/>iInvestments in private companies should continue to flourish in 2025 in light of the revenue and EBITDA growth they delivered this year, and this rosy financial outlook is also confirmed by company leaders. According to a KPMG report in September, 90% of leaders they surveyed in U.S. private companies reported strong optimism about their future growth prospects. For investors, the private company sector remains attractive, but these are not risk-free opportunities. This post reviews three resolutions for investors to consider to limit their downside in pursuing private company investments in 2025.
Resolution No. 1: Due Diligence Remains Essential
“All that glitters is not gold” captures the importance of conducting due diligence before making any private company investment. Three different aspects of due diligence, reviewed below, will assure investors that they are obtaining the information necessary for them to make an informed investment decision.
First, due diligence involves more than a cursory look at the company’s financials. In this regard, investors will want to consider: (1) the company’s expected revenue growth (the pro forma) and where that growth will come from, (2) the projected expenses of the business and (3) the competitive landscape. In each case, the question is whether the company’s plan for success is both realistic and achievable.
Second, companies are not just balance sheets or income statements; they are composed of people pursuing business goals in a competitive marketplace. This aspect of due diligence focuses on the business leaders and their teams. Some of the key questions here are: (1) do the leaders have a track record of success, (2) are they not just passionate about the business, but also creative and adaptable in the way that they address challenges; and (3) are they transparent about how they are operating the business? Negative answers to any of these questions will raise red flags.
Third, are there difference makers regarding the business that make it attractive or suggest it is one to pass on? Positive difference makers may include things like an impressive patent portfolio, a strategic relationship with an established business, or a first-mover advantage in an emerging industry. Some negative difference makers are internal conflict among the existing owners, ongoing litigation against the company or threatened claims, or high employee turnover. Each of these difference makers needs to be explored in more depth to gain a fuller understanding of the business before investing.
Resolution No. 2: Meaningful Participation in Company Governance
“He who has the gold rules,” and investors holding a minority ownership will not have the right to direct how the company will be governed. That does not mean, however, that investors should be completely shut out of governance. The balance to be struck is for investors to insist on securing approval (veto) rights over major decisions by company management. These rights will be on the table in the negotiating process.
The veto rights sought by investors would include the right to approve the following: (1) the issuance of additional equity that dilutes the investor’s ownership interest, (2) taking on substantial additional debt, (3) selling significant company assets, and (4) amending the operating agreement. This short list of approval rights is a bare minimum, but securing these types of veto rights helps to reduce the risk of the investment.
Resolution No. 3: Securing a Buy-Out Right
This may be the most critical resolution for investors to make before investing in a private company. As Willie Nelson might have sung: Mamas don’t let your babies grow up to minority investors without a buy-sell agreement in place. A minority investor who does not have this exit right is likely to be stuck holding an illiquid, unmarketable interest. The lack of a buy-sell agreement becomes even more of a problem if the investor becomes dissatisfied with the company’s direction and wants to secure an exit from the business.
The buy-sell agreement negotiated by the investor needs to cover the following issues: (1) when can the investor trigger the buyout (the investor may need to wait for some period before exercising the buyout right), (2) how will the value of the investor’s interest be determined, (3) what is the structure to pay the buyout amount and (4) what happens in the event the company defaults in payment. Value is the most critical part of the buy-sell agreement, and the investor needs to require that the value of its interest is not subject to minority discounts. These discounts are based on the lack of marketability of the interest and the investor’s lack of control over the business, and they will be substantial if they are not excluded from the valuation of the minority interest.
Conclusion
Private company investing holds the promise to deliver outsized financial returns for investors, and that is likely to continue next year. But this can be a high risk/high reward strategy, and investors who act with resolve will help minimize these risks. Specifically, investors who conduct thorough due diligence, acquire approval rights in the governance documents and obtain a contract exit right will be better positioned for success.
