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PRIVATE EQUITY

 

Extremely high risk, low probability of reward, and anything but glamorous! Avoid like the plague!

 

What is "private equity"? Any investment in a business or company that is not publicly traded on a stock exchange. Since private companies are not publicly traded stocks you don't really know what a fair market price is. Another problem with private equity is that these investments are not subject to the strict SEC regulations and oversight that you get with publicly traded companies. Private equity is a great opportunity for commission-based "advisers" (securities salesmen) to earn high sales commissions and for CEO's to earn high salaries while operating an unprofitable company. A private equity investment could be a Ponzi scheme. Fee-only fiduciary advisers will never recommend private equity investments.

 

Make no mistake, there is an extremely high failure rate of private businesses and often outright fraud is involved in investment operations ranging from very small to very large. If there is fraud involved then you will be left to discover it yourself and then remedy it yourself in court. Don't invest in private equity unless you are a high net worth investor, you have the time and resources to constantly monitor the business, you have the know how (very few do), and you are comfortable with losing 100% of your investment. Private equity is a top favorite way that athletes manage to lose their fortunes. Instead of investing perhaps 2% of their savings they invest 50% or more of their entire net worth in various private business ventures. Remember that the best, most promising companies are publicly traded on the NYSE and NASDAQ stock exchanges. You don't need the headache that is private equity! If you like to take big risks with your money there's plenty of small cap companies that you can "gamble" on without the headaches and excessive risk of fraud associated with private equity, although most penny stocks fail. Legendary fund manager Peter Lynch has said that he was 0 - 25 when investing in publicly traded companies with no revenue but a great "story". With private equity it only gets worse.

 

TRAP: Beware that salesmen may try to trick you into believing that a private equity investment is a publicly traded investment by somehow associating it with a public company. If you can't invest in it by placing a buy order through your deep discount brokerage account then it's not a publicly traded company. Another trick is to try to ride the coat tails of a major company. Example: "We have contracts with Exxon". Whether true or not it makes no difference.

 

TRAP: Don't be fooled into thinking that you are investing in a publicly traded company if you are being sold "shares" of stock in the company. Again, if it's publicly traded then you should be able to research the company by entering the ticker symbol on Yahoo Finance.

 

A chance to "get in at the ground floor"!

 

Promoters are good at pressing your greed buttons by claiming that you are "getting in at the ground floor" before everyone else. But "ground floor" simply means unproven long-shot. There is no revenue or track record by which you can begin to gauge the company's future.

 

Riding the coattails of successful companies / industries

 

Another common sales technique is to try to associate their company with successful companies. They may cite other success stories in the same industry, they may boast that a former employee of a successful company now works for their company or that they have pending contracts with a successful company. For example a stat up oil company might note that a major oil company is drilling nearby.

 

Create the appearance of demand

 

It's also common for promoters to tell you that others have invested or will be investing. This could all be smoke and mirrors. Even if there are investors they're probably unsophisticated ones. Smart investors know to avoid private equity.

 

Good investments are not sold to the general public

 

Good investments are quickly snapped up by institutional investors. The mere fact that an investment is being pushed on an average Joe like you should be an immediate red flag.

 

Affinity fraud

 

Don't let down your guard simply because your friends and family are investing. Your friends and family are not experts like the sharks on the TV show Shark Tank.

 

Identity investing

 

Some promoters will gladly ride the coattails of race, religion, gender, etc or use cause such as being environmentally friendly to lure investors. But the only thing that should matter is making money.

 

Flaunting their community service and family values

 

Promoters are famous for mentioning that they've helped out with charitable causes and that they have a wife and kids. But this has nothing to do with investing in their business. It's a cheap attempt at gaining your trust.

 


The rest of this page is for investors who are actually still considering investing in private equity. This is just a very brief overview to give you some sense of how much of a headache private equity is.


Beware of anyone and everyone seeking investors for a private business venture!

 

Don't ever make a financial decision based a "the sale" being given to you by the person pitching the investment. They're only telling you one side of the story. You will have to do your own research. Finding adequate information about a business opportunity including gauging a fair share price may be difficult if not near impossible to fully determine.

 

"I put myself, my wife and best friend on high paid salary working for a lame duck company!"

