With the development of globalization, investing in someone else’s business has become an increasingly popular way for investors to generate wealth. There are several key principles and benefits to keep in mind when investing in other people’s businesses. First, it is crucial to conduct thorough due diligence on the company’s financials, management team, competitive advantages, growth potential, and risks. Additionally, investing in a business allows investors to leverage the operational expertise and experience of existing managers. It also provides portfolio diversification and can generate attractive returns through capital appreciation, dividends, profit sharing, or equity in the business. However, investors need to be aware of the lack of control compared to owning your own business. There are ways to gain influence through negotiated agreements and representation on the board. But ultimately, the existing owner has final authority over decision making. Overall, investing in other people’s businesses can be highly rewarding for investors who adhere to core principles of careful analysis, risk management, setting clear expectations, and securing legal rights.
Conduct in-depth due diligence on the company’s financial performance
When investing in someone else’s business, one of the most important steps is to thoroughly analyze the company’s financial statements and performance. Look at historical trends and growth rates for revenue, profits, cash flow, debt levels, and other key metrics over the past 5-10 years. Pay close attention to the company’s profit margins and return on invested capital as indicators of the health and efficiency of the business. Also assess the quality and sustainability of earnings by examining metrics like recurring revenues, customer retention rates, destinations of capital expenditures, etc. Analyze how the company has performed through different economic cycles and industry disruptions to gauge resiliency. Review audited financial reports and disclosures for red flags. This quantitative analysis will provide the facts needed to determine if the business has solid economics.
Evaluate the strengths of the company’s management team and corporate governance
In addition to financials, spend significant time assessing the company’s leadership, management expertise, and corporate governance. The capabilities of the management team will be a crucial factor in the continued success of the business. Review the background, experience, track record, and vision of top executives. Make sure their interests are aligned with investors through proper incentives and stock ownership. Examine the company’s leadership pipeline, retention rates, and succession planning. Also look at the composition and independence of the Board of Directors. Ensure there are defined processes for risk management, internal controls, and financial transparency. Discussions with management can provide invaluable qualitative insights into their leadership abilities, strategic thinking, and company culture.
Determine the company’s competitive advantages and growth opportunities
When investing in a private business, it is key to identify the sustainable competitive advantages that enable the company to successfully compete and maintain profitability. These advantages could include proprietary technology, unique intellectual property, economies of scale, network effects, branding, distribution infrastructure, supply chain efficiencies, and more. Assess how easy or difficult it would be for competitors to replicate or displace these advantages. Also evaluate growth drivers and potential expansion opportunities through new products, services, customers, and geographic markets. Seek out companies with multiple channels for growth in revenue, earnings, and intrinsic value over time. But stay objective about projected growth rates and how they compare to industry benchmarks.
Assess risks and have a clear exit strategy
While investing in a private business can deliver outsized returns, there are also substantial risks involved. The company could suffer from execution missteps, competitive pressures, loss of customers, supply chain disruptions, leadership changes, and more. Think through company-specific and industry-wide risks and how the business would perform in worst-case scenarios. Only invest an amount you are willing and able to lose. Negotiate clear paths to liquidity like buyback agreements, redemption clauses, and IPO timing expectations. Set a time horizon and specific milestones which would trigger re-evaluating your investment. Predefine the situations under which you would cut losses and divest. Having prudent risk management strategies and contingency exit plans in place are key to avoiding getting trapped in a bad investment.
Leverage the expertise of existing managers
Unlike owning your own small business, investing in someone else’s established company allows investors to leverage the knowledge and operational experience of existing managers. The managers handle the day-to-day executive decisions, freeing up investors to focus on governance and strategy. Tap into the managers’ industry connections, technical skills, and understanding of the competitive landscape. Work collaboratively to help refine business strategy and expand into new opportunities. Offer guidance and accountability but avoid micromanaging. Negotiate clear expectations upfront around financial reporting, business metrics, and involvement in major decisions. With the heavy lifting handled by experienced professionals, investors can take a more hands-off approach while benefiting from their expertise.
Investing in someone else’s business can enable investors to generate attractive risk-adjusted returns by adhering to core disciplines of due diligence, valuation, risk management, and strategic alignment with competent managers. Key success factors include analyzing the economics and growth potential, evaluating the management team, understanding competitive advantages, setting clear expectations, and having an exit plan.