📈 How to do due diligence on private investment opportunities

Here’s from one of our readers, Jeremy G.

One of our other readers, Chandra P., asked…

Here is the short answer: as a retail investor, you have essentially limited ability to perform meaningful due diligence, and instead must rely primarily on whatever information is provided by the intermediary/promoter (i.e., whoever introduced you to the deal) of the opportunity and your own research.

Here is the longer answer: Because the vast majority of deals you get access to will be through some sort of intermediary/promoter, it’s more important for you to understand how that party is compensated, and how they source and underwrite their deal flow.

While we can’t provide any individualized investment advice, make any investment recommendations, or otherwise provide you with an “easy button” when analyzing early-stage investment opportunities…

What I can do is talk about how I personally approach underwriting and due diligence with regard to the types of opportunities we seek to originate at Equifund.

[Publishers Note: In typical Jake Hoffberg fashion, this article wound up being way too long for one email. Part 1 will be today’s issue and Part 2 will be the Weekend edition. The following week, we’ll likely have a Part 3 to address any questions we received about Part 1 and 2.]

-Jake Hoffberg

P.S. For those specifically interested in the secret to “passive income,” there’s only one concept you need to understand: arbitrage. Go here to read all about it.

How Investors Make Money in Private Markets

In my opinion, our members have questions about underwriting and due diligence for one reason – they want some sort of comfort level beyond the information the issuer/promoter provides.

While we all would love to have a better sense of comfort that any investment we make will deliver above-market returns for below-market risk…

Practically speaking, I think many of us just want to know there’s going to be some level of liquidity (or our ability to exit our position at all, for a gain or loss) at some point in the future.

For this, we need to understand the differences between the Primary Market and the Secondary Market.

In the Primary Market, investors purchase newly issued shares directly from the company raising money (called the “Issuer”) in an Initial Public Offering, or Secondary Offering.

In the Secondary Market, investors purchase existing shares from other investors.

Functionally, this means if we want to exit our position, we have to be able to sell our shares to someone else on the Secondary Markets, ideally for more than we paid.

But more to the point, if you purchased shares on the Primary Market (from the Issuer), how was that issue priced?

Generally speaking, the Issuer has hired an investment bank to help them.

More to the point, it is quite rare that an investor would negotiate directly with an issuer in the Primary Market, or directly with another investor in the Secondary Market.

Instead, that “introduction” is handled by an intermediary of some sort – for example, brokers, financial advisors, private placement agents, and investment platforms.

In addition, intermediaries may offer various financial services to both the buyer and seller (for example, advisory services and investment research).

Because these intermediaries often earn some sort of commission-based compensation – or have ownership in the opportunity they are promoting – there is an inherent conflict of interest you have to be aware of, whenever you see an investment opportunity.

Namely, you need to ask “Why am I being shown this deal?”

Is it because the finder has specifically sourced “good deals,” based on some sort of known investment thesis or underwriting criteria?

Is it just a mechanism for collecting a fee and/or a pump-and-dump scheme?

But back to the main topic of the issue…

Assuming the person or organization providing you with the deal flow is trustworthy, how do you perform due diligence on the deals they introduce to you?

For this, we have to understand how these investment products (called “securities”) come into existence in the first place.

The Lifecycle of a Security: An Introduction to Investment Banking

Quick recap – There are primarily three types of securities:

• Equity Securities (or “Stock”) gives shareholders the potential for capital gains and dividends. Owning equity may also give shareholders the right to vote on corporate actions and elections for the board of directors
• Debt Securities (or “Bonds”) requires the borrower (the Issuer) to repay the principal, plus interest, over a certain period of time to you the loaner (ie. Investor).
• Hybrid Securities – like convertible notes – give investors a combination of debt and equity features

In private markets, companies can raise money under any of several exemptions (like SEC Reg D, Reg A, and Reg CF).

In these situations, the price of the securities being sold is determined by the company raising money (again, the “Issuer”).

However, oftentimes the Issuer will hire an Underwriter – typically an investment bank – to help them with structuring the offering and pricing the deal.

