With interest rates currently near zero, CDs, bonds and banks aren’t providing attractive yields.
By Gary Miller – Managing Director, Consulting Division, SDR Ventures
It is no secret the U.S. economy is performing poorly. First-quarter gross domestic product, the broadest measure of economic output, advanced at a dismal 0.5 percent seasonally adjusted annual rate according to the Commerce Department. It is the worst performance in two years. Both top and bottom lines for major U.S. corporations are being pressured, according to the Wall Street Journal. Apple Inc., Norfolk Southern Corp., 3M Co., Pepsi Co. and Procter & Gamble Co. all took hits.
With interest rates currently near zero, CDs, bonds and banks aren’t providing attractive yields. This is problematic for individual investors who increasingly are considering alternative investments as they search for higher returns or yields.
What are alternative investments? Opinions vary, but to me they include private real estate funds, non-traded REITs, oil and gas programs, startup companies, private equity and venture capital funds. They are extremely complex and some are available only to accredited investors defined by the U.S. securities laws.
Alternative investments require close scrutiny as each option is individually evaluated. There are documents, disclosures and agreements to be read carefully and fully understood. This will be time consuming — don’t rely only on presentations and representations provided by management. If you are asked to invest without being provided with proper and complete legal documentation, walk away. Investing your hard-earned money is not a handshake deal!
The documents and agreements for a typical private placement generally include:
- An offering document or private placement memorandum known, as a PPM, that contains important details and disclosures about the company, its business, its prospects, the applicable risks (internal and external), use of funds and the costs and expenses of the transaction.
- A subscription agreement that contains the terms and conditions of the securities sale and purchase.
- Information regarding the accredited or nonaccredited status of the investor.
The securities being sold can bear many names — stock, shares, membership interests, limited partnership interests, convertible debt, warrants, options.
Below are eight considerations you should incorporate when doing your own due diligence. Remember, as a passive investor you will have little or no say in the management of the entity in which you invest.
First, examine the management team’s professional qualifications, experience and past track record of investment performance. Is management putting in its own funds? Be wary if management has no skin in the game. Check to make sure that management has no criminal or other disciplinary history.
Second, examine the risk factors of the product or service. Is it new to market or a modification of something that exists? Would it involve new or significant change in sales practices?
Third, does the entity have enough money to execute its strategy? If not, the venture could fail quickly. In some transactions, you may be contractually required to invest additional capital in the future if management makes capital calls.
Fourth, examine the anticipated internal rate of return in the context of the entity’s investment strategy. Is it realistic?
Fifth, understand the duration of the investment. Many investments do not have redemption rights. Your money could be tied up for years.
Sixth, examine all management fees and expenses paid to management and others. Review the use of funds. A company must describe how it will use the net proceeds raised from the offering and the approximate amount intended for each purpose. Beware of vague statements like “the proceeds will be used for general working capital purposes.”
Seventh, closely examine the securities being sold. Understand the rights, restrictions and class of securities being offered, and management’s ability to change the capitalization structure. Sometimes the founder or existing shareholders retain full voting control of an entity.
Finally, if you can afford to invest, determine if you can afford to lose all of your capital if the investment craters.
A quote attributed to Will Rogers, or perhaps Mark Twain, applies: “I am not so much concerned with the return on capital as I am with the return of capital.”
Gary Miller is managing director of SDR Ventures Inc.’s consulting division, where he helps middle-market business owners prepare to raise capital, sell their businesses or buy companies, and develop strategic business plans. He can be reached at 720-221-9220 or firstname.lastname@example.org.
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