Four questions to ask before investing growth equity

More and more people I know consider investing in private companies with friends and family a more interesting opportunity than putting all of their investment capital in the stock market. I applaud this out-of-the-box thinking, but it does take a different mindset and an extra layer of diligence to make this type of investing profitable.

Is the industry or investment strategy something that you understand? If you do not fully understand the investment opportunity, how can you properly assess the risk and the reward? I am a big believer in risk equals the reward. If you see an opportunity that has high investment returns and you don’t see a lot of risk, then you are not identifying all the risks. High returns equal high risk, so pay attention.

Do the people you are interested in understand the fiduciary responsibility of taking on outside capital? Do they use professional third-party accountants to prepare their financials on at least an annual basis? Do they have a controller or other responsible party who can generate accurate and timely information to not only make decisions, but share understandable data with investors? Will they take the time to communicate with you at least on a quarterly basis what is going on with the investment and what the opportunities and challenges are? Like any relationship, communication is key.

Does the growth plan make sense? Many entrepreneurs I talk to are overly optimistic and underestimate the investments that need to be made in their business to make their growth plan come to fruition. The plan is oversimplified because they have only paid attention to sales growth and assume expenses will remain largely unchanged, thus translating into outsized future profits. Is this team capable of making the difficult decisions and doing the planning involved in high-growth companies? I would argue that many people could manage a business that remains roughly the same size year in and year out. However, someone who has the foresight to run a profitable business that is growing over 25 percent a year is uncommon.  

Have you done a background check on the person you are investing in? Have you spoken to other people who know the executive management team? Are these people whose opinions matters to you? Understanding the type of person you are investing with and what their motivations are for needing outside capital is important. I learned in credit training in my first job many years ago the 3 C’s of investing and lending: Cash flow, collateral and character. We were always told that character had repaid more loans and generated more investment returns than the other two C’s combined.

I would like to see regulatory changes that allow more people to participate in the private equity industry, but that does not mean that you cannot invest directly in private companies yourself. Just keep in mind that, when investing in private companies, you need to hold yourself responsible for paying attention and having the energy to engage when needed.

Jeffrey Kadlic is co-founder and managing partner at Evolution Capital Partners