[Publishers note: Legally speaking, Equifund is not an investment bank. However, Equifund does provide a similar service to Issuers seeking to raise capital on the investment platform regarding deal structuring, pricing/valuation, and marketing materials.]

Across the capital markets ecosystem, here is how the investment banking process works.

• Phase 1) Origination: the initial phase of the investment banking process, where companies looking to obtain capital are identified and brought to the attention of the investment bank

This stage involves scouting for promising businesses or projects that may require capital to grow, expand, or execute strategic initiatives.

Investment bankers often collaborate with entrepreneurs, business owners, or institutional clients to explore potential deals, and assess their financial viability and alignment with the bank’s investment objectives.

Additionally, firms often specialize in certain types of financings as they gain expertise in specific sectors, industry groups, deal stages, or across broader secular growth themes.

For example, at Equifund, we are actively seeking Issuers who are looking to go public within the next 1-3 years…

We have also recently expanded into Real Estate opportunities, as rising interest rates have made it more expensive to borrow from traditional sources and have created new interest in raising equity capital from retail investors.

• Phase 2) Underwriting: the process of evaluating and assessing the risk associated with issuing or investing in securities such as stocks, bonds, or other financial instruments

When a company decides to raise capital by issuing securities (such as stocks or bonds), an investment bank acts as an underwriter.

Fun fact: The term “underwrite” originated in the 17th century when marine vessels were underwritten for insurance risk for overseas voyages. The insurance company would “sub-scribe” (literally to write underneath or “under-write”) the policy by signing their name at the bottom of the document, acknowledging consent that the policy is in force.

The underwriter assesses the risk associated with the securities offering, determines the appropriate pricing, and the terms of the underwriting agreement (UA).

• he UA is under a “firm commitment” basis, this means members of an underwriter syndicate are required to buy the shares from the company to sell to investors, as opposed to a company selling the shares directly to investors.
• If the UA is under a “best effort” basis, which most high-risk securities are, this means the underwriter agrees to give their highest personal effort to sell as much as possible of the shares, but has no obligation to purchase any of the issue.

In addition, the underwriter may form a syndicate – a temporary group of financial professionals formed to handle a large financial transaction that would be difficult to handle individually.

If there are many managing underwriters involved in an underwriting process, a hierarchical structure is often established to ensure efficient coordination.

Among the managing underwriters, one is selected as the lead manager (or “book runner”). The remaining underwriters are designated as “co-managers.”

The lead manager is responsible for making key decisions regarding the structure of the offering, including the number of shares to be issued and the pricing of the securities.

They collaborate with the issuer to determine the optimal offering size and price range.

Additionally, the lead manager coordinates the allocation of shares among different investors, such as institutional buyers and retail investors. They aim to strike a balance between maximizing proceeds for the issuer and ensuring demand for the securities.

Said another way, investment banks help corporations create a new securities product to sell called “stock” or “bond” – as well as attempt to create a market for that stock – and in return, earn compensation in the form of fees and commissions.

So what do underwriters look at in order to create this product?

While I can’t speak for what other companies do, at Equifund, we look at:

