March 31 , 2003

Invest in a Private Company ?
by Marcel Chartier

I have recently had an interesting and enlightening experience. Through a connection within a company I was contacted and presented with an opportunity to buy shares: six whole shares for $100,000. This is not an unusual amount for private investment. The company appears to be fast growing and plans for expansion are currently in place. The company has a model for operation that generates high gross margins, over 35%. From a business perspective we are talking about a business that makes money “hand over fist”. Boy was I enticed - enthralled! I was just waiting to throw my pennies at this opportunity!

Ah, but of course I have learned to research the situation first. So these are some of the questions I asked and some of the paraphrased answers I recieved.

Q. What is the average wage of the employees?

A. Don't exactly know, they work on commission.

Me, red flag. How do you know that for just a small amount more a competitor can't just lure your staff away?

Q. What is the labour environment like? Any chance of unionization?

A. Great labour environment, over a 100 staff. Anecdotal information about staff gushing all over about work environment.

Me, red flag. First most people don't gush about their work environment, and if they did, the employer would be able to say why. Workplaces that grow over 50 are at higher risk of unionization as workplaces have a critical mass and start developing personnel issues related to size. It made me feel that they had not thought about this.

Q. How is expansion going to be staffed?

(The first business location was staffed with many experienced people from other businesses paid slightly premium amounts, which appear to be discontinued for new locations).

A. From the primary location.

Me, red flag - my contact stated to me that inexperienced staff were selected for management and supervisory duties who do not have management or supervisory backgrounds. Nepotism was also a factor.

Q. Is there a dividend?

A. No. Not at this time.

Me, red flag. If I am putting $100,000 into a business and am not recieving a dividend, or an accumulating dividend to be paid out at some future point, then I will come last after the other debts the business has. I may never see an income stream. And, why no dividend or mention of ? In a business that appears to have good cash flow a small dividend should be provided or planned to be provided for a private share owner.

Q. What is the voting structure of shares?

A. Each of the original owners have 100 shares. There are now over 300 shares outstanding.

Me, red flag. Even if I bought my 6 shares, how would I ever influence events over the usage of funds or my money? I would be at the mercy of the original owners regardless of their decisions. This ultimately would affected me negatively. This struck me as a good deal for the original owners, not necessarily for me.

Q. What is the exit strategy? How do I get out when I want to?

A. The prospectus said that one could not sell shares for an indefinite time. The company representative stated that their intent is to buy back shares after 3-5 years.

Me, red flag. Indefinitely? That could mean never. The whole point of investing is to be able to get out at some time with increased value. If there was an intent to buy back, then some schedule for repurchase should have been in the prospectus.

As you can see, a very good business, with great cash flow and wonderful margins does not a good investment make. The conditions of the investment are such that if you do invest you may for a long time not be able to get out, or get out with what you have (though in this case, I think the risk was limited to the downside). The inability to influence the company activities through the voting structure was a severe concern. Also, you have to compare this investment to other types of investments. If you took the equivalent value and bought equities, especially in a down market, you could realize great gains, while diversifying risk and having a clear exit strategy. Or you could take that $100,000 and start your own business, at least you would have more control over it.

The lesson I learned is that even a good business can be a bad investment if the conditions make it a poor investment for you. If my risk profile was different, if I was a truly “wealthy” person, I may have taken this opportunity as it may have complemented my other investments. And only if this investment represented a small portion of my investments - the risk would be minimized.

Investments have to be based on you. You have to deterimine if it is a good plan for you based on your circumstances, based on your risk tolerance, and based on what other investments may yield and their risk- reward profiles.