Red Flags When Considering Private Company Investment

The public market fell last year, and so did the value of private companies. So is now the time for new investment in private companies? The best answer is that it depends. There’s never a bad time to invest in great companies. It’s a great investment opportunity during tough business cycles when a great business is declining in value. However, the risks involved in investing in private companies are worth noting, so it is wise to consider whether there are any red flags before making an investment in a new private company. According to LendingTree, 18.4% of his US-based private companies went bankrupt within just one year, 49.7% went out of business within his five years, and 65.5% went bankrupt by 2010. In this post, we review some of the red flags that should be carefully evaluated before making a new private equity investment.

Lack of transparency in financial reporting

The first red flag may be the state of the company’s financial books and records. When a company’s financial reports don’t give a clear picture of the company’s performance and potential investors can’t tell if the company is thriving or underperforming, that’s a big concern. Questions include: (2) Does the company partner with a reputable outside accounting firm or handle all financial and tax matters in-house? (3) Does the company have an influential CFO or Accountsperson who demystifies the financial position of the company?

If the answer to any of the above questions is no, that’s a red flag. If the company’s financial reporting is confused, if the company has no external oversight, if there are no experienced chartered accountants, and if the company does not have a strong financial It is unreasonable to expect nasty things to suddenly improve after the investment has been made.

Low or inconsistent profit margins

If financial reporting is clear but reflects that the company’s earnings are not stable, it is as serious a problem as poor financial reporting. Ideally, investors want their profits to grow rapidly, or at least trend upward. However, startups often take time to become profitable, so investors should consider them. pro forma Understand the key factors that lead to profitability. For example, securing a contract with a major client, achieving a certain level of access/traffic to the company’s website, obtaining a patent for a major product, or a licensing agreement on an existing patent.

Investors must decide whether to make risky investments before hurdles are met or wait until milestones are reached before joining. However, that delay can make the investment more costly or unavailable. Once the hurdles to profitability are cleared, companies may no longer need to invest, or the price of investment may rise significantly as the value of the company increases. This is a classic risk/reward scenario that investors need to evaluate carefully, and before making an investment, a company should consider whether the hurdles are legally within reach. We need information from the management of

rapid employee turnover

If your employee turnover rate is high, this is an important red flag. This suggests many issues with the company, such as leadership issues, lack of a strong corporate culture, and inability to scale the business over time. To determine reasons for turnover, more information is needed to determine the type of employee leaving (actual employee or contractor), the reason for the turnover, how quickly the turnover occurred, and the issues that caused the turnover. due diligence must be carried out. can be fixed.

high client concentration

When a company’s success is limited to a small number of clients, that’s a red flag to consider. If the loss of a single customer puts the company in a tight spot, the investment is risky. So follow-up questions include: (2) How likely is the company to diversify its customer base over time? (3) What contingency plan does the company have in case he loses one of his biggest customers?

Relative access to capital

The purpose of investing in private companies is to secure a reliable return based on the future growth of the business. For your business to grow, you need access to capital. So the key question is whether you have the ability to access the capital you need to fund your growth curve. This capital can take the form of borrowings, such as lines of credit, from existing investors who have pledged to fund the company’s growth, or from anticipated rounds of additional investors. This additional investment will have a dilutive effect on the investor’s ownership. Investors should consider whether future dilution is worth the risk or whether anti-dilution protection should be sought.

Before making an investment, investors should understand what access to capital the company actually has available. Many companies with bright futures were derailed by their inability to access capital at key points. By the time they had the necessary capital, other more well-funded competitors in the same space had jumped out and were unable to regain momentum. If you don’t want , that’s another red flag.

Conclusion

Investing in private companies carries inherent risk, as most private companies have not survived the test of survival over the past decade. Investors should therefore be willing to take relatively high risks in their pursuit of outsized returns, although some of this risk can be mitigated if heeding the key red flags and addressing the concerns they present. can be mitigated. If the investor’s due diligence confirms that the company’s financial reporting is sound, its earnings are sustainable and trending upwards, and it has the ability to secure the necessary capital for future growth, this poses a risk. It may be worth taking.