Investing in private companies is not easy. These are risky, illiquid, long-term investments, so you need to do a lot of work upfront to increase your odds of success.  That’s why Ryan Caldbeck, founder  of  CircleUp shares his experiences with us as to what investors must do before investing. So let’s look at what he says:

• Talk with the CEO. You really should not invest in a private company without first talking to the CEO. How can you bet on the team if you haven’t talked with them? This is why we facilitate conversations through conference calls and our online forums. Speaking with the CEO will give you invaluable insights into leadership’s vision and ability to execute. So that’s how you know if you share the vision and values of the CEO of the company and if that person and leadership team execute their vision. You have to talk to a CEO to truly understand the risks associated with execution and to decide if you believe in the company and the CEO’s ability to deliver results.

2) Have a Diversification Strategy (and execute on it). It’s unlikely you will be a successful private investor if you’re putting money in just two or three companies. Data from the Kauffman Foundation suggests a sound approach is to have seven to 10 investments. You need to determine how much you want to allocate to this asset class and then diversify your investments to reduce risk and increase your odds of success.

3) Talk to an expert. Find someone who knows the industry that interests you. I would recommend consulting a professional investor in the space or an investment banker focused on the category. Don’t know one? Start looking on LinkedIn – spending a few hours networking will help you realize there were questions you didn’t know you should ask.

4) Talk to customers. The more customer data you can get, the better. At a minimum, you should talk to three to five customers who use the product. You want to understand from first-hand users what’s to like about the product and what void does it fill. Pay attention to the types of customers a company has; it’s a good sign if you hear them actually promoting the products they’re using.

5) Understand growth. How is the company growing and how will it continue to grow?  Has the business grown by acquiring distribution or has it been successful increasing sales at the same stores? Obviously, to understand growth, an investor has to dig into the key financial statements—the balance sheet, income statement, and cash-flow statement.

6) Know the exit strategy. Know the exit scenarios for the industry that interests you. How big will the business need to be, and with what margins, to go public or be an attractive acquisition target?

7) Talk with your lawyer.  Legal documents associated with investing in private companies are complicated. Show every document to your lawyer for feedback.  You may not care about all of your lawyer’s points, but you should understand them.

8) Understand the business. Follow Peter Lynch’s investment maxim “Invest in what you know.” Before investing in a company, use the product, study the business. The better you understand the business, the more confident you’ll feel about your investment. Why would you invest in a tech company if you don’t have a tech background?  Do you understand how to diligence the next hot mobile app or the technology trends that will impact it? Stick to what you know well.

9) Calculate the per unit economics. Amazingly, many companies in recent years have attracted investors despite the fact that they lose money on each “unit” they sell. Sadly for their investors, many of these companies also have no plan to change that situation. If you’re investing in a beverage company, you should understand how much it makes—or loses—on each bottle. The formula is simple: revenue minus full costs, including marketing and distribution costs.

10) Know the deal. Determine how a company’s valuation and deal structure stacks up against others in the industry. Look at the valuation relative to comparable companies based on multiple factors, including revenue, net income, growth rate, risk profile and capital structure. Good companies are not always good investments—especially if the valuation is too high. As Warren Buffett once said, “Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives good results.”

Ultimately, any investor needs to obtain as much information as possible about the business, the industry and the deal. There are no sure bets, but the more you know, the better your odds of success.

Source:

Ryan Caldbeck

Ryan founded the investment marketplace CircleUp after nearly seven years of investing experience in consumer product and retail-focused private equity. His experience in private equity exposed him to many great consumer and retail businesses that were too small to obtain funding through the customary private equity channels.

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