The first step is to make sure
that the company is financially sound. However, even if this is true, the
pitfalls are numerous. Before investing, follow these four tips:
1. Ensure the business has a
sound strategy.
If you’ve read our columns, you
might be familiar with the three questions that every successful business
must answer:
·
Why should a prospective customer buy my product or service rather
than a competitor’s?
·
Is there a segment of the market that values the thing that makes
my offering different from the competition and is it large enough to support my
business?
·
How will I cost effectively reach this segment of the market with
my message?
Before you invest in a business,
make sure that these three questions have been answered well. If they haven’t,
you could see the value of your position decline precipitously.
2. Know why the owner needs the
money.
If the owner needs money to make
payroll, we would suggest caution -- ensure that the business is
financially sound. On the other hand, if the owner needs money for capital
improvements to expand or to fund working capital for a rapidly growing
enterprise, that’s a better situation. We’ve found good investment
opportunities when the owner of a successful, growing business needed money for
personal reasons (for example, to buy a house).
3. Verify that the majority owner
is a good businessperson.
Remember, when you buy a minority
interest in a small business that the majority shareholder runs, you are making
a bet on that person. Good business plans are a wonderful thing, but in our
experience, they always need to change. The person running the business will
have to recognize changes to the competitive environment and pivot.
4. Make sure you will be
compensated.
Without constraints, a
minority interest in a privately-held business is only worth what the majority
shareholder says it is worth. Consider this: You write a $100,000 check. The
majority shareholder then proceeds to manage the company very successfully,
generating a lot of cash.
However, the majority owner just
sucks the cash out of the business by increasing his or her own compensation
and never declares a dividend. Further, he or she never sells the
business, but passes control to the next generation. You will never see a
nickel from your investment. You might as well have flushed your money down the
toilet.
When making minority
investments in privately-owned companies, insist on constraints:
·
The majority
shareholder’s compensation must be formulaic. Raises in compensation are a
function of growth and profitability. The majority owner can’t just increase
his or her compensation at will. He or she has to declare a dividend to
get cash out of the business. Obviously, when dividends are declared, you get
paid.
·
Earnings may be retained
in the business for only a limited time. If the business generates cash,
dividends must be declared, unless you approve otherwise.
·
Control a myriad of
other ways that the majority shareholder could get cash out of the business,
such as paying a spouse $500,000 per year for being a receptionist or paying
above-market rates for services to another company he or she owns.
·
The majority shareholder
must devote his or her full effort to the enterprise. Don’t make an investment
in a business and then have the majority partner take a full-time job at
another company.
·
Protect
yourself against dilution or sale. If the majority owner is going to sell
shares, have a right of first refusal. This prevents him or her from issuing
new shares and diluting your interest or from selling to a new owner with whom
you do not wish to work with.
Finally, insist that
your prospective on the business be considered. Admittedly, this is a “gentlemen’s
agreement.” You can’t force the majority shareholder to listen to your point of
view. However, do make it clear up front that you want to be heard.
Making minority
investments in privately-held companies is risky business. The tips above are a
good start, but this is a complex topic. If you aren’t experienced, reach out
to experts before investing.
