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Advisors, Private Equity

7 Mistakes to Avoid When Making Direct Investments


As the number of family offices that pursue direct investments in private companies increases, so too do the number of misguided deals. Over the years we’ve heard plenty of examples from family offices where the direct investments they made were tremendously successes, but also where there were lessons to be learned. In the spirit of passing on that knowledge, we have compiled a few common mistakes made in direct investing:

1.   Poor Due Diligence

Many single family offices have small teams, and therefore, limited time to investigate opportunities.  This can lead to sometimes 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.

2.   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.

3.   Not Understanding the Exit Before You Enter

As a direct investor, you may experience the following performance breakdown on your investments: only 1 out of 10 investments will work out extremely well, two will make some money, and seven of the investments may 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 substantial effort and time investment 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.  So it is really important to have a clear plan to exit your investments.

4.   Overzealous Negotiations

Often negotiations can fall apart due to valuations which are not based on realized sales, or that are based on someone’s past track record.  CEOs tend to want the world for their company because that is their role, to be the visionary that is passionate about the opportunity.  The single family office investor’s job, however, is to bring the management team or owner back to reality without insulting them, wasting their time, or suggesting their hard work and business are 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 a key to completing a direct investment.

5.   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.

6.   Throwing Good Money in 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.

7.   Not Having an Attorney Review Everything

This sounds obvious, but too often important, seemingly inconsequential clauses are not included in the contract and adjusting the contract becomes increasingly difficult as time passes since signing the agreement.  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.  One rule of thumb to follow is that if the other party writes the contract and assures you that everything “looks good and ready to sign,” then you are in trouble.  The reverse of this mistake is also true, if you can always be the one to prepare the initial contract, and the other party either doesn’t review it completely or doesn’t have an experienced attorney review it you have a marked long-term advantage while forming many contracts for various partnerships and investments over time.

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