2008 Wealth Guide: The private payoff

Written by ProfitGuide Staff

With so many different investment options available to entrepreneurs, it’s a wonder why any would hand over their hard-earned funds to a privately run company. Although some startups have huge potential, most new businesses fail within a few years, making them high-risk investments. And while more mature private enterprises might be a safer bet, they offer less growth potential and lack liquidity, making it tough to cash out.

But if you weren’t hard-wired to confront risk and challenges, you wouldn’t be an entrepreneur, would you? That helps explain why many business owners do take the plunge into owning shares of private companies other than their own. And the potential for market-whipping returns from private investing never loses its lustre. According to a 2007 study by the Kansas City, Mo.-based Ewing Marion Kauffman Foundation, a successful investment in a private company generates a 260% return on investment within 3.5 years; try getting that from your mutual fund. And there are other benefits to investing in a private firm, such as the significant opportunity for networking, personal development and learning. While the risks can be equally sizable, savvy entrepreneurs build in ways to mitigate them.

Doug Robbins is one entrepreneur who builds his personal wealth by investing in private businesses, typically those with revenue ranging from $500,000 to $5 million. Robbins is president and founder of Hamilton, Ont.-based Robbinex Inc., a business intermediary specializing in the sale of mid-sized, privately held companies. A serial entrepreneur with experience in a variety of industries, he believes his knowledge, coupled with his cash, can help almost any company grow. “It’s not uncommon for me to look at a small business, wiggle my nose and find a way to make the sales double,” he says. For example, he once invested in a small dry-cleaning business and, using his previous experience in real estate to help the owner choose good locations plus his sales and marketing savvy, helped to expand the firm by nine new locations. That’s just one of more than 30 companies in which Robbins has invested over the years.

Robbins typically finds such companies through his own business. People come to him looking to sell, sometimes because the bank has called their loan. If he can conceive a way to help the company out of trouble, he’ll present the opportunity to the small-business owner, and many gratefully accept. He recommends that entrepreneurs find investment opportunities through their bankers, lawyers or accountants. You can even peruse Internet sites and classified ads.

A private investment can pay out in a number of ways: dividends, presuming the firm is profitable; the sale of additional equity to other private investors, such as venture capitalists; a public offering; and acquisition by a third party. Robbins typically takes a share of the company’s profits as well as receiving fees for sitting on its board of advisors. However, he accepts that it can take quite a while to get his money out: “You have to be patient.”

You also have to stomach risk. Although Robbins has enjoyed returns of 100% per year in some cases, he has also lost 100% per year. He says he’s happy if he does well on one in three investments, with the gains from the stars more than making up for the losses on the dogs.

A big part of mitigating that risk is to carry out due diligence. “The most important thing is to know a lot about what and who you’re investing in, so that you can’t be smoked or BS’d,” says Robbins. “Then, you need to monitor your investment, no less than monthly. I want to see a business plan, I want to see the monthly results against plan and understand any variances. When I don’t find those things happening, I become uncomfortable.”

Mauro Lollo, co-founder and CTO of Oakville, Ont.-based Unis Lumin Inc., a technology-services provider, wasted no effort investigating his opportunity to invest in a private technology startup in 2005. “I spent two months, reviewing the market [the product] was addressing, the need and how topical it was, in terms of the consumer space,” he says. “I tried to nail up the good and the bad.”

For several years, Lollo had known and respected one of the founders, who’d indicated his dedication to nurturing the business by investing his own money in the company. That and the market potential of the product convinced Lollo to invest several hundred thousand dollars in cash and kind in the startup.He believes the firm will be ripe for acquisition within five years, delivering a return of more than 20 times his initial investment.

Unlike most private investors, Lollo has gone to great lengths to keep his investment on track: he has become the company CEO, a job to which he devotes a half-day per week. “It’s taxing in terms of time, but I can get myself better rounded from an executive perspective, and build my personal network,” he says. “It’s a great learning opportunity in an industry complementary to my own.”

Before you buy into any private company, ensure the firm’s capitalization is in line with its growth plans, advises John Teleske, a partner in the Vancouver office of national accounting firm BDO Dunwoody. If the firm needs to sell more shares in the future to grow, your equity will be diluted. You can avoid this problem and many others by hiring professional help. Both Lollo and Robbins used lawyers and accountants to assess and set up their deals, draw up contracts and give tax advice. Lollo says you can expect to pay about 5% of your investment, or a minimum of $10,000 to $15,000, in professional fees.

You could even try to tap the expertise of a full-time angel investor, who makes private investments for a living. “A lot of people put money into deals that are bad because they like the entrepreneur or the technology or the market,” says Ron Thompson, founder of Toronto-based Corporate Angels, a network of angel investors. “You can always find some supporting data to justify why you like it, but maybe the founder hasn’t got the expertise, the market isn’t as easy to penetrate as you think it is or the technology isn’t as good as you think it is. To the naive, you don’t really realize all these things ahead.” But with a little help from on high, you’re more likely to achieve the big payoffs that private investing can deliver.

Originally appeared on PROFITguide.com