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Private Equity

5 Direct Investment Risks — and How to Mitigate Them

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Direct investing can be risky. If it weren’t, every investor would simply allocate 100% of their capital to this area and not bother conducting thorough due diligence. One study conducted in 2011 by the Center for Venture Research at the University of New Hampshire showed that 24% of the angel investments from the 2011 market study ended in bankruptcy. (We will be covering early stage investments, venture capital, and private equity at next month’s annual Family Office CIO Summit.)

1. Technology Risk

When it comes to investments in high-tech companies, a great deal of the company’s success rides on a few programmers or the acceptance of a certain technology in the marketplace.

How to mitigate: One way to mitigate this risk is to invest in tranches or installments. For example, you could invest $1M upfront, another $1M once they have a working prototype, another $1M once they have reached $500K in revenue, and a final $1M once they reach $1M in total revenue, etc. This will help protect you further instead of investing $4M upfront without any goals for the company to meet to access the additional capital.

2. Market Risk

For new offerings, there is always a risk that the marketplace will not accept the products or services the company is offering. Pets.com, which sold pet products online, is a great example. Too much money was spent upfront on marketing the brand in the marketplace, while the actual market was slow to adopt buying from this new company because they were so early to the online pet retailing game.

How to mitigate: To mitigate market risk, invest only in what you and your team know and understand (see my article on staying within your core competencies for more), validate the opportunity with real competitors and customers if possible, and evaluate the management team’s related experience to ensure this is not one big experiment. As Michael Masterson, a mentor of mine, says, make the company fail fast with an offering, and put the obligation on the company raising capital to prove the market is there.

3. Competitive Risk

There are always risks that existing established customers will emulate a company’s offerings and use their superior distribution or marketing reach to crowd the company out of the marketplace. There is also a risk that dozens of copycat businesses will emerge and lower the margins and unique value offering that the company you are investing in provides.

How to mitigate: To mitigate competitive risk, think about how to build barriers to entrance for competitors. These barriers can include a book, newsletter, magazine, and other thought leaderships assets. Barriers can also include trademarks, domain names, and patents. Companies should research the market and try to predict what potential competitors will do so that you can make it very challenging for them to succeed. If you block your competitors successfully, then they may lose interest and look for more fertile ground to compete on.

Kevin Harrington — who is worth several hundred million dollars, operates the As Seen on TV brand, and has been featured on the popular TV show Shark Tank — said in a recent interview that when his company launches a product now, they test it within a small niche market. Once the product is a proven winner, they buy up every domain name related to that product. Sometimes his company even creates a number of their own copycat products to make the space look more crowded than it is, and then they launch nationally with infomercials and direct marketing.After launching products and investing in companies for 20 years, Kevin says that only one out of 10 investments will be a home run, six to seven will lose money and be quickly closed down, and two to three will generate a moderate return.

4. Management Risk

This is the biggest risk for young companies, as often the person who can write great code, bake amazing bread, or pen lots of books on a small topic is not also the person who is an excellent CEO. Many times, the CEO will need to grow themselves faster than the company is growing, or be replaced.

How to mitigate: To mitigate this risk, evaluate the management team to see if they are coachable or open to being on the board instead of being in a CEO position. It can also be helpful to require personal guarantees from the founding team, include performance clauses that force them to hit revenue hurdles, or retain voting rights or board seats.

At some companies with a visionary founder who does not necessarily excel at management, investors or advisors will compromise by installing a Chief Operating Officer or similar C-Suite executive who can handle a lot of the management and day-to-day operations of the firm, even if he or she does not have the CEO title. Tim Cook served as Chief Operating Officer at Apple before rising to the CEO role following Steve Jobs’ passing. As Apple grew to one of the largest corporations in the world, the challenges of management were beyond what any one person could reasonably be expected to manage, even an executive with Jobs’ talent. Cook provided a level of comfort to investors and customers that the company would meet the intense pressures effectively. The Apple management story highlights the importance of looking beyond only the CEO when evaluating management risk and looking for capable leaders throughout the ranks to help strengthen top management.

5. Finance Risk

If a product works and sells well, the company may need additional financing to fuel the expected growth, buy inventory, enter new markets, or expand distribution channels. Sometimes clauses imposed by early investors make it difficult for future investors to participate.

How to mitigate: It is important to think forward to this point in time, and work with someone experienced in setting up such deals so that you don’t block future investors, which may turn out to be critical to the company’s success. Whenever possible, try to avoid abnormal deal terms, deals which require multiple rounds of investing, and think about whether you need other investors to lose in order for you to win.

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