This post is excerpted from The Single Family Office: Creating, Operating & Managing Investments of a Single Family Office.
There are pitfalls with any type of investing, and direct investing is no exception. Here are some of the most common mistakes family offices make.
- Poor Due Diligence
Many single family offices have small teams, and have limited time to investigate opportunities. This can sometimes lead to rushed due diligence or over-reliance upon third parties who promise strengths of due diligence, but who also may be very busy and stretched thin. At the very least, most single family offices should be conducting 40 hours of due diligence, background checks, reference checks, and fact-gathering practices before making an investment.
- Not Anticipating Future Rounds
Most companies will need to raise capital more than once; you should expect this and structure your deals at the outset to reflect that potential reality. If you do not structure your deal correctly, you may lose the chance to participate in future rounds, or your shares may be diluted by future capital raises.
- Not Understanding the Exit Before You Enter
As a direct investor, you may experience the following performance breakdown on your investments: Only one out of 10 investments will work out extremely well, two will make some money, and seven of the investments will on average lose money or just not grow. This is why it is important to diversify your direct investment holdings. As with any investment, you want to prepare a concrete strategy for exiting the investment and recouping your money (hopefully with a nice ROI). If you have a timeline in mind for holding and exiting an asset or a company, be sure to plan out when you will approach potential buyers, look for strategic mergers and acquisitions, and explore an initial public offering, if that is realistic. An IPO, for example, takes a substantial investment of effort and time to execute, and the SEC has a set process and timeline for selling shares to the public that you will need to follow. As any wise investor can tell you, when you sell is sometimes even more important than when you buy. It’s crucial to have a clear plan to exit your investments.
- Overzealous Negotiations
Often negotiations can fall apart due to valuations that are not based on realized sales, or are based on someone’s past track record. CEOs tend to want the world for their companies. Their role is to be the visionary that is passionate about the opportunity. The single family office investor’s job is to bring the management team or owner back to reality without insulting them, wasting their time, or suggesting their business is not valuable. A difference in valuation is a top reason for a direct investment to get derailed. There is always a tension between what the owner of the asset believes is a good, attractive price and what the seller believes is a fair, attractive price. The ability to find a balance between these is key to completing a direct investment.
- Not Storing Dry Powder
It is often valuable to invest in a company through two or three phases instead of investing all the money upfront. This is not employing the dollar-cost averaging technique used in stock trading; rather, this gradual expansion of a direct stake aims to encourage the CEO and company to meet certain milestones to unlock the next level of funding, and it guards you against the company possibly going down in flames and losing your entire investment.
- Throwing In Good Money After Bad
Operating businesses often ask current investors for more money to get their product to market, but statistics show that follow-on investments typically are not a good idea unless the business has been a great success already. Instead of putting another $10M into a business that is struggling, family offices should consider other opportunities where you could invest $10M into a business with great momentum and market positioning.
- Not Having an Attorney Review Everything
This sounds obvious, but too often important, seemingly inconsequential clauses are not included in the contract. Adjusting the contract becomes increasingly difficult as time passes. You should compare an ideal or preferred contract with the one that you receive so you can see which clauses, scenarios, and terms need to be completed before signing. If the other party writes the contract and assures you that everything “looks good and ready to sign,” then you may be in trouble.