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7 Deadly Sins Of Private Deals

When folks ask if investment decisions are more art or science, I answer, “Yes.”

Truth is they are a little of both with some luck scattered in, but that doesn’t mean an investor can’t establish some rules or guidelines to follow. 

I approach considerations with what I call a “Hate to Love” model in the private space.  I identify everything I can hate about a company and the opportunity, then work backward. 

The goal is eliminating enough in the hate category to have a comfort level under which I can move forward.

That doesn’t mean every one of those names will become an investment as I may never reach the love side of the equation, but it helps me speed the process to consider offerings in a timely fashion.

The best approach I’ve found for myself is to identify seven situations that fly the yellow flag high in the air. I refer to them as the Seven Deadly Sins of Private Deals.

I should note these aren’t deal killers, but they require more information, follow up, or much stronger stories in order to even make it into the possible category.

Actions Speak Louder Than Words 

Management’s/Insider’s Actions into any capital raise – If management or insiders are selling into any offering/raise or those same folks have shares unlocked before me, then I take a step back. Why do I want to buy something management is selling? 

No matter how deep I dig, they will always know a little bit more than I will. Also, any member of the executive team or large insider should be willing to hold the stock as long as me.


Experience Matters

Inexperienced Management – Not every company is going to house an executive suite filled with folks who have built and sold companies before; however, if the manager has no prior exits, a history of failed companies, or no prior ownership in companies, then it will need a compelling story. 

As a side note, I don’t love seeing a Board bloated with big names but names unwilling to buy the stock or get involved in the company. That hints they may only be for show as a way to cover up other flaws.

If It Ain’t Broke…

A solution looking for a problem – This may be one of the most common yellow flags. A company can have a cool service or product but if no one is in need of it then it becomes a difficult sell. A product or service should solve an existing problem. 

Of course, the company’s offering could improve upon an existing solution in the marketplace but if we don’t have a current problem then the total addressable market is likely much smaller than the company will want me to believe.

Time to Get Paid

A large portion of the money being raised will be spent on executive compensation – When I see a significant portion of the intended capital raise earmarked for general working capital, my concern increases. If I see a projected expense for executive compensation in the 10-15% range of the capital being raised, I step back. If that level is 20% or higher, I run away.

Keep It Simple

A complex cap table – When I see a multi-layered company where the company raising capital is owned by two other companies in disproportionate shares and I can’t get a straight answer on voting rights or who is in charge, I get concerned. A simple structure eliminates so many questions. 

Complex ownership can create messy divorces and in-fighting. With a simple structure, I easily know who owns what, how much, and I can more quickly discover if they are a friendly shareholder or one with a foot out the door.

Toxic Meltdown

Toxic Debt/Financing – Walking into a meeting, this is one of the first topics I’ll tackle. Do you have debt? How is it structured? Who owns it? Convertible debt will also come into play here as it has the ability to dilute my shares in the future. 

Often, venture capitalists will refer to their debt offering as non-dilutive but high interest rate debt with lots of covenants can quickly cripple a company and force them into low-priced, highly-discounted share offerings to those same debt holders.

The Three Amigos

A company that touts an institutional investor that turns out to be one of the Stay-Away-Three – It’s the biggest of the yellow flags for me when one of these three hedge funds shows up on the cap table: Sabby Management, Hudson Bay Capital, or Intracoastal Capital. 

Look, I’m sure they are great folks and their funds perform just fine, but the types of deals I see companies enter with any one of these funds (often all three) create a death spiral of financing. It’s rare I see a capital raise involving these names that doesn’t involve aggressively priced warrants and the promise of dilution along with downround financing. A downround is when a company raises money at a valuation below a previous round.

Bottom Line 

Overall, I expect to see at least one of these flags on any company I consider. Often, I’ll see more than one and it doesn’t immediately disqualify them from consideration; however, if the number of flags hits 4 or more, it is an immediate no. If the number of flags hits three, it’s a huge uphill battle for the company to win my love. And if I see number seven, then the rest of your story better be picture perfect if you want any of my investment dollars.

While most folks will talk about what you should look for in a deal, for me, looking for what you should look out for in a deal is first on my list.