Choosing members for your group
One of the most significant benefits of an Investment club, apart from spreading the risk, is that you can leverage knowledge from all the members, so invite members that will compliment your skill set.
Ultimately you should look for members that you feel will be keen to get involved (and likely to be committed throughout).
Make sure each potential member understands the risks involved and that there is no guarantee that the club will be profitable.
Consider the following, when choosing:
Type of club
The Club’s members will largely be governed by the type of club you are looking to start. For instance, this might be more of a social club, rather than a strictly business club. Whichever type you decide on, choose members that are aware of this and buy in to that approach.
Aim for individuals that you feel will add some experience or knowledge in a certain area. For example, if you decide on equity only investments, members might largely consist of people with experience in this sector. If, however, the investment type is mixed, look for members that will provide some knowledge in each of these areas.
How many members will there be in the club and do you want to put a limit on this? More members obviously means more capital, but it can also mean it becomes harder to manage.
Depending on how you structure the meetings, multiple members can result in difficulty finding suitable meeting dates and venues.
There is no set number of members prescribed for an investment club. Anywhere between five and 15 members seems to be a common size, with 20 being a suggested limit. If you intend to use a stockbroker, check on the maximum number of members that will be allowed on the same account.
Talk through the following with your prospective club members, to ensure that everyone is fully aware of their expected commitment:
Discuss whether you are going to institute an initial buy-in amount. Apart from providing immediate capital to invest, this can also cover the initial set up costs.
Another option is to ask every member to contribute as and when expenses arise. Just be mindful that someone will need to be tasked with managing this and following up on unpaid members.
For simplicity, an initial buy-in which covers all expected costs for the first year (as a start) is worth pursuing. Alternatively, agree on a yearly contribution for expenses, so that all other contributions are strictly reserved for investments.
Agree on the frequency and amount that each member will contribute on a regular basis. Ideally this should only be for investment purposes and related investing costs (like trading costs). If you want to include running costs for the Club in this amount, then do a thorough budget exercise on expected costs and make sure there is enough left for investing.
There are three common ways to split holdings in an investment club:
1. Equal holdings
Under this method ever member holds equal holdings in the investment company and contributes tan equal amount on a monthly basis.
The big advantage of this is the simplicity, in that everyone holds the same voting rights and share in the club. The disadvantage is that members cannot buy more of a certain investment should the want to. Obviously they can do this in their personal capacity though.
2. Optional additional holdings
Under this method a minimum monthly amount is agreed, but members are able to invest more in a certain investment should they wish.
Agree whether these additional holdings have voting rights or not and if so, you might also want to put a rule in place about whether any single member can hold a majority.
The advantage of this is that members can invest more if they want and take advantage of the economies of scale. The disadvantage is that the treasurer will need to manage this carefully and keep track of which member has more invested in each investment. Selling each of investment will need to be carefully calculated to make sure profits or losses are apportioned correctly.
Under this method members buy units in the club, which are determined by the market price at the time. Agree whether there is a limit on the number of units each member can buy and also whether any single member can hold a majority.
As an example:
If you start with 10 units of £100 each, the starting value is £1 000.
At the time of the next monthly contribution you need to value the portfolio of investments. Assume this works out as £1 100, this means each unit is worth £110.
If members want to contribute a further £1 000 this is 9 units (rounded for example purposes).
This means there are now 19 units and the value is £2 100 (£110 per unit rounded).
The advantage of this is that the market value is regularly updated so any sales or buy outs should be easy to action. Members can also buy multiple units. The disadvantage is that rules will need to be agreed on to calculate market value and depending on the investments held (if not just equity), this is not always easy to do. The treasurer must keep a record of the number of units and value at each stage.
Minimum Membership Period
You will need to agree on a minimum membership period. This should be strictly enforced and only a few agreed circumstances should be allowed as acceptable for early termination.
The reason for this is that paying out the leaving member is an admin intensive process. Investments need to be valued and cash needs to be made available for physical payment.
Bear in mind the investment type will influence this too. For example, imagine you are invested in startups through crowdfunding sites. Your money is locked up until their exit strategy materialises. The investment is thus illiquid for this period and it might take a number of years before it becomes liquid. A shorter membership period than this will then cause difficulties when trying to pay out the members leaving.
Even with listed equity you might have taken a long term approach and agreed on a minimum holding period. Needing to sell before this stipulated time has been recached to cover a buy out, is not ideal.
This refers to how leaving members will be fairly paid out and is possibly one of the trickiest areas. Don’t avoid discussing, as it is far easier to agree on this ahead of time.
When discussing consider the following:
How will you value the leaving members investment?
This might sound straight froward, but depending on the assets invested in it could be anything but. As an example, the possible illiquidity of Startups has been mentioned above. Do you value this at cost or if there have been subsequent investment rounds do you value at this increased value. Also with property do you value this at cost or will you need to get a professional valuation performed.
Who will cover the costs?
If you decide to liquidate your assets for a buy-out, there will obviously be costs involved. You need to agree who covers these. For instance if you decide to liquidate equity there will be trading costs. Will the investment club as a whole cover these or will only the leaving member bear the cost.
How are the funds made available?
To physically pay the leaving member how will you put together the capital. Some options might be:
- Leavers are bought out by a single member or multiple members. Be careful to discuss whether you will allow a member to hold a majority interest through doing this. A majority held by an individual, obviously allows them to wholly influence investment decisions.
- All the existing members buy out the leaving member and equally increase their shareholdings.
- If a new member has already been identified, then this member could pay out the departing member.
- Agreement made by majority vote to sell one or more specified investments to cover the payout. This should be in advance of the leaving date.
- A percentage portion of all the investments relating to the leaving members share is sold. This option assumes all investment are easily liquidated and is likely to be the most expensive option, as there will be multiple selling costs. As an example if there are 10 members you would sell a tenth of all the investments held.
- A further option is to try a mixture of the above or a tiered approach where the above are ranked and at leaving announcement you go through the list in order of ranking to see which option will be used.
How will you decide on new members? Will this simply be by nomination or does the leaving member need to find their replacement. Alternatively, do you agree on what skill set you think will benefit the club and then search for a candidate based on those criteria.
Be careful about advertising to the general public as this might be viewed as selling a security, for which you require a license.
Possibly the least pleasant of the discussions, but don’t skip it for this reason. All members need to be made aware of what is expected from each of them. Once this has been discussed, agree on a way to measure this.
Even if this is a social club, members will all be investing money and taking on risks, so you want to avoid situations where members don’t contribute equally.
Measurement might be as simple as attending a certain percentage of meetings and presenting a certain amount of investment ideas in the required format within each year financial year.
Once agreed, discuss what will happen if a member does not meet their obligations and formalise these in set rules.
Please note, this is not measuring the performance of each member’s suggested investments, this relates purely to their involvement level within the group.
Performance of investments should purely be done at a club level. A single member might have proposed it, but there should be voting system to choose whether to invest and thus everyone is accountable.
Remember, there is no guarantee that investments will make a profit. Singling out an individual for an investment’s poor performance, will only erode trust within the group. It will also result in making members less likely to want to put forward suggestions in the future.
Constitution and Club Rules
Once you and your members have agreed on the rules, formalise these and the constitution in documents, which every member must sign. These should be stored in a place that is freely accessible to all members at any time. You might also be required to submit these to the Bank, when applying for an account (see Investment Vehicle).
Draft Constitution and Club Rules documents can be found at Redmayne Bentley.