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Don’t Believe the Hype – Investing in Private Companies

May 03, 2014

What would you say if I could get you a 500% return on your money over the next 2 years with little to no risk?  Sound too good to be true?  Unfortunately it is, but that doesn’t stop thousands of investors every year losing money in bad investments.

Early stage investment in companies used to be reserved for the wealthy industry players but in recent years it has become more and more common for mainstream investors to find early stage investment opportunities.  As a result, we are seeing more and 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 try and 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 some stories out there 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, 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 participate also?

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 you 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 by wealth managers to their clients but these could also be other professionals, such as lawyers, CPA’s, etc. 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 so can sway an investor into doing a risky deal. Care and attention need to be taken here to ensure the opportunity is objectively assessed.
  • Online Crowd funding (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 if they are successful your upside is pretty limited. There are some property related opportunities in this space that can be somewhat interesting. This is still an evolving concept and at this time the requirement for good due diligence is firmly in the hands of the investor.
  • Emails – Just delete them, you do not have a relative in Nigeria!

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 mid 20%’s to mid 30%’s due to the level of risk typically taken on.
  7. What is the risk of failure? Are the investors anyway 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 found a good opportunity and it meets all of the right criteria, it is critical to hire a professional that has 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 if 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 / 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.

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