Evaluating Local Investments

The Due Diligence Process

Now that you have assessed your financial situation and written down your investing rules, you are ready to start evaluating investments to learn if they are a good fit for you. That process begins with gathering information on a potential investment, such as a business plan, offering documents, and financial statements. Even at this early stage, you can learn valuable information about how prepared a business is to take on investors and execute their plan. Do they have a business plan? If not, consider referring them to a reputable business consultant, Small Business Development Center, or an independent expert with experience in their industry, and ask them to get back to you when they develop a more cohesive plan. If they do have a business plan, is it well-written, well organized, and understandable? Does it consider risks, competition, and downsides anywhere near as much as it focuses on upsides and rewards? Was the business plan written with the help of, or reviewed by, someone outside the business that is qualified to do so? If a business has not done these things, then there’s a significant likelihood the people behind it have not done a complete job of mapping out their strategy. Many investors will not even consider investing in a business that does not have a clear and compelling business plan.

Next, does the business have a prospectus, private placement memorandum, or legal agreement for taking your investment? There is not necessarily a right or wrong answer here, but at this point, simply take note of whether or not the business appears to have done their legal homework around accepting investments. Some local small business people are not aware of securities laws, so you may be able to offer them basic guidance or referrals to help them address this area.

Once you have gathered this information, begin the process of reviewing it, developing questions that the materials do not address, asking them, adding the answers to your trove of due diligence information, and then repeating the process until no more questions remain. Clearly, if at any point you decide not to invest, there’s no need to go any further. Here is a basic map of the evaluation process.

Concept & Industry

First, start by exploring the overall concept of the business. Be sure that you understand it, and that it makes sense to you. Who does the business serve, and what needs does it meet? How does it create value and make a profit, generally speaking? Is it a new and unproven business, or an existing business with a demonstrable track record? What contributions does it make to your community?

Second, look at the bigger picture of the industry that the business is a part of. Is the business in an industry that you know and understand, or know nothing about? Is that industry growing or stagnating? Is it seasonal?

Management Team

Third, evaluate the management team. Many people believe that management is the single most important part of any investment, since they are the people who will carry out the business plan, make the crucial decisions along the way, deal with the unexpected, and ultimately be accountable for your investment. Who is on the management team? Who selects the management team? The owners or Board of Directors usually choose who manages a company, and therefore management can be replaced by them, which is good to know. You can typically find this information in the business’ Operating Agreement (or similar legal agreement). Next, identify any advisors, consultants, or other people that are influential to management, but not actually part of the management team, and make sure you are comfortable having them around. Are there any advisors missing that could really improve the team? If so, make suggestions. The due diligence process provides an excellent opportunity to give your input to your potential investees.

Next, look into the background and track record of the management team. Do they have prior experience directly related to what’s spelled out in the business plan? Do they have business experience at all? Can you verify their experience and general character by checking their references or credit history, or doing Internet searches? Is their track record good and does it inspire your confidence? Often, many different skill sets will be needed to execute a business plan, such as sales/marketing, retailing, operations/logistics, finance, and general management. Does the management team have all the skill sets they need, or are any key skills missing?

Next, evaluate potential risks in the management team. Is the team diversified with many people able to lead, or is there one primary leader on whom the success of the business depends? Especially if an indispensable leader is older, is there a succession plan in place? Does the company have “key man” life insurance on that person? Would that insurance be used to pay back your investment? What if the key person is disabled and cannot work? Especially in small businesses, it’s important to consider a variety of potential scenarios when evaluating the management team, and what happens to your investment in those scenarios.

Financial Statements

Financial Statements don’t have to be hard!

Fourth, consider the financial side of the business. You don’t need to be an accountant or banker to evaluate financial statements, but you do need a basic comfort with numbers. If you’re not, consider getting help for this part. Financial information comes in two forms: Historic numbers that report what actually happened in the past, and projected numbers that reflect assumptions about how the future will unfold. Startup businesses may not have historic numbers, but existing businesses will, and you should review them to get to know the business from a financial perspective.

There are three main kinds of historic financial statements: Income statements that reflect what the business made and spent money on over time, a balance sheet that shows what the business owns (assets), owes (liabilities), and the difference between them (equity; the net worth of the business) at a single point in time (e.g., the end of the year), and cash flow statements which reflect how cash comes in and out of the business over time. Tax returns can be another good source of historic financial information for those that can interpret them. For basic due diligence purposes, you should obtain, at minimum, a recent balance sheet and the last few years of income statements. Businesses that are taking care of their bookkeeping responsibilities should be able to promptly provide accurate, up-to-date financial statements. Consider it a warning sign if this is not the case.

