Evaluating a Private Investment

You are a successful entrepreneur or professional and are approached to invest in a business (or a syndicated real estate deal): What should you do?  

I’ve seen this question come up numerous times in my career. A client would be approached by an investment opportunity, but not have much of an idea of where or how to start evaluating it and would give me a call for advice.

What are some considerations when looking at a deal?

What type of investment will this be? Are you an equity partner, a lender, or a combination of both? Is the equity common shares or preferred equity? There are pros and cons to every option.

What are the potential returns? You should expect a higher return for investing in a private company compared to a passive real estate or stock market investment. This type of investment comes with more risk and an investor should be compensated appropriately for taking that risk.

How are you going to conduct due diligence? What records are you going to have access to before you make the investment? Looking at the company’s cash flow and understanding its ownership, operating agreement, and any other debt is critical to determining the risk.

What do you think about your new partner’s character and finances? Do they appear to live a fancy lifestyle or within their means? Do you know anything about how prior business partners have been treated, especially if something went poorly? If things went badly, character will matter above all else.

Regardless of whether it is an equity or debt investment, here are some considerations to think about:

• What are your return expectations? What gives you confidence the company can meet these returns?
• When will the money be put in? Is the entire investment made up front or through capital calls over time? If there are multiple investors are you certain they can meet their capital calls? What happens if they can’t?
• If this is debt, how will interest be paid? Cash paid or accrued? Will there be a different rate for each?
• How will your capital be returned? Monthly, annually, through a royalty, or at the culmination of an event?
• If you are providing debt, do you get a lien on any assets? If so, what lien position do you have?
• What restrictions should be put in place on the company? Distributions, owner’s compensation, or restrictions on any company debt or capital expenditures? 
• Dispute Resolution: How would a dispute between partners be solved? Is there an option to be paid off early or be bought out? How will that price be determined?  
• What type of time commitment will this require from you? If you’re an equity partner, will you be asked to take on any contingent liabilities like guaranteeing debt or leases? Is the company insured in order to protect officers? Does the company have or will it create a formal structure with a board of directors?

Investing in private companies when it goes well can provide above market returns and lifelong partnerships and friends. Investments that go poorly can result in capital loss, headaches, or worse. Understanding what you’re getting into and evaluating an opportunity with trusted advisors can increase your chances of success.