 

Starting a private equity business venture is one of the easiest way to create a job for one's self. The company principal (CEO, director, officer, etc) can create healthy monthly salary payments for himself for many months while doing very little, whether the business succeeds or fails. They prioritize spending for themselves.

 

Since a principle has control over how much he is paid, if the company actually does become profitable, he can further manipulate the company coffers by increasing his salary (and reducing pay to investors). A company must legally maintain sufficient capital, but if given a large lump sum of start-up money from investors, this leaves plenty of time to enjoy a healthy paid salary. If and when the start-up sum of money runs out, the principal can simply ask for more investor money and continue enjoying his paid salary.

 

While a company principal is enjoying his paid salary, there are many other creative ways in which they can feed off of or even steal from the corporation. Perhaps an opportunist principal wants to help employ his unemployed wife, a relative or best friend with a nice salary. A principal can create false invoices, over pay for goods and services while accepting under the table kick backs, work out back room deals, etc.

 

Always do a full background search!

 

Just who are you dealing with? Con artists are very adept at networking with people (affinity fraud) and gaining people's trust with their personality and / or professionalism. They have the characteristics that people like. They may come across as mild mannered and meek or outgoing and down to earth. They might be religious, well connected, and may have lots of prior business experience with a long list of high profile clients and references. All of this means nothing! Never do business with anyone without doing a FULL background search! You might be surprised to discover that they have declared bankruptcy in the past or that they have had falling outs with past business relationships.

 

You could pay for a criminal and civil case history background search, but due to the Federal Law (Fair Credit Reporting Act), consumer reporting agencies are limited to reporting events going back only 7 years. If you want to find out someone's litigation history beyond 7 years you will have to hire a private investigator. Private investigators have access to paid subscription databases and other sources that aren't available to the general public. While there is actually no single database that keeps an archive of all court records, a private investigator should be very helpful. To do a more complete search it may come down to doing in-person case file research at local courthouses near where the person of investigation lives or once lived.

 

TRAP: Beware of name changes, as well as DBA and corporation names. When someone has a dark past (of lawsuits, bankruptcy, criminal past, etc) they often use alternate names, go by nicknames or middle names or change their name (legally or illegally), or they simply did business under a business name, either incorporated or as a DBA.

 

TIP: Ask for references, then try to locate all of the other people who they did not reference.

 

A bullet proof contact with "teeth" is a must!

 

When putting up money for a private equity business venture it is an absolute must that you hire an attorney to draft up a bullet proof contract that will protect you in every way regardless of who you are dealing with. Lawyers use the term "with teeth" to describe a contract that has stiff remedies for dead beats who may fail to adhere to the terms of the contract. Cut no corners on this. It doesn't matter who you are contracting with because con-artists are the people you least expect including a friend, someone "well connected", "well-established", "experienced", a "great guy", etc.

 

Lawyers are a necessary evil. A good business lawyer should be aware of the biggest things that could go wrong and protect you contractually. Contractually you must have clear and concise remedies that protect you from any breaches that may occur at every step of the way with no wiggle room for legal grey areas or loopholes. Yes it will probably cost you thousands of dollars to draft up a contract, but this is unavoidable and all part of the misery that is private equity. If you don't want to hire a specialized attorney to draft a contract then don't invest in private equity. Period!

 

HUGE MISTAKE: Never ever try to save money by accepting the entrepreneur's own contract. Hire an attorney! They will almost certainly reject their contract.

 

TRAP: Don't expect an attorney to give you personalized investment advice or talk you out of proceeding with entering into an investment agreement whether he thinks the investment is a long shot, terrible investment or otherwise. Attorneys don't make money when clients decide not to hire them to write up contracts.

You could specifically hire someone such as a financial adviser to evaluate the business venture but chances are they will tell you the same types of things described in this article -- private equity is extremely high risk and has a very low probability of reward.

 

Even a bullet proof contract with "teeth" cannot protect you from everything

 

Sometimes con-artists flat out steal your money and then disappear, die, or go to jail. How many times have we heard stories of fraudsters getting caught but they had already spent the money that they stole and so the investors were left with next to nothing?

 

Sometimes incompetent lawyers don't cover all of the bases when drafting contracts. And even when suspected, not all incidents of fraud can be proven as fraud or identified.

 

Sometimes incompetent management makes honest mistakes that lead to lawsuits against the company which then kills your investment.