To learn about analyzing financial statements, check out the links to basic education on the topic listed in our Resource List. Start by familiarizing yourself with the items you see on the statements, making sure you know what you’re looking at. Can you tell how much cash the business has on hand? How much debt? How much profit it made in recent periods? Often, these numbers don’t mean much on their own, but take on greater meaning when compared to other numbers in the form of financial ratios. For example, the debt-equity ratio, which is total liabilities divided by total equity, gives an indication of how leveraged a company is, and therefore how much risk might be associated with its current level of debt. For most financial ratios, there are no absolute levels that tell you if a company is financially healthy or not. The best way to use them is to get a general sense of how the various financial aspects of the business compare with each other, and perhaps to other businesses, and to identify potential strengths and weaknesses that you can inquire further about.

Financial projections are the other type of financial information that you should be investigating. Usually, they are presented as future, or pro forma, financial statements, such as future income statements and balance sheets. The best projections use models, which separately forecast many of the factors that go into the ultimate result. For example, a model-based financial projection might show assumptions about how many widgets the business will manufacture, how much they will sell for, and what the business’ various expenses will be over the coming years, in order to create a series of future income statements. Projections that show the most important parts of the business, and how they contribute to the bottom line over time, can tell you a lot about how the management team believes the future will unfold for the business. Review the projections, comparing them with historic statements, and ask management about anything significant that catches your eye, such as large one-time expenses, or changes in trends of ongoing expenses, like salaries, marketing, interest, travel, and so forth. The answers can reveal how well they have thought out their business plan, their values, and more. For example, if the business is spending a lot on salaries, how does that compare to other businesses in similar situations? Here, watch out for businesses that intend to pay management generously with new investment money, rather than prioritizing investment in the parts of the business that drive future sales and profits. If the business is spending a lot on marketing, does it have an actual marketing plan, and does the management have a proven track record with marketing? If not, is a marketing consultant in the budget? As you can see, financial projections are a rich area for generating questions to ask management and learn about what you are potentially investing in.

“When looking at projections, your purpose should be to uncover the assumptions that underlie the numbers, ask yourself if they make sense, and if not, ask management to explain them.”

As a potential investor, keep in mind two related points about projections. The first is that they are based on assumptions. When looking at projections, your purpose should be to uncover the assumptions that underlie the numbers, ask yourself if they make sense, and if not, ask management to explain them. For example, many companies that are raising money will, optimistically enough, show rising revenues/sales in the coming years. Since this is one of the easiest areas for a business to fall short of expectations, you should question what will drive that projected sales growth. You would want to see sufficient marketing expenses to spread the word to potential customers and drive those rising sales. As another example, let’s consider a startup company. When are sales projected to begin? Is it reasonable to assume they can start by then? Will the company have enough cash to cover all its expenses until then? Does it have enough extra cash to survive in case expenses are higher than expected, or sales take longer than expected to begin? These are all major assumptions that affect a business’ ability to survive and thrive over time.

The second point to keep in mind about projections is that they are inherently uncertain, though to different degrees. To illustrate, an established business should be able to use their current sales numbers and growth rates to develop a reasonably accurate set of projections based on their current reality, whereas a startup business will typically have little to no idea of how many widgets they will sell over time, although startups with thoroughly researched business plans should have a much better idea. Without quality information to go on, businesses essentially have to make educated guesses. Therefore, get a feel for how certain or uncertain the projections are by asking management to explain how they came up with them. As you get to the bottom of the projections, you may get a sense of how conservative or optimistic they are. Businesses with overly optimistic projections set themselves up for a greater likelihood of worse-than-expected results. Because of that possibility, you’ll need to evaluate the impact on the business, and your investment, of future results that fall short of projections. If sales miss expectations, and/or expenses end up higher than expected, then profits will be lower. Will that leave enough money for you and other investors to be paid interest or dividends, or to get your principal back? If not, is there a Plan B, both for the business, and for you personally? Diligent businesses will do this work for you by presenting best-, worst-, and middle-case scenarios with a different set of projections for each. Other times, you may have to do your own figuring. The bottom line is that the worst-case scenario is something you need to be able to live with, given the amount of money you are considering investing. In this way, the due diligence process can help you decide the optimal amount to invest, as you come to understand the risks of your potential investment better.

Deal Structure

Next, you’ll need to examine the terms under which you will be investing, which is called the deal structure. All of these terms should be recorded in a legal agreement. For Direct Public Offerings (DPO’s), this document will be called the prospectus. For some private offerings, especially larger ones, it will be called the Private Placement Memorandum (PPM). For most local private offerings, the agreement will need to be negotiated by the parties (which can include multiple investors, each investing separately under similar or different agreements) and written up by an attorney, or if everyone is comfortable with it, written by one of the parties to the investment. Though it’s always recommended to have an attorney review legal agreements before signing, many local investors and local small businesses opt to write their own investment agreements, especially for smaller and more straightforward deals, such as promissory notes (i.e. loans). The main risks with doing it yourself are that an important term could be omitted, be written in a confusing or contradictory way, or conflict with existing laws or regulations. The consequences of this could be non existent, or severe, depending on how things unfold.

