid into the club, but the stocks themselves will be owned by the LLC.  This should make like 1000 times simpler, because otherwise issues would quickly arise like different members earning different returns on investment, which would be irritating to calculate and track.  The club will just own the shares, and each member will own a portion of the club.

This brings up its own issues, like members leaving the club for whatever reason.  If this were to happen, the member leaving may not own a nice even portion of each position, meaning the club could not just sell the shares the member is entitled to in order to pay them off.  This is where the rules are not hammered out yet.  The club will offer the option for other remaining members to buy-out the leaving member's percentage, which it is hoped will alleviate this concern, but there is always the chance no one wants to and the club cannot return 100% of their investment to them.  What will be done in this scenario will have to be figured out in the weeks to come.

Voting

Each member would have one voting share of the investment club, regardless of percent ownership of the investment club.  How voting is going to be set up otherwise is still up for discussion.  We need to determine what percentage of votes is required for different types of decisions, be it a simple majority, 2/3rds, or unanimous.  That would depend on what the vote is on, and even the types of things can be voted on.  Obviously a vote would be required to change what stocks are being invested in, but there are so many variables at work that I have not fully wrapped my head around it yet.  I am hoping to have most of this figured out by the time the first meeting happens in a few weeks.

The number of members required for a vote will also have to be discussed.  I don't want to make decisions without every member having the chance to vote, but this is probably not going to be possible every time.  A number needs to be determined that is high enough to ensure group representation, but low enough to give some flexibility.  A percentage would probably be best, say 75% of members present, but percentages get messy with small numbers of members.  If we had ten members, 8 would need to be present if 75% attendance were required, but everyone would have to be at the meeting if it were only three members.  A hybrid system could also be set up, with 75% or 4 members need to be present, whichever is larger.  

Meeting Frequency

I want to make the meetings frequent enough to allow for a full discussion on the club's long term plan, as well as a review of the club's performance.  In addition, this is a learning experience for everyone, so the meetings need to be frequent enough that members actually come away with some useful knowledge about investing.  At the same time, meetings should not be too frequent because getting everyone together often will be difficult, and holding pointless meetings just discourages participation.  We are currently looking at quarterly meetings, which would be four times a year.  This seems like enough meetings to discuss new information and adjust positions as necessary without overwhelming members.  This also would be more workable with people's schedule, as I have found that getting the entire group together for a meeting is difficult.

Flexibility

I also want to make sure the club is structured in a way that allows flexibility in how the money is invested.  Quarterly meetings is good, but if some anomaly occurs that pushes a stock we are interested in to half its value, I want to be able to move on it before the next quarterly meeting.  Whether that is set up via an emergency vote, or whether a prior vote is structured in such a way that allows for that flexibility I don't know.  Voting is still a bit messy in my head at the moment, but it should get cleaned up within the next few weeks.

Initial Investment and Down Payment

To start the club, a small amount of money is needed prior to fully funding the club in order to pay for legal and any other fees that might arise in the formation of the LLC.  It is not expected to be much, but the money does need to come from somewhere.  The plan currently is to require all new members pay a non-refundable down payment of around 10% of the initial buy-in amount in order to fund the LLC with enough money to start operations.  The reason for making the down payment non-refundable is to provide some sort of assurance that interested members will not back out when it comes time for the full buy-in.  I really do not want to put in hours of work setting this up, only to have most of the members back out and be left with a hassle to deal with on my own.  If a member really wants to back out, the club is at least compensated somewhat.

The initial investment will be laid out in the club contracts, and is going to be due on day one of operations, a date that has been roughly set for the easiest time of the year for everyone to fork over the full amount (bonus time).  This is still a bit in the future, but is actually a good time because there is still so much work required to develop all the by-laws, set up the LLC, learn enough about investing, and research the companies we are interested in.  This is being done at the same time when all of us are working full-time.  What is still up for debate is whether the 10% down payment counts towards the initial buy-in (ie 90% would be due on day one) or if the buy-in would remain unchanged (ie 100% would be due on day one, and each member would have paid a total of 110%).  It is a relatively minor detail, but it is still something to be ironed out.