 

If the business is dependent on third parties such as contractors and distributors, their mistakes or acts of fraud could derail the business venture. For example if the business manufactures a product that is shipped to a distributor and then that distributor goes bankrupt without paying for the product, you might never recoup your investment.

 

If the business produces a product, a consumer lawsuit could wipe out the business.

 

"We're over budget! We need more money now or the business comes to a grinding halt!"

 

It is very common that lame duck business ventures go over budget and when they do the whole operation may be left perilously in limbo until someone (like you) puts up more money to save the business. If and when this happens there may be nobody interested in forking over more money. All of a sudden you may be faced with forking over more money than you previously anticipated. This is just one of the many risks you take by investing in private equity. Going over budget may be due to unforeseeable events during the normal course of business, due to very poor management decisions or outright fraud, or due to the fact that you just plain invested in a lame duck company.

 

"I'm so excited about this business venture that I'm going to be investing in it too!"

 

A commonly used technique of deception used by salesmen to try to sway you into investing is to verbally tell you that they are going to be investing some of their own money in the business. They are so confident that they are putting their money where their mouth is! It must be good, right? Wrong! All too often they either never do, or they only invest a tiny, trivial amount, or after the fact they will claim that they paid for various goods and services in cash and then declare that as their "investment".

 

As always, verbal promises mean nothing. A bullet proof contract with "teeth" that is drafted by your attorney is the only way to legally hold them accountable for representations made. Otherwise contracts will typically have a clause that reads something to the effect of "This Agreement supersedes and replaces all prior agreements and understandings (whether written or oral)". Even without this clause, trying to remedy any verbal representation in court is an expensive and difficult if not lost cause. A properly written bullet proof contract will hold the salesman's failure to put up money as an act of fraud. Actually the money should be placed into a separate escrow account in advance of you signing anything, and there should be no right for them to back out afterwards. In this manner, if they were to take money out of the account this would be a clear act of fraud / theft.

 

Control the money and account for everything!

 

Since private equity is so synonymous with fraud, you need to be in control of your money at all times by writing checks for daily expenses yourself or by hiring your own independent accountant to write checks. Just giving money to an entrepreneur to be left in charge of handling your money and creating his own accounting leaves the door wide open for fraud to occur. They cannot be allowed to have a hand at creating their own benefit. With private equity you must keep tabs on where the money is going at all times. If you don't have time, then hire an independent auditor or accountant to follow the money trail. If you insist on taking a huge risk by leaving an entrepreneur in charge of money then only pay them in installments as requirements are met including full itemized accounting. But again this leaves the door open for fraud to occur.

 

TRAP: Beware of fraudulent "back room" deals. For example a con-artist might conspire with someone to make a "back room deal" to over pay for goods or services in exchange for under-the-table payments.

 

TRAP: "Office expenses: $1,674.27" is not an itemized accounting. Con artists love to provide broad accounting statements that are not itemized.

 

CRITICAL: Is the entrepreneur allowed to earn a salary or not? If so, in the contractual agreement you must declare in great detail what work they will be doing, how many hours per week, etc. And they should be paid on a weekly basis so that you can fire them at any time.

 

VERBAL REPRESENTATIONS AND AGREEMENTS DON'T EXIST

 

Note in the contract any representations made by the the producer such as promises to provide various things such as labor, use of property or equipment for free, otherwise they can pull a bait and switch on you after the ink dries.

 

Also any bright and rosy performance projections should be regarded as nothing more than "sales talk" to get you interested. Accordingly, if possible leave yourself with an exit clause if revenue / performance achievements are not met. There's nothing worse than investing in something and then quickly finding out that it's a bust, but you can't get out of the contract.

 

DISTRIBUTION OF PROFITS

 

The investor should be priority one. You will need to speak to an expert to determine what is a reasonable share of profits for you to earn. For example with film investing the standard model for a pure investor who has no involvement in day to day operations is for the investor to earn 100% of "first monies" and then 50% to 70% of "2nd monies". 1st monies are all net profits earned up until the total investment amount is paid off. 2nd monies are all net profits earned thereafter.

 

Just as important as your profit sharing model is that of the managers who are seeking investors. How are they being paid for their labor? What labor are they contributing? How are they sharing in profits for their own cash investments if any?


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