A few years ago, I had a client tell me he invested in a fancy bowling alley — the new party hot spot in town. It’s since shut down. Another client shared that he joined the board of a start-up and they’re looking to raise capital. He wants to figure out the right dollar amount to invest.
High-net-worth investors are approached often to put their money into a private company looking to grow. The offers come in all shapes and sizes: Small companies need capital to expand, start-ups often need several rounds of financing, and friends or family members with a “Shark Tank” type idea want to make a run at creating their dream.
These investment ideas often sound exciting and exclusive and seem to hold the potential for much higher returns than a traditional stocks-and-bonds portfolio. So how do you determine which ones to say yes to, and when to walk away?
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Before tying up your money in one of these ventures, take the following steps to help ensure you make a good decision.
Create a financial plan: If you have a large sum of extra cash, first create a financial plan to determine your financial goals, such as paying off your mortgage or topping off your children’s college accounts.
This step enables you to back into the amount left over for unplanned expenses and investing. It also gives you time to understand any offer and perform due diligence on the company. You want to plan your investment carefully and not succumb to pressure from the person asking for a commitment by a specified date.
A financial plan also allows you to budget properly for this investment. I recently explained to a client that investing in private deals can be like planning a trip to Las Vegas. You should commit a certain amount of money that you’re willing to roll the dice with — and leave the ATM card at home.
Examine the deal: These suitors will take many forms — a former business colleague, family member or the chief executive officer of the company. Start by finding out the following information:
- How much of their own personal money they’ve invested in this deal;
- What percentage of their total assets does it comprise;
- How long they’ve been associated with this company/start-up/opportunity.
A CEO or other senior leader seeking cash should have a considerable amount invested in this venture. Also, ask to speak with other private investors and about their experience to obtain unbiased information.
Public information will be minimal, so it’s key to do your homework. Since financial statements of private companies aren’t available, ask for a recent profit-and-loss statement and the company balance sheet, and carefully examine their pitch book for footnotes about the financials.
Next, look for a positive track record. If the company has raised capital before, how successful was that offering? What was the return, and how long did it take to return the original capital to investors?
Understand that private funds don’t always calculate performance using the same metrics as publicly traded investments. For example, they may use a metric called the Internal Rate or Return, or IRR, to illustrate an expected future return.
Learn as much about the business operations as you can and see if their strategy for growth sounds reasonable with the right leadership in place. Check out social media sites to view backgrounds and personal traits of the key leaders. Ask yourself what level of intelligence about the company you’ll receive going forward. A member of the board of directors will have more insight than someone who only gets an annual report.
Finally, understand why this company is looking to borrow private dollars instead of getting a bank loan. Because any company seeks the lowest cost of capital, it’s likely that its 6% interest payment to a private investor make more sense the 10% a bank may charge. And a bank will likely also limit lending more money to a company that’s already highly leveraged.
With a financial plan in hand, decide the amount of cash you are willing to invest. It’s important not to exceed this budget unless the initial investment is profitable and you decide to reinvest in future deals. If your return is negative, don’t invest any more money.
Just as important, understand how each deal is structured. Because most private investments have limited liquidity, money is required to be tied up for long periods. Remember, there is no open market to sell your investment if you are no longer happy or need cash. Know these three items:
- The company’s estimated time frame for returning your capital;
- If there will be future capital calls where you’ll be required to invest more cash;
- Any other liquidity restrictions.
I once had a client whose brother got him into a private real estate deal when he was in his 30s. Years later, he discovered the only way to get his money back out was to pass away. He immediately valued that investment as $0 on his personal balance sheet.
The limited liquidity aspect of these investments means your assets needed to cover living expenses and taxes during retirement should generally be invested in a more liquid “core investment portfolio.”
Funds for private investments should primarily consist of money you won’t need to access for 10 years or more. Above the core portfolio, investors can typically afford to have a much higher allocation to private funds.
Public vs. private?
As a final step, consider whether you can buy into a similar investment in the public market. If so, you can remove the liquidity risk and have more control and transparency, and usually lower fees.
Private funds often charge extremely high fees, including performance fees for generating a favorable return, and sometimes upfront fees. In addition, you will likely be receiving a K-1 tax form for income from a private investment, which often means filing an extension on your tax return each year.
Investing in private ventures can be fun and provide a sense that you’re at the forefront of something big. While there is the possibility of above average returns, it can also put your entire financial life at risk is you go in too deep.
Weigh the risk factors and have a committed budget, and enjoy the ride knowing you’ll still be financially comfortable regardless of the outcome.