Adding Members

Once the club is formed and the founding members have paid their buy-in, the club needs the ability to add members.  I am not against growing the club a bit, but it also needs to be able to replace members that leave the club.  The plan at the moment is to require any potential new members to follow a similar buy-in structure to founding members, paying a non-refundable down payment of 10% the full buy-in, then the entire buy-in amount once the new member is voted in.  If the potential new member were not to be voted in, the deposit could be refunded, but not if they decide they are no longer interested.

What is yet to be decided is the amount of a buy-in.  I really hate the idea of having to vote on changing the by-laws if we don't have to, so I do not want to make the buy-in a fixed amount and be forced to change it in ten years when that amount is just too low.  There are a couple options floating around, one of which is making the buy-in $1000 in 2013 dollars, meaning the amount would adjust with inflation, or making the buy-in sufficient to ensure the new member owned a minimum percentage of the club, say 5%.I am not sure which one I like better, because the former will slowly dwindle down to a smaller and smaller percentage of total club ownership, while the latter will slowly become a larger and larger amount that may be too high for anyone to want to join.  This is something that is going to have to be up for debate at the first meeting the club has planned in a few weeks.

Members Leaving

The club will also have to deal with members leaving.  As I mentioned earlier, each member will own a portion of the club itself, not any actual stocks, so selling off stocks in order to pay them off 100% may not be possible.  An option to allow one or more members to buy out the leaving member's percentage is definitely going to be the preferred method, since this won't reduce the overall value of the club, and also pays the leaving member off 100%.  I cannot guarantee that any of the members will want to do this though, so there needs to be a way to handle the small percentage that may be left after remaining members buy out any portion of the leaving member's percentage they want, and the rest is funded though selling off shares.  I am not sure how this is going to get handled yet, though it may come down to the leaving member needing to wait until an even amount can be paid to them, either through another round of member buy-outs, or selling of more shares.

When a member is allowed to leave is also going to be tricky.  I don't want members to have the ability to just up and leave as soon as they join because this is going to be a headache for the other members and won't provide sufficient time for their money to accrue interest, but I also don't want them to feel stuck in the club forever.  Some minimum amount of time will need to be set for members to stay, but what that number will be has not been decided.  Whether it is one year, two years, five years, or ten years, I am not sure.  One of the issues with setting this time too long is that a few of the founding members are up for retirement within ten years, so I don't want them to be forced into staying on when they are retired and trying to cash out their investments.

Family Members Participation

While this club is a workplace club, I don't want to discourage club members' family members from investing as well.  This, however, brings up the issue of voting, because if each family member was considered a separate club member, the one person would effectively control multiple voting shares and could have a strong influence on the direction the club goes.  To avoid this, I think we are going to allow the club members to handle family members' money however they want, but as far at the club is concerned, there would only be one person investing, the original member.  If a member's cousin wants to invest his or her money as well, they would have to give the money to the club member, and the club member would have to give it to the club.  This would also allow family members to invest smaller sums than the amount required to join the club and maintain membership, and I think that may be more appealing for some.

The First Ever Meeting of Investment Club is Imminent

Now that work has died down to a manageable pace, investment club is moving towards its first ever meeting.  This is not an official meeting since the club is not yet formed and no interested parties have signed a contract to make their membership official, but it is a meeting to iron out the rules I discussed above, and get everyone's input on the plan.  We are all of similar experience when it comes to running an investment club, so I think everyone should be around to provide their thoughts as to how the club is structured officially.  The hope is to get agreement on the ideas I have as to setting up the club, so real work can begin to get the LLC created, creating the by-laws and member contracts, and setting up a brokerage account so money can be collected by the club.  Once this is done, the club is well on its way to actually moving forward and investing real money.  I am quite excited and nervous at the same time, so hopefully the meeting goes well.  I plan to post again after the meeting, so look for another post on the subject in a few weeks.