/>iPrivate company investing is inherently risky, but these risks can be mitigated if investors take proactive steps before making this type of investment. This due diligence action plan for potential investors includes the following specific steps: (1) identifying whether key factors are present in the businesses that mark it for success, (2) evaluating the current and future capital structure of the investment, and (3) securing a contractual exit strategy to provide an off-ramp if things do not go as planned. The failure rate of private companies is high but investing in early-stage companies continues to flourish because the financial rewards can be so great. In this high-risk/high-reward scenario, an investor who adopts the approach discussed in this post can improve the prospects for success, while also reducing the risks of this investment.
Evaluating the Differentiating Factors: The Secret Sauce of Private Companies
There is no way to state with certainty that an emerging private company will succeed on a long-term basis, and the failure rate for new businesses is quite high. According to the Bureau of Labor Statistics, 40% of companies fail in the first three years, almost 50% within the first five years, more than 65% within 10 years, and only 20% survive beyond 10 years. With these odds seeming stacked against new companies, it is difficult for anyone to know which companies will successfully run the gauntlet and remain in business for a decade or longer.
Based on my experience working with entrepreneurs in many different fields over the past several decades, however, there are telltale signs that will improve the odds of success. The key factors discussed below are the secret sauce that should be evaluated carefully before investors move forward to provide capital to an emerging growth company.
1. Quality/experience of management team
The first factor is the experience of the company’s management team and, in particular, whether the company founders are first-time entrepreneurs, or whether they have a track record of success in other businesses. The statistics bear out that company founders who have already had success in starting another business are a better bet to repeat that success in a new company rather than a first-time founder who is tying to start and grow a business for the first time.
Experienced company founders have learned from their past mistakes. As a result, they are more adaptable to changing market conditions, they are more flexible in their approach to the company’s operations, and they are more focused on getting the company to the next stage of development. In sum, their past experience makes them more nimble, creative and flexible, which creates more avenues for the company to achieve success. Unfortunately, while selecting companies with experienced management improves the odds of investing, this factor alone does not provide a guarantee of success. Founders of new businesses who had success in the past also have a failure rate in starting new companies, particularly when they have moved into industries in which they do not have significant prior experience. The experience factor should therefore be taken into account with the others that are discussed below.
2. Product or service that provides a differentiating factor
The second factor to be considered is whether the company has a distinguishing feature to its product or service that will provide it with a competitive advantage in the marketplace. Doing something new in a way that brings real value to consumers or business buyers is a recipe for success. One good example in the consumer space is Spanx. This new product fit a strong need for women of all shapes and sizes, and it quickly became a phenomenon because, for at least a time, there was nothing else available in the market that fit this same need.
Another more recent example is Summer Moon Coffee. There are so many coffee shops in Texas (even without including Starbucks locations) that it seems unlikely that a new coffee shop could emerge successfully. Yet, Summer Moon’s addition of a sweet cream to its coffee has generated strong appeal, and it is currently a private company with about 20 locations in Texas. Coffee is a popular, readily available product, but the differentiating sweet cream factor allows Summer Moon to distinguish itself in this active market. Similarly, Black Rifle is another fairly new entrant in the coffee market, and its ethos of being founded by a former Green Beret, hiring veterans to work for the company and appeal to a strong homeland also allows it to distinguish itself for success in this crowded industry.
3. Growing market need for product or service
A company with a great product or service has a definite chance to be successful, but the odds of long-term success are significantly greater when the market for the product or service is growing rapidly. Therefore, a business that has thoughtfully targeted emerging growth trends is positioned well for success. These growth trends could relate to aging consumers, the movement of large groups of people to Sunbelt states, the desire for healthier foods, or the sharp rise in the price for home insurance.
All of these trends are significant and present opportunities for new companies, and there are many others that create entirely new markets or, like Summer Moon and Black Rifle, expand existing markets. A company with a business model that ties directly into and that will benefit from these trends presents a better opportunity for investment than a business that has a niche market that is stagnant or, worse, may be declining.
Determine the Capital Structure of the Investment
The next due diligence factor has multiple components to it. The first aspect requires the investor to study and gain a full appreciation of what is referred to as the capital stack. This will be reflected in a spreadsheet that identifies all of the company’s owners and includes the specific percentage that each owner holds in the business. The investor should also inquire to determine how much the other investors provided in capital to the business, including all of the founders. If the company’s founders have not made any capital contributions, and their ownership interest is based solely on their sweat equity, it is worth exploring the circumstances to make sure that the founders are fully committed to the company.
Second, and importantly, the investor needs to determine how future capital contributions to the business will be structured. If the investor is making an initial or early-stage contribution, it is likely that the company will require additional rounds of financing. As a result, the investor needs to be concerned that future rounds of financing will substantially dilute the investor’s share of the business. This can be handled in a variety of ways, i.e.,the investor can agree to make additional contributions infuture rounds of financing to maintain its original percentage ownership, or the investor can insist that its percentage of this business will remain static even if it does not make additional capital contributions. The investor’s concern regarding future dilution can be handled through the purchase of preferred shares that provide it with priority rights that will not be impacted by future financings or it can insist on including an anti-dilution provision in the investment documents to maintain its ownership percentage.
Secure an Exit Strategy (A Put Right)
The last element of the investor’s due diligence strategy needs to be securing an agreed exit path, which will be in the form of a put right. This is a contract that permits the investor to trigger a redemption/purchase that requires the company to buy the investor’s interest in the business. We have written extensively in the past about buy-sell agreements, and this agreement will need to address: (1) when the put right can be triggered, (2) how the value of the investor’s interest will be determined, (3) how the payment for the investor’s interest will be structured, and (4) what collateral, if any, will be provided by the company to protect the investor in the event of a default in payment.
Conclusion
The risks of private company investing cannot be extinguished, but they can by reduced when investors take proactive steps to conduct specific types of due diligence before making the investment. When the investor confirms the business has legitimate distinguishing factors that differentiate it in the marketplace, when the company has a capital structure in place that protects the investor as additional capital is raised, and when the investor secures a put right that provides a contractual path to an exit, these steps will definitively lessen the investor’s financial exposure in making this high-risk investment.
