The public markets were down last year, and private company values also took a hit. So, is now a good time for a new investment in a private company? The best answer is it depends.  There is never a bad time to invest in a great company, and when the value of a terrific business is lower in a tough business cycle, it is a superb investment opportunity. Before making a new private company investment, however, it is wise to consider if there are red flags, because the risks involved in private company investing are notable. According to LendingTree, 18.4% of private companies based in the U.S. fail within just one year, 49.7% go out of business in five years and by year 10, 65.5% have failed. This post reviews some of the red flags that should be carefully assessed before making a new private equity investment.

Lack of Transparency in Financial Reporting

The first red flag may be the condition of the company’s financial books and records. If the company’s financial reports don’t clearly set forth how well the company is performing, and a potential investor cannot discern whether the company is flourishing or floundering, that is a major concern. The basic questions to ask include:  (1) Are the profits or losses of the company clearly stated in its financial reports; (2) does the company work with a reputable outside accounting firm or does it handle all of its finances and taxes internally; and (3) does the company have a strong CFO or controller who presents the financial condition of the company in plain terms?

If the answers to any of the foregoing questions is no, that is a red flag. If the company’s financial reports are muddled, if the company has no oversight from outside, experienced CPAs, and if there is no one at the company with a strong grip on its finances, it is not reasonable for an investor to expect that these troubling issues will suddenly improve after the investment is made.

Declining or Inconsistent Profit Margins

When the financial reports are clear but they reflect that the company’s profits are not stable, that is as serious a concern as having poor financial reporting. Ideally, investors want to see profits rapidly increasing, or at least trending upwards. Startup companies often take time to become highly profitable, however, and that will require the investor to review the company pro forma to understand the critical factors that will lead to profitability. For example, the company may project it will become profitable when certain key hurdles are reached, such as securing a contract with a major client, achieving a certain level of visits/traffic to the company’s website, obtaining a patent on its key product or securing a license agreement on an existing patent.

The investor will need to decide whether to make a riskier investment before the hurdle has been achieved, or to wait until the milestone is reached before coming on board. That delay, however, may make the investment more costly or unavailable. Once the hurdle has been cleared to profitability, the company may no longer need the investment, or the price of investing may have increased substantially as the company’s value increased. This is a classic risk/reward scenario that the investor will need to carefully evaluate, with input from company management to determine whether the hurdles are legitimately within reach before the investment is made.

Rapid Employee Turnover

When employee turnover is high, this is an important red flag. It suggests that there are a host of problems at the company, including leadership problems, lack of strong company culture and an inability to scale the business over time. Determining the reasons for the turnover require more due diligence to be conducted to determine what types of employees are leaving (are they actual employees or contractors), why they are departing, how quickly they can be replaced and whether the problems that caused them to leave can be fixed.   

High Client Concentration

If the company’s success is pinned to just a small number of clients, that is yet another red flag to consider. If the loss of a single customer would send the company into a tailspin, that makes the investment more high risk. Follow-up questions would therefore include (1) whether the company’s major clients are subject to long-term agreements or whether they have the ability to opt out of the agreement at any time; (2) what is the likelihood that the company can diversify its client base over time; and (3) what contingency plans does the company have, if any, in the event that it were to lose one of its largest clients?     

Relative Access to Capital

The goal of investing in private companies is to secure a robust return, which is based on the future growth of the business. For the business to grow requires it to have access to capital, and a critical question, therefore, is whether the company has the ability to access the capital that it will need to fund its growth curve. This capital could be in the form of borrowing, such as a line of credit, from existing investors who have committed to fund the company’s growth, or from an expected round of additional investors. This additional investment will then have a dilutive impact on the investor’s ownership. The investor needs to consider whether future dilution is a risk worth accepting or whether it should seek anti-dilution protection.

Before making the investment, the investor needs to understand what specific access to capital is actually available to the company. Many companies with potentially bright futures have been derailed when they were not able to access capital at a critical point. By the time that they obtained the necessary capital, other better-funded competitors in the same space leapt ahead and they were never able to regain their traction. If the company is unwilling to discuss its plans for growth and its ability to access capital in the future, that is another red flag. 

Conclusion

Private company investing comes with an inherent degree of risk because most private companies do not stand the test of time to survive past ten years. An investor, therefore, has to be willing to accept a relatively high degree of risk in pursuing outsize returns, but some of this risk can be reduced if key red flags are noted and the concerns that they present are addressed. If the investor’s due diligence confirms that the company’s financial reporting is sound, that its profits are supportable and trending upward, and that it has the ability to secure the capital necessary to fund its future growth, this may be a risk worth taking.