Be Prepared: An Essential Guide To Private Investing

“Be Prepared” is the Boy Scouts’ official motto.  It was constantly drilled into my 11- to 18-year-old brain over 50 years ago as we planned our troop’s many camping trips   in the hills of eastern Kentucky.  And it has stuck with me as the starting point for my countless subsequent adventures.

I’m now an investment banker, who specializes in raising private equity and debt for young companies — a “venture banker,” if you will.  A highly demanding field, it’s critical that investors (aka “angels”) prepare before they commit their capital to these high-risk, buy-and-hold investments—privately buying an equity or debt security issued directly by a smaller, and usually quite fragile, private business.

The returns can be great, but if you’re not prepared before you make each investment, you’re likely to find yourself, metaphorically speaking, shivering in the forest and wondering why you didn’t bring that extra layer of long johns.

What Does Investor Preparation Include?

Preparation = investment goals + issuer analysis + security understanding

There are three separate, but interrelated, areas of consideration you need to address before making any direct private investment.  Know your investment goals, study the company in which you plan to invest, and understand the piece of paper you are getting for your money (the security).  While these considerations may seem basic, I’ve found that the vast amount of information inherent to each private investment opportunity is overwhelming, particularly if you don’t organize each analysis in a consistent way.

  • Investment goals: As with any investment, you must have a clear idea of what you are trying to achieve. Capital gains or higher current returns?  You need to know how much risk you can tolerate. Consider how much of your portfolio you can prudently allocate to these types of higher-risk investments.  Can you afford to lose the money committed to the investment?
  • Issuer analysis: Any question you might ask the company that wants your money is fair game, though a nondisclosure agreement may be appropriate for certain more confidential topics, especially where technology, trade secrets, or customers are involved.

Make sure you know who controls the business and check them out.  Do you know basic accounting (only Accounting 101 is needed)?  And can you evaluate the business’s historical and projected financial statements?  You need to know which assumptions drive its success.  Is this a promising, high-growth company that hasn’t had any sales yet or one that consistently generates positive cash flow and can comfortably service a debt investment?

  • Security understanding: Do you know what securities are and how equity differs from debt? Does the security being presented to you for investment make sense for that issuer to offer? Consider whether the terms (share price for equity, interest rate for debt) are commensurate with the risks associated with the issuer.  Make sure you know how the issuer will pay back the investment (cash flow for debt, usually a sale of the business for equity securities).

Being Prepared: Some Basic Questions

During your preparation, consider the following questions:

Investment Goals

    • What do you want to achieve from this investment: current income or capital gains?
    • How much of your investment portfolio can you allocate to this class of investment?
    • Within this allocation, what’s the largest investment you can make and remain diversified?
    • Are you prepared to hold equity investments for at least seven years (for early-stage companies)?

Issuer Analysis

    • What does the company do?
    • Does it have revenues, profits and/or positive cash flow?
    • Who are their owners and managers?
    • Who are their customers, and how do they acquire them?
    • How do they do what they do, and what can stand in the way?
    • What kind of security should they be offering?

Security Terms

    • Is this a debt or equity investment?
    • Will this security deliver the type of return you’re seeking?
    • Is the projected return fair for the risks involved?
    • How will your investment be paid back?

Now Comes Due Diligence

Due diligence is akin to fact-checking a politician.  Guidelines for this deeper analysis are fairly easily found online, such as our firm’s downloadable “Due Diligence Checklist.”  Details matter, but, to repeat, first you must understand the forest for the trees (see the section above about what investor preparation includes).  Unless organized, the myriad facts you collect and evaluate won’t have any relevance to your goal: a compelling investment return.

Whatever your political persuasion, Reagan probably said it best: “Trust, but verify.”  If you don’t trust management, you shouldn’t be making the investment in the first place.  You’ll be in trouble from the get-go. The legal documents that back up your investment probably won’t save you.

If, during your analysis, the company takes offense at your questions and deeper research, that’s a red flag, and you should move on to the next opportunity.  Never skip this step, even if it’s your brother-in-law’s company.

Even a purportedly large and very successful company can crash and burn if, for some reason, a herd of investors has gotten behind it, each one relying on the diligence they thought others had done.  Particularly glaring examples of collapses by FTX and Theranos illustrate why even professional investors can’t skip this important, preliminary step.

Investing Is The Easy Part

After you’ve bought in, you must stay on top of the investment.  Private companies are always in crisis mode.  Before you invested, finding capital was at the top of the list; now they’ve probably moved on to another challenge.

Take steps to ensure that the company is regularly telling you, in writing, what’s going on. Encourage management to hold semi-annual investor conference calls and, if possible, visit the business once a year.  Regular investor updates are good for everyone, and they are necessary distractions for management from their day-to-day activities.

Direct private investing provides a chance to do something meaningful with your capital as you invest in promising companies that can make our world a better place.

To realize greater investment returns, however, you need to be prepared.  You’ll have to earn the private investment merit badge.

The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.

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