Buy low and sell high. Sounds simple—and attractive. The buy low/sell high mantra is particularly enticing when applied to purchasing a minority stake in a private company, which has enormous growth prospects and the promise of huge potential returns. The pursuit of these high returns, however, comes with steep risk factors as these are often high risk—high reward investments. In the absence of crystal ball to guide investment decisions, investors need to be wary and conduct extensive due diligence. This Post addresses some of the red flags that may arise in the due diligence process and signal that the proposed investment is one to avoid.
Unexplained Problems in Financial Performance
It is not uncommon for emerging growth firms and family-run businesses to keep less than stellar financial records. As a result, the lack of pristine financial statements is not always a warning sign, particularly when the company is able to provide potential investors with reports that include essential financial metrics. Investors need to be able to secure financial information from the company that permits them to assess the following key data points, among others:
- What are the actual revenues of the business over the past 3-5 years; what is the source of the revenues, i.e., how diverse is the business base, how many different customers and how long are customers retained
- What is the true profit margin of the business—what are the actual costs of producing the products or delivering the services of the business
- What are all liabilities of the business, both short- and long-term.This requires identifying all of the company’s existing and all contingent liabilities
- What compensation is being paid to the executive management—including all benefits and costs that are being reimbursed
Warning signs do arise when these financial measures show unexplained, negative trends, such as negative spikes in revenues, eroding profit margins or loss of key customers or accounts. When the company has these issues, the business owners need to be able to offer credible (and documented) explanations that help to restore confidence in the validity of the historical results and regarding the company’s projected financial performance.
Lack of Full Financial Disclosure
A related point to financial due diligence concerns the degree to which the investor is provided access to the company’s financial information. Most companies will require potential investors to sign a non-disclosure or confidentiality agreement (“NDA”). After an appropriate NDA has been signed, however, the company should not continue to impose burdensome restrictions or sharply limit access to its financial information.
If a company refuses to provide a prospective investor with reasonable access to the company’s financial documents after an NDA has been signed, it is a red flag. Companies that place undue restrictions on access to their financial records may do so because the full picture of their financial performance is a dismal one. The refusal to grant access may therefore signal that there are serious (and undisclosed) problems with the company’s financial results.
High Employee Turnover
If the company exhibits a high rate of employee turnover, this is a definite indicator of trouble. The due diligence process must permit the investor to understand the underlying reasons for the high turnover rate, which will likely include, if possible, interviews of former employees to learn why they left the company. A hostile or unpleasant work environment or distrust in management is a troubling sign for the company’s future prospects.
Until the company has identified the problems causing the turnover and taken actions to correct the problems, it may be advisable to hold off on making any investment. If the problem stems from the management style of a brilliant, but highly temperamental, business founder who has been running the company, this problem may be impossible to resolve without a change in management. This kind of leadership problem can generally be detected readily, however, from interviews with senior management, as well with the company’s rank and file employees.
Adoption of Exit Strategy
The final point does not relate to the company’s financial condition, but concerns the fundamental structure and terms of a minority investment. As we have covered in earlier Posts, it is essential for minority investors to secure contractual exit rights (“a corporate prenup”) at the time they make their investment. We will not revisit the various types of contract exit rights that can be negotiated, but if majority owners refuse to provide reasonable exit rights for the minority investor, including a fair valuation formula applied at the time of the exit, that refusal should be considered a stop sign in regard to a potential investment.
Conclusion
The quest for high returns from private company investments is inherently risky. But investors can mitigate those risks significantly by conducting thorough due diligence before making an investment. This vetting process will include obtaining documents from the company to understand all aspects of its financial performance, closely evaluating its management team and business operations and securing a redemption right, which provides the investor with a contractual right to exit the business in the future.