Investing in a Privately-Held Company
We have frequently focused in this space on how small, mid-size, and early stage companies should get funding as they start or grow their businesses. In this article, we focus on the other side of that transaction, to talk about how an investor should go about investing in private companies.
The risks of this type of investing are well known. First, there is a high risk of failure, especially for startups. The failure rate for startups has been estimated to be as high as 90%. Second, most companies that are looking for funding have not been able to get it from traditional sources, so most likely someone in the business of investing has already evaluated the company and decided to pass on it. Also, because there is almost no government oversight of private companies, there is a higher risk that you may get taken for a ride. Unlike public companies, there is no requirement that there be regular reporting of financial statements or important developments that affect the company, or any government oversight as to the accuracy of statements that are provided.
On the up side, private companies, especially startups, can offer the potential for great rewards for the risk takers. These opportunities can come to a potential investor in various ways, e.g. if you are a friend or relative of a founder. Some investors actively look for private investments to diversify their portfolios. Others may choose to invest through an angel investors group or another organization where multiple investors pool their funds to back particular companies that they select together. Angel investor organizations are especially popular because they help provide funding in the early stages of a company’s development and tend to focus on particular industry sectors.
What should you be looking for? Here are the basics to consider when evaluating an investment in a privately-held company:
1. Business Plan: This is the key document that every new or established company that is looking for funding should prepare and provide to you. This document should outline current operations, management, marketing, and financials, as well as plans and projections for the next 3 to 5 years. Key areas to focus on include the following:
- Competitors: A red flag should be if a big player, like an Amazon, may enter the space.
- Customers and suppliers: Smart companies try and diversify both their customer and supplier base. A one-customer or one-supplier company should raise a lot of concerns.
- Risks: A good business plan should clearly state the risks of the investment. The founders are in the best place to identify the risks, and if they have not done so, they should be asked about them.
- Assumption in Financial Statements: Projections especially are critical indicators of the company’s ability to succeed. These should be reviewed carefully.
Once you have reviewed the business plan and are ready to move forward, consider bringing in others to provide their perspective. If this is an industry that you are not familiar with, get someone who knows the business to review the product offerings. If reading financial statements is not your strength, get your accountant or financial advisor to review those for you.
2. Investment Vehicle: It is important to consider the kind of investment you are making. Is this a loan, equity, or debt that converts to equity? Generally, pure debt has a lower return on investment than pure equity. However if you are looking for the next Apple then equity will be your best bet. It will be important to match your financial ability and risk tolerance to the type of investment vehicle that is being offered. Smaller companies and start-ups may be willing to tailor the investment to match your needs or tolerance.
Although most private companies will only accept funding from accredited investors (those who have met certain net worth and sophistication requirements), some will allow nonaccredited investors to participate in funding rounds as well. In either case, your investment should come from discretionary funds and not your next month’s mortgage payment.
Investing can be both lucrative and interesting, but it requires caution and understanding of the risks and rewards involved.
Business Insights is hosted by the Law Firm of KPPB LAW (www.kppblaw.com).
Sonjui L. Kumar is a founding partner of KPPB LAW, practicing in the area of corporate law and governance.
Disclaimer: This article is for general information purposes only, and does not constitute legal, tax, or other professional advice.
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