When an entrepreneur or business executive experiences a liquidity event and suddenly has access to significant newfound wealth, it’s amazing the deluge of business opportunities that seem to come out of the woodwork. Whether it’s a brother-in-law, a friend from high school you haven’t talked to in decades, or a golfing partner from the club, it can feel like suddenly everyone has a “hot deal” for you to consider.
Now, to be fair, some of these business opportunities can be worth exploring and may ultimately prove to be lucrative. The trick is how to decipher which opportunities hold promise and which are best to avoid.
For example, many a successful entrepreneur has been enticed to invest in a restaurant venture with the proceeds from their last exit. While investing in restaurant launches can be exciting (and who doesn’t like food!), they are also notorious for potentially devolving into “money pits” with a seemingly endless need for additional investments to eventually (hopefully) become profitable and see a meaningful return.
There is no shortage of similar stories of direct deals gone bad, but then there are the legendary stories of early investors in Apple, Facebook, etc….
Like any smart investment, the key is to do your homework. And when it comes to navigating direct deals, don’t try to go it alone. Unless you are a seasoned investor in private markets, seek out advisors who have years of experience analyzing and executing on direct deals. A qualified advisor can help assess potential opportunities through a comprehensive lens of considerations that go well beyond projected returns. Alongside your advisor, consider the following questions before committing any capital:
Who else is investing, and what is their level of expertise?
Understanding who is involved can provide valuable insight into the quality and credibility of the opportunity. Are there experienced operators, industry experts, or sophisticated investors participating in the deal? Request and review any partnership, operating, or shareholder agreements to understand governance, voting rights, and the alignment of interests among investors.
What are your liquidity and exit options?
Unlike publicly traded investments, direct deals are often highly illiquid. Review any restrictions on transferring, selling, or redeeming your ownership interest. Consider how long your capital may be tied up and whether there are provisions governing ownership transfers in the event of death, disability, divorce, or other life events.
Are you assuming personal liability?
Carefully review whether the investment requires any personal guarantees, indemnifications, or obligations beyond your initial capital contribution. Personal liability can significantly alter the risk profile of an otherwise attractive opportunity.
Do you understand the business and industry?
Investing in industries where you have experience, expertise, or a genuine interest can provide an important advantage. If the business operates in a sector outside your knowledge base, seek independent experts who can help evaluate market dynamics, competitive risks, and operational challenges.
Are there regulatory or licensing requirements?
Certain industries may require investors, owners, or board members to maintain specific licenses, registrations, or regulatory approvals. Understanding these requirements upfront can help avoid unexpected compliance issues.
Have you conducted thorough background checks?
Investigate the management team and other partners involved in the venture. Review litigation history, bankruptcy filings, regulatory actions, and prior business ventures. A strong business concept can still fail if the leadership team lacks integrity, experience, or a successful track record.
Is this part of a pattern of failed ventures?
Pay particular attention to serial entrepreneurs or sponsors who have a history of launching multiple businesses that ultimately failed or declared bankruptcy. Past performance is not always predictive, but patterns often reveal valuable insights about management practices and risk.
What are the tax implications?
Direct investments can create complex tax consequences. Depending on the business structure and location, you may become subject to filing requirements or tax liabilities in additional states or countries. Work with tax professionals to understand the full impact before investing.
Have intellectual property risks been evaluated?
If the business relies on proprietary technology, branding, patents, or trademarks, conduct appropriate due diligence. Existing patents, trademarks, or intellectual property claims could expose the company to costly litigation or limit future growth opportunities.
Are there international considerations?
For businesses operating globally, evaluate the legal, regulatory, and political environment of each jurisdiction. Special attention should be paid to intellectual property protections, contract enforcement, currency risks, and foreign investment regulations.
How does the investment fit into your overall estate plan?
A direct investment should be evaluated within the context of your broader wealth transfer strategy. Ownership interests can create valuation, succession, and liquidity challenges for heirs if not properly integrated into your estate plan.
Do you have a buy-sell agreement in place?
A well-drafted buy-sell agreement is particularly important when investing alongside family members, friends, or closely held business partners. These agreements establish clear expectations regarding ownership transitions, dispute resolution, and exit mechanisms, helping preserve both capital and relationships.
Are there fiduciary considerations?
If you are investing assets held in a trust, family entity, or other fiduciary structure, ensure that the investment aligns with your fiduciary obligations. Trustees, in particular, may be subject to heightened duties regarding risk management, diversification, and prudent investment practices.
Will your involvement remain private?
Clarify whether your participation will be disclosed publicly or used in marketing materials to attract additional investors. Your name, reputation, and perceived endorsement may carry value, and you should understand how they may be used before committing capital.
Could future capital calls dilute your ownership?
Many private businesses require additional funding rounds as they grow. Understand whether there is an expectation for future capital contributions and what happens if you choose not to participate. Failure to invest in subsequent rounds may result in ownership dilution and reduced influence over business decisions.
The Bottom Line on Vetting Direct Investments
Direct investments can be an attractive way to diversify wealth, support innovative businesses, and potentially generate outsized returns. However, they also carry unique risks that are often absent from traditional investment vehicles. Conducting thorough due diligence and surrounding yourself with experienced legal, tax, investment, and wealth-planning advisors can help ensure that opportunities are evaluated objectively and aligned with your long-term financial goals.