Our parent company has decades of experience structuring private credit for investors, so we sourced a few suggestions for those looking to capture high returns by lending money to companies.
Several years ago, a small import/export consumer goods company approached us to raise capital to build inventory. In the course of conducting our due diligence, we discovered that the owner of the company previously had sold a business and, rather than pay federal taxes on those gains, he had used all the proceeds to improve the operations in a second (entirely separate) company.
His company’s accountant, on learning of the owner’s decision against paying the IRS, quit the firm, and the owner was using a part-time bookkeeper to manage the finances.
Consequently, we declined to bring the investment to our community — even though the business was making money, had great products, was well known in the industry, and the investment structure should have been rewarding to its investors. Those two decisions — making management decisions that might affect the success of the investors’ loan (e.g., being forced by the IRS to settle its claim) or producing financial reports based upon a part-time employee’s efforts — are red flags that, when discovered, should cause you to walk away. There are plenty of worthy companies looking for your investment dollars.
Keep your focus on three areas that can give you an early warning to impending problems…
Management: It starts (and ends) with the people … the owners and managers of the business to whom you are lending. No contract or agreement with them will make up for dishonesty or incompetence. What do you know about them? Have you conducted thorough background checks? Don’t skip criminal reviews, conduct a lien and judgment screen, and analyze their past business performance.
Case in point: we were checking the backgrounds of another company’s principals who had invited us to help raise capital. The two principals whose names we were given checked out. However, digging further, we discovered the name of another company principal who, until weeks before, had served six years in jail for securities fraud. Yes … that counts as a red flag...
Credit Analysis: A debt investment is very different from an equity investment. While most companies can issue equity to raise growth capital, most venture-stage companies (i.e., younger businesses that have not yet generated positive operating cash flow) — and other more established businesses with recent troubles — should not finance their businesses using debt. Unless the borrower can “service” the loan, steer clear. Remember, you will not be participating in the issuer’s future profits, so prioritize the sources of loan repayment in your analysis. If there are multiple sources of repayment, you will be better served in case the primary one doesn’t work.
Business Operations – the “how’s” of the business. How do senior managers manage? Weekly staff meetings? Standard Operating Procedures? Do they have strong interpersonal skills? Do they encourage input from all levels of employees, or is it an insular, tightly controlled process by an inexperienced owner?
Ask how information (financial and otherwise) is collected and used across the organization. Are business decisions made with good data … or hope? How strong is the borrower’s financial staff? Is this, financially, a well–managed company?
We could go on, but this should be good fodder for thought. Take a look at an additional resource — Carofin’s Seven Key Questions For Evaluating a Private Company, as well as our “Due Diligence” and Investments: What do I Really Need to Know?
Invest with confidence, but only after collecting the facts.