The structure of a deal can, and generally should, include the following terms. Be sure that all relevant details are addressed in the agreement. For equity offerings, the company’s Operating Agreement is an additional document you’ll need to review for important details.

1. Who are the parties to the agreement? For loans, repayment security can be increased by including a cosigner in the agreement, who guarantees repayment of the loan.
2. How much is being invested, and when?
3. How will the investment be used by the company? Are there any limitations on this?
4. What kind of investment is being made? For example, a loan, equity shares (ownership), revenue shares, etc.
5. What kind of updates, such as financial statements, written reports, or meetings in person, are investors entitled to receive with regards to their investment, and how often?
6. What payments will be received in return, and when? Will they be in cash, goods and services, or both?

For loans:

1. What is the interest rate, and does it change over time?
2. How often does compounding (adding or “accruing” interest to the balance of the loan) occur?
3. When do payments begin? Sometimes, small businesses can benefit from not having to make payments for an initial period after the investment is made, so they can focus on building their business. During that period, interest will accrue, but the investor will be paid afterwards.
4. What constitutes default? Default generally means a failure to make payments on time, or at all. It is usually defined by the agreement as the borrower missing one or more payments for a certain number of days after they are due.
5. What are the consequences of default? This part is very important, as it gives the borrower an additional incentive (beyond just wanting to keep their word to you) to stay on track with payments. Can the borrower “cure” the default by getting back on track with payments, and if so, how?
6. Is the loan backed up by collateral? Collateral is something of value that the lender keeps, or is entitled to receive, in the event of default, in order to compensate them for not receiving the payments they were promised in the agreement. It’s common for real estate and equipment loans to be backed up by the real estate and equipment itself. Otherwise, collateral is fairly rare in local loans.

For equity:

1. How much will be paid out in dividends, and when?
2. How many shares are being purchased, what percentage of the company does that represent, and how is the whole company being valued?
3. What kind of voting powers (i.e. control) does the investor receive?
4. Are there restrictions on transferring or selling your shares? (Usually, there are.)

For revenue shares:

1. How is “revenue” defined?
2. How are the revenue share payments calculated? Do they have a cumulative cap or time limit?

Look at the Big Picture

Once you’ve reviewed all the individual terms of your potential deal, consider the big picture of the deal, including other investors. Here are some sample questions to consider:

1. What’s the total amount of money being raised in this deal, from all investors? What happens if the company raises only part of the funds they need? Do early investors get their money back? Sometimes the business’ situation can change dramatically depending on how much they are able to raise, so you should anticipate those different scenarios.
2. How much debt and equity will be in the company after the deal is done? In other words, what will the company’s balance sheet look like? If debt will be very large relative to equity, perhaps the company is borrowing excessively. If you are purchasing a portion of the company’s equity, is it being valued fairly relative to what the balance sheet shows?
3. What is your expected annual return, after considering all the factors?
4. Is the risk in line with the expected returns? In other words, are you being compensated fairly for the risk you are taking?
5. Are other investors receiving different returns than you? If so, are their returns in line with yours, relative to the risks everyone is taking?

Finishing Up

If you’ve made it this far, congratulations! You’ve gathered a lot of information and evaluated many different aspects of your potential investment, including the concept, industry, management, financials, and the deal structure. If you’re still interested in making this investment, then it’s time to take a step back to look at the whole picture.

First, you’ve already looked at a variety of optimistic and pessimistic scenarios with regards to the management team, financial outcomes, and so forth. Are there any other potential scenarios you have not considered yet? What are the most likely outcomes, in your view? Are unpleasant outcomes extremely unlikely, or not? Are you comfortable accepting all the risks you’ve become aware of?

Next, circle back to your investing rules. Is this potential investment a good fit for all of them? Will you have enough liquidity after you make the investment? How much of your total local investing allocation are you filling up with this one investment—are you leaving enough space for other local investments you may want to make in the future? Will you be making the investment in a way that optimizes its tax consequences, such as through a Self-Directed IRA, or holding it directly in your name? Is the investment in alignment with your values?

Do you have any remaining questions for the management team? Have you developed a trusted relationship and good line of communication with them, and do you have confidence that this will continue during the term of your investment? If not, how did you get this far in the process?

What do the other members of your due diligence team say about this investment? Are they also investing? Why or why not? What do your professional advisors say? If they are not supportive of the investment, why not? If you plan to invest against the advice of an advisor, it may turn out fine, but be sure that you have addressed all their concerns carefully.

What does your intuition, or gut feel, say about the investment? Imagine that you just signed the agreement and handed over the check. Do you feel great? Remember that it’s good to take risks in investing, as long as you can tolerate them and sleep at night. If you are feeling really positive about the investment, are you being overly optimistic? Are you following a group’s opinion instead of your own?

At this point, you should be able to make your decision. If you’ve decided to proceed, make arrangements to sign the legal agreement and transfer your investment money. You’re now a local investor – Welcome to the club!