Private equity investments are a much different animal than investing in publicly-traded stocks. Private investments require longer holding periods and contain little or no liquidity. Access to information from financials to company executives is usually far more limited, and the risk you’re taking compared to investing in a blue-chip stock is considerably more. However, with increased risk comes the potential of larger returns. This promise of high returns can lead to investor euphoria or what I like to call greedy hope. It is best to begin the due diligence process with an expectation of finding red flags. As an investor, you’re the one who holds the chips – companies in need of an investment should be courting you. While we have written more extensively about due diligence in our Private Market Investor Series, here are a few steps that will help any investor begin to uncover the fundamental promise or problem areas within an investment offering.
Numbers Don’t Lie
Underneath the clever marketing and convincing sales pitch are some real numbers. Ideally, new companies should show consistent growth over a number of years, along with small debt. Here are a few basic questions to ask:
- How much has been invested to date? At what valuation?
- How much equity has the leadership invested?
- What is the revenue model?
- What is the burn rate?
- What are the cost of goods?
- What are the margins?
- How much cash do they have on hand?
- How much credit do they have access to?
- How much debt do they have?
- What are prior year-over-year sales?
- What are the 5yr growth projections?
- Where does the company spend its money? Research, infrastructure, employees, etc.?
- How long will it take the company to become revenue positive?
- What assets does the company have? Do they own real estate, IP, or equipment?
What is the company’s bottom line? Make sure next year’s growth projections are realistic. While the management may feel like “this is the year we explode” – entrepreneurs are notoriously optimistic. See what their overheard expenses are like, and compare them to total sales.
Remember – not all industries are created the same. Restaurants vs. Oil & Gas; Real Estate vs. Biotech – comparing these are like night and day. Invaluable numbers can be found within the industry, as well as a company’s competitors, but it’s important to decipher the numbers you’re looking at. Take a step back and look at a company’s industry holistically. Depending on the industry, some of these numbers are easier to find than others. For instance, the biotech industry is very secretive due to proprietary drugs and testing. Nearly every company lives and dies by testing, as well as approval from the FDA. Industries like Real Estate or Oil & Gas are easier to evaluate – monthly reports are typically available from state and federal agencies that can provide insight as to how strong an industry might be.
Corporate Structure and CEO Experience
Leadership is the most important aspect of a private company to evaluate; good leadership will beat a good idea or product. The CEO’s ability to navigate the challenges of an early stage company will often determine whether the company can establish enough traction to grow. Representatives from the company should make management accessible to potential investors or provide references. Ask the difficult questions. What is the CEO’s previous experience? Have they managed any companies before this? If so, were these ventures successful? Again, you’re the one who’s putting money at stake – if you have $100,000 at risk, getting references from prior business partners or joint ventures should not be considered out of the question. First time CEOs probably do not have ample experience in the intricacies of growing or running a company. Also take a look at how major decisions are made – is the CEO completely in charge? Or, does the company have a board that can potentially override the CEO in order to benefit the investors. Be sure to see who’s on the Board. If it’s just a mix of the CEO’s golfing friends, then this could be a major red flag.
Understanding the operating agreement, subscription agreement, PPM or other corporate governance documents is integral to making the determination to invest. The governance documents are the only documents an investor can rely on when things go bad. Do shareholders have any voting rights? How do shareholders remove a manager? Can the company require additional capital contributions from shareholders? What actions can management take without shareholder approval? What is the liquidation preference of the shares?
Private companies have the ability to dictate the terms of their shares but companies who are in need of capital don’t necessarily have the luxury of setting strict, less-than-favorable investment terms. They can set specific dividend dates, anti-dilution provisions, create new share classes, have no-sale clauses, buy-back provisions and any number of other important rights, duties, and responsibilities of the management and shareholders. Finally, look at the terms from a variety of angles – specifically what are your rights, duties, and responsibilities as a shareholder when major events occur: What happens if the company fails? If the company is sold, goes public, or merges with another company? If management commits fraud or negligence?
Investing in a private company is an exciting prospect, yet it’s important to set realistic expectations. There are a number of questions you should ask, and areas to vet prior to putting your money at stake. Remember to rarely take numbers, estimates, or forward-looking statements at face value – do your research. It’s important to review investment terms with a fine tooth comb – and, as a best practice, you should also engage an attorney and a certified financial planner to review investment documents. If you are not an expert in the industry in which you are investing, find someone you trust who is and ask them to review the offering carefully. Ultimately, as an investor, the risk and research falls on you.