Don’t Believe the Hype – Investing in Private Companies

January 06, 2015
Deborah Helton

Deborah Helton

Director

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Austin Buckett

Austin Buckett

Manager

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What would you say if I could get you a 500 percent return on your money over the next two years with little to no risk?  Sound too good to be true?  Unfortunately, it is but that doesn’t stop thousands of investors in losing money in bad investments every year.

Early-stage investment in companies used to be reserved for the wealthy industry players, however in recent years it has become more common for mainstream investors to find early-stage investment opportunities.  As a result, we are seeing more clients come to us for advice on investing in small privately held companies ranging from startups to existing businesses.  The potential upsides from these investments can be very large and can become very intriguing for investors looking to outperform the public markets.  However, in most cases the rewards still do not represent the risks being undertaken in a private investment. Remember, while private investments may have become easier to find, the underlying risks of those investments has not changed.

While there are stories of massive returns on small investments, they are few and far between and usually the result of good timing and excellent execution.  But if an investment opportunity is touting great returns from the get-go then the likelihood is it’s either a scam (think Pyramid, Ponzi, etc) or just a very bad idea.  Either way, the investor will be the one losing out.

So where does that leave the mainstream investor?  Should they stay away from private company investments altogether and potentially miss a home run opportunity or can they also participate?

The answer is yes, provided they have their wits about them and can objectively assess an opportunity.

So how do you find out about investment opportunities in the private markets?  Below is a summary of the typical ways to find an opportunity:

  • Sourced through an investment group – This is by far the best way to source private investments; they typically require an investor to meet certain wealth and income levels (making sure you can afford to lose your investment without going broke) and they will typically vet any opportunities so only real deals are presented.
  • Presented by a professional – Typically these are presented to clients by wealth managers or other professionals such as lawyers or CPAs. The quality of these opportunities varies greatly. A good professional will ensure sufficient due diligence is done prior to making a presentation and that the guidelines set by the SEC are followed. In order to assess if this is a good opportunity always seek a second opinion, make sure the presenter has done suitable due diligence and understand the financial (if any) relationship between the presenter and the opportunity (i.e. do they get commission if you invest? If so, is it clearly stated up front?)
  • Presented by a friend or family member – This can result in great opportunities as you have an early look at something before other investors, but it also comes with an emotional tie that may sway an investor into doing a risky deal. Care and attention need to be taken here to ensure the opportunity is objectively assessed.
  • Online crowdfunding (i.e. Kickstarter) – Generally high risk as most opportunities are ‘ideas’, however, the investment levels can be very low. Many product-based investments will just return you a copy of the product not an actual share of the company so the upside is limited if they are successful. There are some property-related opportunities in this space that can be somewhat interesting. This is still an evolving concept and the requirement for good due diligence is firmly in the hands of the investor at this time.

So once you find an opportunity what then?  Below are 10 questions to ask yourself when presented with an investment opportunity:

  1. Has the lead operator(s) been successful in the past in the same or similar industry?
  2. What is the industry? How big of an impact can the business have? For example, software generally has much higher upside than a restaurant as the customer base is likely to be much larger.
  3. Is there a well-documented investment presentation that includes discussion around the market, competitors (and how the company will differentiate itself) and significant risks associated with the company?
  4. Does the company in question have a thought out and documented business plan and strategy to execute on its objectives?
  5. What stage is the company in and does the value represent this stage? For example, is the company an idea/concept or does it have a proven product with supporting revenues and customers?
  6. How and when will your investment start to return profits and/or principal? What is the annual return on your investment and how does this compare with your other investments? For reference, a private investment in a small company should command annual returns of 25 to 35 percent due to the level of risk typically taken on.
  7. What is the risk of failure? Are the investors in any way obligated to provide additional funding and/or will there be saleable assets in the event the business fails to recoup some of your investment?
  8. Do the presented financial projections use aggressive or conservative assumptions? For example, in the case of a restaurant what is the average expected spend per customer and the number of customers per night and how does this compare to industry norms?
  9. Can you afford to lose the money you plan to invest?
  10. How do you exit your investment? Is there a clear plan to realize a return to all investors and is this reasonable?

Once you have identified a good opportunity and it ticks all the right boxes, it is critical to hire a professional with experience in private company investments to make sure your interests are protected and the necessary legal paperwork is completed.  A good advisor will ensure:

  • The financial presentations use reasonable assumptions.
  • All legal documents are reviewed to ensure you are protected and that any shareholder, member or note agreements are drafted suitably and in line with any presentations made.
  • You fully understand your commitment going forward (i.e. will you be contacted for additional funds down the road or will the company likely have a need to bring in additional investors at a later stage).
  • Any proprietary knowledge or technology is owned by the company and included in the investment.

Finally, below are red flags that should make you run fast in the opposite direction:

  • The opportunity does not come with a thought-out business model and strategy.
  • Financial presentations use best case scenarios only.
  • There is no contingency plan if things do not occur as planned.
  • The opportunity is in a low performing industry or has stiff competition in place (i.e. very limited upside).
  • The person presenting the opportunity has a history of poor performance or ‘excuses’ for prior failures.
  • The opportunity requires you to commit and sign on the spot or in a short window that does not allow for sufficient due diligence.
  • The person presenting insists on representing your interests and is against you utilizing an independent professional to help in your analysis.

Overall, private company investments can provide significant returns to investors but they also carry significantly increased risks.  So if you have enough wealth to stomach a small percentage being invested in high risk / high return investments then investing in private companies may be something to consider.  Just remember to be diligent and careful in your approach and always get a second opinion from an unrelated party.

Austin Buckett, ACA, CM&AA, is a Manager at BiggsKofford Capital and specializes in helping clients acquire, grow and exit their businesses as a licensed investment banker within Mergers and Acquisition arm of the company.

Deborah Helton, CPA, is a Director at BiggsKofford, CPAs, a Colorado Springs-based accounting and consulting firm, and a member of the National CPA Health Care Advisors Association. Mrs. Helton specializes in assisting physicians align their goals with simple tax strategies and business coaching to eliminate surprises and assess risk.

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