PCI

How to invest in Privately Held Businesses (PHB)?

The shares of a PHB are usually owned by the founding entrepreneur, plus his/her friends and family members.

Legally a PHB can be a sole proprietorship, a limited liability partnership (LLP) or corporation (LLC), or an S-corporation. The decision-making power usually rests with the individual or small group holding the majority of equity in the business.

Investing in Privately Held Businesses

PHB's offer us 2 types of investment:

1. as angel investors using our own funds, expertise, knowledge, and experience, or
2. as a venture capital firm, acting as a group of investors during any of a company's growth stages.

Level of investment:

• arm's length: an investment without active participation in the operation/decision making of the PHB, conform applicable contract-law and tax-law rules,
• fiduciary relationship like being a member of the company's board of directors,
• equal relationship like management involvement, whereby we invest our funds and our time through offering our expertise, knowledge, and experience.

We take mutual considerations into account when we prepare and sign a MOU and a PA, in order to be able to conduct an elaborate DD, and then make a decision to go forward or not.

If we go forward, then we need to assess whether we need a reserved-matter minority or a majority ownership position in the company, including its risks, responsibilities, and liabilities.

 Types of Business Categories

In order to assess this, we need to determine in what stage of growth the company is in order to evaluate its risks/rewards.

 Stages of Growth

Bankrupt
Bankrupt firms can provide great value at a low price, if the reason for bankruptcy is clear. If the market- and firm-fundamentals are good, cash-flow, P&L and BS ratios will tell the Why. This high-risk investment often requires high personal involvement in order to be highly lucrative.

Turnaround
Companies requiring turnaround are in failure mode. If cash flow, business model, and fundamentals are OK, but mgmt is bad, then things can be fixed, if you as an investor do the work. Successful turnarounds offer high ROI.

Startups (Seed-level funding)
Startups have no management track record or proven business model, and therefore present a high risk, because 80% fail in the first 5 years, except a few new paradigm start-ups like Microsoft, Google, Amazon, Apple, etc.

Second-Level Funding, type A,B,C,D.
A business got off the ground with their seed capital infusions, but now needs more capital to grow. If their fundamentals, track records, and resident mgmt are capable of handling the growth, then they are usually less risky than a startup. This level of invested debt or equity may be subordinate to that of the startup investors. The markets need to be thoroughly assessed so as to determine the growth feasibility.

 

The Pros and Cons of PHB's vs PTB's

Pros:

• Investing in a PHB vs PTB (Publicly Traded Business) allows the Investor to insist that it must be repaid by a certain date and at an agreed upon ROI, or offer an option to exit or continue with certain option dates.
• They are usually small enough to analyze what the business is in its core, and who really manages it.
• They provide early-in opportunities, which could produce super returns.
• Their 'simple' financial reports and bank statements will give the needed business trend information.
• PHB's allow for an easier influence in decision making.
• There is less competition to buy equity.
• The ROI required for you to invest can be negotiated, apart from PHB's performance.

Cons:

• It is more difficult to obtain truly comparative performance data and industry benchmarks.
• PHB's are not held to the more rigorous accounting, reporting and transparency standards required of PTB's.
• PHB's may have a "founding entrepreneur" embedded at the helm, without the requisite management skills needed for the current or next stage of development.
• PHB's often have difficulty accessing needed capital.
• PHB's may have issues like succession, compensation, and direction among the principal owners.
• As a new minority investor, you may have less influence than the original board or management team.
• Unless an upfront provision was made, it may be difficult to get out of your investment.
• PHB's may retain fewer reserves than PTB's.

Summary

When considering an investment in a PHB it is necessary to carefully research the target company, including:
• competition,
• track record,
• market niche,
• financial reports,
• bank statements,
• management skill levels,
• the principal relationships,
• conducting background checks,
• cost trends as a % of revenues,
• know the management very well,
• why the company needs your investment,
• review of all their pending/historical civil court cases.

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