How to Properly Invest in Privately Held Companies

Smaller, privately held companies often watch their cash flows closely as they balance outstanding receivables and payables. The extra cash is needed to fund growth and new product innovations, among other things. This, along with the fact that smaller private businesses have historically had problems accessing new capital, enhances opportunities for private investment in these companies.

For the purposes of this article, a privately held business (PHB) will be defined as one whose shares are not publicly traded. PHBs may be owned by a founding entrepreneur, his or her family members and/or a few investing partners. Although, they are almost always closely held.

Such companies may take any number of legal forms, including a sole proprietorship, a limited liability partnership (LLP) or corporation (LLC) or an S-corporation. The decision-making power usually rests with the individual or small group holding the majority of equity in the firm.

PHBs may offer a variety of types of investment, both for angel investors acting on their own, or for investors who access them through a venture capital firm. Having chosen your access route, there are still a variety of choices to make regarding your level of investment.

For example, you can choose to be an "arm's length" investor with no active participation in the operations or decision making within the PHB. This is much the same as owning a few shares of a publicly traded company. With a small or family-owned business, however, you may be employed in the management of the company — in other words, your investment might come with a job. For an investment of significant size relative to the total capitalization of the company, you may be expected to participate as a member of the company's board of directors (to advise on the policies and direction of the firm and to review management performance). When it comes to a family-owned firm (if it's your family), other family-oriented considerations may dictate your level of participation and authority within the firm.

After taking into account the considerations above and making a decision to go forward, you must decide on whether you are looking for a minority position or a majority ownership position and the responsibilities and risks that go along with being the principal owner, if applicable.

As you assess your investment targets, you will want to evaluate the business category occupied by your candidates, and the risk/reward characteristics of each.

There are many business categories and some of them overlap, but the list below provides an overview of each:

Startups

Startups tend to be high risk with no management track record or proven business model. Four out of five startups fail in the first five years, according to the National Business Incubation Association. On the other hand, startups with no proven track record or business model that are operating in new paradigms have produced many millionaires. Superstars such as Microsoft, Google, Amazon and Apple are good examples.

Second-Level Capital Acquisitions

This category includes companies that have gotten off the ground with their first capital infusions, but now need more capital to grow. These companies have a performance record, and while they are usually less risky than a startup, investment debt or equity may be subordinate to that of the original investors.

Turnaround

Companies requiring turnaround are in failure mode. If cash flow and the business model and fundamentals are good, however, bad management decisions can be fixed, and you as an investor can make it happen. If cash flow and fundamentals are bad, prospects for recovery are extremely limited. Successful turnarounds offer high return on investment.

Growth Opportunity

Companies whose growth is being stymied by a lack of capital may be good investment targets if their fundamentals, track records and resident management are capable of handling the growth. The markets for the growth need to be assessed to determine the feasibility of the growth plan and potential.

Bankrupt

Bankrupt firms can provide great value at a low price. Here, the question is "why did the firm go bankrupt?" If the market in which the firm operated and the fundamentals (and cash flow potential) are good, the reason could be bad management, lack of expense control, receivables collection, productivity, etc. This is a high-risk investment that can require high personal involvement. It can be very lucrative or devastating.

We have looked at the types and categories of investment in PHBs and can now review some of the overall pros and cons of investing in privately held businesses versus publicly traded companies.

Pros

• Investing in a PHB allows you to set an upfront exit provision for your investment. It can be made on the condition that it must be repaid by a certain date and at an agreed upon rate of return. It may also be set as an option to exit or continue at a number of option dates.
• These businesses are usually small enough for you, as an investor, to get your arms and mind wrapped around what the business is and who the management people really are.
• PHBs provide the investor early-in opportunities, which can produce extraordinary returns.
• The business trend information of the average PHB is more easily accessed and discerned from their relatively simple financial reports and bank statements.
• In a privately held business, you are more likely to be a significant investor and, as such, can influence operational decisions.
• In PHBs, there is less competition to buy equity than with a publicly traded company.
• When investing in a PHB, you can negotiate the rate of return required for you to invest, apart from company performance.

Cons

• It is more difficult to obtain truly comparative performance data and industry benchmarks for PHBs.
• These businesses are not held to the more rigorous accounting, reporting and transparency standards required of publicly traded companies.
• PHBs may have a "founding entrepreneur" embedded at the helm, without the requisite management skills needed for the current stage of the company.
• Private companies often do not have easy or inexpensive access to needed capital.
• PHBs may have family member issues such as succession, compensation and direction among the principal owners.
• As a recent minority investor, you may have less influence than the original board or management team.
• Unless an upfront provision was made, it may be difficult to get out of your investment.
• PHBs can be riskier than publicly held companies, as they may retain fewer reserves.

When considering an investment in a privately held business, research your target company carefully, including financial reports, bank statements, market niche, competition, management skill levels and track record, cost trends as a percent of revenues, the principal relationships and why the company needs your investment.

If it all looks good, keep your investment small enough to preserve your portfolio diversity. If you are a minority investor — with or without board or management participation — know the people you are investing with very well, including conducting background checks and a review of any pending/historical civil court cases with which they have been involved. Set the term and the rate of return of your investment on the way in, especially if it is "just an investment." If you do your homework, there is money to be made investing in privately-held businesses.