Risk and Reward: The Most Important Questions Private Business Investors Should Ask

I have had the good fortune and opportunity to invest in private businesses including software startups, real estate, and micro-breweries. Although the business domains vary considerably, a careful investor must ask several common questions before taking the plunge. Investing outside the publicly traded markets of stocks, bonds, mutual funds, ETFs, REITs, and other liquid assets generally means less information, less liquidity, and more risk; therefore more due diligence is needed to reap the higher potential reward. I want to share my insights into the general investment process and how one should balance these risks and rewards for consistent success when investing in private businesses and markets. Throughout the analysis, I will highlight questions which if left unanswered could be red flags.

1. Is the capital instrument equity or debt? Are investors shareholders or bondholders? What are the voting rights?

How will you, as the capital producer, benefit from the business success? Will the relationship be an obligation (eg interest and principal on a loan)? Or will earnings be paid on a discretionary basis (eg dividends on shares)? Can you vote on the future of the business during shareholder meetings? Can you actively participate in board of director meetings and influence the future of the firm? Or are you a passive, silent investor? Some instruments such as convertible shares can behave as both equity and debt; these were profitably used by Warren Buffett and Berkshire Hathaway during the 2008 financial crisis.

2. What is the Legal Structure of the Business? LLC? Partnership?

Has the business been established in the US? If so, then which state? Or another country? What laws and contracts are enforceable in that legal jurisdiction? What is your tax liability as an investor? What is your legal liability as an investor? Usually, the general partners assume liability for product fraud or service failures, however, one should ask and find out what applies to the limited partners and investors. If you might have serious, significant tax and legal liabilities, then that is a red flag.

3. When and how much do investors get paid?

Are distributions a discretionary percentage of net income? Or, are the distributions an obligation that is a fixed coupon related to some principal or a variable percentage indexed to some market benchmark? Are payments monthly? Quarterly? Annually? If you do not know when and how you are going to get paid, then that is a red flag.

4. What is the Business Plan and Model? Product or service? Target customers? Industry? Research, development and operations milestones? Intellectual Property?

What is the business selling? Who does the business serve? How will the business compete against others? Why will it be successful? Think about Porter’s 5 Forces. Buffett, Munger, and other legendary wealth accumulators only invested in businesses they understood, that had competitive moats, and could be invested in at an undervalued price with margin for error. Peter Thiel urges entrepreneurs to Think Big and have 10X monopolistically competitive advantages to survive and profit in a flat world. While these abstract principles are easy to articulate, it takes considerable discipline, patience, courage, and skill to apply them when others are losing their head (greed) or their shirt (fear). If you do not know how the business will make money (not just revenue, but a bonafide profit), then that is a red flag.

5. How has the business performed Historically? What is the Expected Return of the investment?

Is there historical precedent to the business? Are there statistics from an industry association or academic research? Or is it based on rosy assumptions baked into the oven of an Excel spreadsheet model? Can you judge whether the proposed return on the capital instrument is fair? If the return is low or excessive, then understand why. Excessive returns can be a red flag. If an investment is too good to be true, then it probably is (hint: think Bernie Madoff).

6. What type of Assets will be purchased with the investment?

Will the assets be physical such as plant, property, and equipment (PPE)? Or are the assets intellectual property such as software, patents, or food recipes? Will the capital be used to hire employees and contractors? Will the money be spent on marketing, supply chain distribution of products, or rental of cloud computing services? If you do not know what the money will be used for (eg TBD), then that is a red flag.

7. What is the investment Time horizon?

How long will your capital be used? Is it 90 days? One year? Ten years? Forever is a long time, and time is money. What are the operational milestones for the business assets?

8. What is the Liquidation mechanism for returning funds?

How do you get your money back if things go bad? If you cannot get your money back, then you guessed it… that is a serious red flag.

9. How much Additional Financing (e.g. Debt, Equity) will be used alongside and after this investment?

Are you an angel and the first to invest? Or, will there be other rounds for other operational milestones? Will subsequent equity dilute your stake and make it less valuable? Will additional debt increase the risk on your tranche? Do you have a primary lien on the business assets as collateral?

10. What are the Risks of the business?

We covered some risks in earlier questions, however understanding and weighing risks is one of the most important factors in investing whether it is public or private markets. Greed can cloud the human mind to only look at the upside, and fear can paralyze and obsess to the downside. The last twenty of years (let alone the last two hundred!) in the aftermath of the dotcom bubble of 2000 and the financial crisis of 2008 should suggest to the careful investor that one must consider both the risks (downside) and rewards (upside) when evaluating a private market investment. Think about the fundamental business risks in terms of financing, personnel, competition, technology, legal, and regulation.

These questions represent some of the most important considerations before making an investment in private businesses and markets. However, they are not a guarantee of success. If you are interested in learning more about how great investors and economic historians think, check out the following resources. The Most Important Thing: Uncommon Sense for the Thoughtful Investor by Howard Marks is my favorite. A brief, fun romp through the past is A Short History of Financial Euphoria by John Kenneth Galbraith; a lengthier, more comprehensive volume is Manias, Panics, and Crashes by Charles Kindleberger. Good luck and stay in touch.

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