IN RECENT WEEKS, the world met WeWork founder Adam Neumann. The meeting did not go well. WeWork had been preparing an initial public offering for its stock and things seemed on track. But the IPO was shelved and Neumann was out of a job.
The proximate cause: A Wall Street Journal profile of Neumann detailed the entrepreneur’s odd habits and fanciful notions. Among Neumann’s stated goals: to become president of the world, to earn a trillion dollars and to achieve immortality. All of that was on top of concerns about WeWork itself.
The company is a leader in the fast-growing market for co-working spaces, but it seems to be having a hard time making money. Last year, the company brought in $1.8 billion—an impressive sum—but its expenses were $3.5 billion, nearly twice its revenue. At that rate, it was difficult to see how it was ever going to become profitable.
No doubt about it: Investing in private companies—or in private companies going public—carries risk. But it also carries the potential for extraordinary gains, which is why it can be so tempting. As a general rule, I recommend sticking with simple, publicly traded investments. But if you do want to make private company investments, how can you tilt the odds in your favor? Ask lots of questions—and then ask some more. Here are topics to include in your initial due diligence:
Business model. While every business is unique, there are really only a handful of proven business strategies out there: A company can either invent a brand new market or it can enter an existing market, either at a lower price or with a differentiated product. If you’re considering an investment in a new business, ask yourself whether it follows one of these proven strategies—or whether it’s just another undifferentiated business entering an already crowded market.
Business economics. Most businesses incur losses in their early years, until they build up the necessary scale. In WeWork’s case, however, it already has hundreds of locations and billions in revenue, and yet it’s still incurring losses. In fact, its losses are growing. If you’re evaluating an investment, you at least want to see the numbers heading in the right direction. If not, it’s fair to ask whether the idea is just inherently unprofitable.
Governance. In the case of WeWork, one of the first red flags was the extraordinary degree of control exercised by Neumann. While common shareholders were entitled to one vote per share, his shares were initially slated to carry 20 votes per share. As a minority investor in any private entity, you’re always at a disadvantage, but if you see this kind of thing, it tells you a lot.
Objective. Ask what the founder’s objectives are. Is the goal to build the company to sell it or to grow it over time, so one day it can pay dividends to its owners? Those are both valid objectives, but you want to be sure your goals are aligned with the founder’s. You also want to be sure the company’s operating agreement is fair to outside shareholders, especially if the plan is to grow the business for the long term.
Managers. In the world of venture capital, there’s a saying: “Bet on the jockey, not the horse.” In other words, bet on the founder. I see the logic in this, but I would also urge caution. When it comes to charismatic entrepreneurs, it can be difficult to distinguish between a genius and a charlatan. Both can be convincing storytellers. It’s often only with the benefit of hindsight that we can tell the difference. I would pay as much attention to the business as you do to the founder.
Minimum investment. With any business—public or private—things can go wrong. For that reason, if you’re going to get into private investments, you should diversify. Often, private investments come our way through friends and family. That’s fine. But try to have some sort of logical process, so you don’t make a small number of big bets on things that just happen to cross your desk. I would go as far as assigning an allocation to private ventures in your investment plan.
Fees. An easy way to diversify is with an investment fund. But keep in mind that private funds differ from standard mutual funds in an important way: When you’re investing in regular mutual funds, the research shows that fees are a good indicator of a fund’s future performance. But when it comes to private funds, I see fees as being far less important. To be sure, private fund fees can be among the highest out there, but I still wouldn’t get hung up on that. Instead, I would spend much more time thinking through the other factors listed above.
Adam M. Grossman’s previous articles include Staying Positive, Need to Know and Passive Stampede. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.