Investing in privately held companies is not easy as these shares are illiquid and risky. The holding period is also relatively long. While there are never any guarantees in investing, there are always methods to mitigate the risks.
While every investor realises that diversification is important, some investors, generally high net worth individuals (HNI), go one step forward and start investing in private companies. It is evident from the last few years that HNIs are investing in private companies with strong growth potential. Investing in privately held companies is not that much easy as these shares are illiquid, risky and holding period is relatively long term.
Therefore, one should consider the following before investing in private companies.
Understand the business model
Investment bankers, who represent the vendor firm, normally present the best picture to you in the sales pitch or information memorandum. So, you should understand the business model which they present and identify the associated risks. Pose questions to them regarding the risk mitigation strategies envisaged by them. If the sector you propose to invest in is totally new to you, it is better to hire an expert who understands the sector and can ask critical questions to the investment bankers and elicit answers on your behalf.
Vision and value statements
You read about the company’s vision, mission and value statements. They look appealing on paper but are they really executable? Most companies stumble in the execution part. If you are serious about investing a significant amount in the company, ask for a meeting with the CEO and key managerial personnel. It will help you understand the risks and assess whether the company has the ability to deliver what it promises.
Understand and assess growth
Before investing, you should understand how is the company growing and how will it continue to grow. Assess the growth; is it organic or inorganic? Organic growth is the growth rate achieved by a company by increasing its output and sales internally whereas inorganic growth means growth through acquisitions or mergers. Generally, organic growth is considered more valuable than inorganic growth. To understand growth better, an investor should analyse the financial statements in detail.
Per unit economics matters
Surprisingly, many companies in recent years have attracted huge investors despite the fact that they lose money on each unit they sell. Check what is the plan of the company? If the company has no plan to reverse the loss per unit, then there is no merit in looking at the company as a potential investment. Suppose you are considering investing in a biscuit-making company, you should understand how much profit or loss on each packet. Compute revenue minus total costs including general adminstartaive, selling and distribution costs.
Do not get carried away with revenue minus marginal cost.
Share purchase agreement and exit strategy
Share purchase agreement can be an extremely important aspect, especially when things do not go as planned. Calculate the required rate of return on your investment and enter into an agreement with the promoters. Plan the exit strategy for the company that you plan to invest in. Assess and identify when the company can go public or it could be an attractive acquisition target.
To conclude, it is important to take a measured decision. There are never any guarantees in investing, but there are always methods to mitigate risks. Investment decisions need to be guided by the above parameters and finally a degree of personal judgement and trust, especially when investing in private companies.
The writer is a professor of finance & accounting, IIM Tiruchirappalli