Disadvantages for private equity, when you're the investor?

[mountaineer]

Hey guys,

Just been doing a lot of research about venture capital and private equity lately, and haven't really come across this. Most of the pros/cons arguments, are from the entrepreneurs point of view. But I'm more looking for what are the pros/cons when you're the investor.

Example. If I owned 10% of 10 companies. If any of the companies grew, my 10% value would go up. If they go down, the value of that 10% recedes. But I'm thinking more of the non-monetary pros/cons. Legalities if you will. If something extremely negative happens with one of those companies that brings about lawsuits or government involvement or the like, how much would your 10% be involved in that, and how would/do you deal with that as an investor?

 

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[Darkside]

Hey guys,

Just been doing a lot of research about venture capital and private equity lately, and haven't really come across this. Most of the pros/cons arguments, are from the entrepreneurs point of view. But I'm more looking for what are the pros/cons when you're the investor.

Example. If I owned 10% of 10 companies. If any of the companies grew, my 10% value would go up. If they go down, the value of that 10% recedes. But I'm thinking more of the non-monetary pros/cons. Legalities if you will. If something extremely negative happens with one of those companies that brings about lawsuits or government involvement or the like, how much would your 10% be involved in that, and how would/do you deal with that as an investor?

Generally, investors are protected from lawsuits since they are not directly involved in the operation of a business in the same way that if you purchased Coca Cola stock and tomorrow Coca Cola was found to have purposefully put poison into their soda; the CEO and people directly involved might be taken to court but you as an investor are legally protected; the value of your stock would probably go down though as bad PR will tend to reduce sales.

 

[mountaineer]

Ah good point, makes sense. I also suppose most stipulations could be put in the contracts for protection as well.

 

[John C.]

With a minority interest in a small company, I would not be worried about suits and/or government regulators. Assuming that you are not active in the management, you should not have any potential problems as long as the structure is a corporation or LLC. You should never enter into a partnership as an investor unless it is a limited liability partnership.

What you should be concerned with is the governance provisions. How will the company be managed? What are the duties of the officers to protect your investment? How well do you know the management of the company? What has been their track record? How much "skin" do they have in the game (what is their investment, potential loss?) You never want to invest where the management does not have some real investment in the company.

Is there an adequate "Private Placement Memorandum"? The PPM lays out the plan of operation, the risks, the track record of management, etc. There should be full disclosure.

Investing in private companies is high risk. Your investment is generally very illiquid ... which means you generally can't get your money out if you need to. Unfortunately most new companies underestimate the funds and/or time for the company to become self-sustaining. Which means there will often be need for additional funds. So what are the non-dilution provisions in the event of additional financing is necessary?

This is not something to be entered into without lots of due diligence.

 

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[mkzhang]

As an investor in a PE fund? Minimal to no risks at all other than a loss of all your money. The money is usually managed in a fund holding company, in which you are a limited partner, and the fund holding company invests into a the fund's management holding company as a limited partner, and the active management of fund is the general partner of the management holding company with no economic interests.

Therefore unless the management team is proven to commit fraud, and the management holding company entity's veil was pierced (meaning everyone takes full personal liability for their offense), and that the limited partner of the management holding co, the fund holding co, its general partner (the fund owner's personal investment) was found to have committed fraud in their investments as well, your money usually is not tied up in any criminal or liabilities.

 

[easymoney99]

You protect your self from those serious extreme bad examples by screening your investments thoroughly. They must pass a test which makes them VERY unlikely for those bad things to happen. You shouldn't invest in shaky or shady companies that have high risk of bad things happening. Course I only say that because I read about how to decide if you want to invest in a company, I've never actually done it.. yet.

 

[mountaineer]

Sounds good. I have a couple ideas floating around on the involvement of VC's and just couldn't find anything pertaining to an opinion other than the entrepreneurs. Your comments make me feel a little easier. I do have a good VC lawyer to handle paperwork and whatnot, but I'm more or less still in the research phase. I did find a couple books from the VC's POV, so I'll be picking those up soon too. Outside of just a money loss, are there other general problems that would be consistent in PE?

 

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[mkzhang]

You're trying to start up a PE / VC? Or invest into a fund?

 

[mkzhang]

You protect your self from those serious extreme bad examples by screening your investments thoroughly. They must pass a test which makes them VERY unlikely for those bad things to happen. You shouldn't invest in shaky or shady companies that have high risk of bad things happening. Course I only say that because I read about how to decide if you want to invest in a company, I've never actually done it.. yet.

If you have ever tried to invest into private businesses, you will know how impossible what you said becomes... lol

 

[mountaineer]

Ah just looking. Had a different approach for a crowdfunding site, but current laws make it a bit difficult to proceed as far as equity goes.

 

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[mkzhang]

Are you talking about the securities exchange act of 1934? You can sell equity to investors if you are 1) an equity owner or 2) an executive officer or board member.

I am not a lawyer so don't take my word for law, but that's how its done from the various deals I've seen.