1. Corporate Records – These are all the documents related to the actual entity itself:
   1. Certificate or Articles of Incorporation, as amended to date, including pending amendments or Certificate of Formation or Articles of Formation for LLCs or similar constituent instrument
   2. By-laws for corporation or operating agreement for LLC or equivalent document, as amended to date, including any pending amendments
   3. Capitalization Structure that includes issuance date and price of all corporate securities and a description of any rights attached to preferred shares
2. Financial Records – These are all the documents related to the financial history and forward-looking assumptions:
   1. Current financial statements (profit and loss, cash flow statement, balance sheet)
   2. Revenue/sales projections and budget
   3. Latest corporate tax return
   4. Material contracts, agreements, and policies
   5. Joint venture, cooperative, franchise, or dealer agreements
3. Personnel Matters – anything related to the people working at the company (or contracted to perform services:
   1. Employment and consulting agreements
   2. Nondisclosure, development, assignment, and noncompete agreements with any employee, consultant, or independent contractor and list of employees who are not parties to such an agreement
   3. Employee benefit plans, programs, or agreements (pension, health, deferred compensation, bonus, profit sharing, and any other benefit plans)
   4. Resumes for all management personnel of the Company
   5. List of all employees of the Company, including a schedule of all salaries, bonuses, fees, commissions, and other benefits
4. Intellectual Property Matters – anything related to the core advantages the business has in the marketplace:
   1. Schedule of all trademark, copyright, and patent registrations or applications, and related filings
   2. List of all agreements or understandings with third parties, whether now in effect or terminated, for the design, development, programming, enhancement, or maintenance
   3. All documents, materials, and correspondence relating to any claims or disputes with respect to any intellectual property rights of the Company or any of its subsidiaries or any third party
   4. Any opinions of counsel concerning the strength of a patent(s) and how difficult they may be to protect against infringement
5. Legal Matters – anything related to current or previous legal issues the company is facing:
   1. Threatened or pending litigation, claims, and proceedings
   2. Consent decrees, settlement agreements, and injunctions
   3. Consents, decrees, judgments, orders, settlement agreements, or other agreements to which the Company is bound requiring or prohibiting any activities
   4. All documents and correspondence relating to any pending litigation, threatened litigation, or disputes which could potentially lead to litigation involving the Company, its executives, its officers, or its directors
6. Other Business Information – anything else published by the company that is relevant:
   1. Press releases, articles, or promotional materials published about the Company since incorporation, which are in the Company’s possession
   2. Any external or internal analyses regarding the Company or its products or competitive companies or products

Once the underwriting process with management has been completed and there is a mutual understanding regarding the price and terms of the offering, the next phase is…

• Phase 3) Packaging: the process of assembling all necessary financial and legal information related to an investment opportunity into a comprehensive presentation which includes a discussion on the risks involved and any conflicts of interest

Investment bankers create a comprehensive package – often referred to as the registration statement – that highlights the key features, financial projections, market analysis, and potential risks of the investment opportunity.

With regards to public offerings, this would be the Form S-1. With private offerings, it would be the Private Placement Memorandum (or PPM), Form C, or Form 1-A.

This package, also known as an offering memorandum or prospectus, is presented to potential investors to solicit their interest and support in the investment.

• Phase 4) Marketing: the process of promoting the investment opportunity to potential investors.

This process involves conducting roadshows, presentations, and meetings with institutional investors, asset managers, high-net-worth individuals, and other potential buyers of the securities.

Investment bankers leverage their extensive network and market expertise to generate interest for the investment opportunity.

This is commonly referred to as the “Roadshow” – a series of presentations and meetings conducted by the underwriters to promote the offering to potential investors.

Roadshow events may attract hundreds of prospective buyers interested in learning more about the offering in a face-to-face setting and online. Events may include multimedia presentations and question-and-answer sessions.

If you’d like to see how we market offerings on Equifund, go here to check out our current listings.

• Phase 5) Closing: the process of collecting cash, executing orders, allocating shares, and completing the offering.

Assuming there is interest in the offering, investors will sign subscription agreements and send in funds.

Once that happens, the investment bank finalizes the terms of the offering, allocates the securities to investors, and receives the proceeds from the sale of the securities on behalf of the issuer. If the offering is over-subscribed (too much interest), the lead underwriter will dictate how the shares will be allocated, usually on a pro-rata or first-come-first-serve basis. Any investors that don’t receive their full request will be refunded the difference.

Last but not least…

• Phase 6) Post-Close: everything that happens after the closing, which usually involves ongoing monitoring and reporting regarding the performance of the investment.

After the transaction is completed, the investment bank may continue to provide guidance and assistance to the issuer in various matters, such as investor relations, financial reporting, and compliance requirements.

Additionally, the investment bank may facilitate secondary market transactions, conduct research, and offer strategic advice to assist with ensure the long-term success and growth interest inof the investment and therefore beneficial trading volume.

Final Thoughts: Underwriting and Syndication in Crowdfunding

To state this again, legally speaking, Equifund is not an Underwriter or investment bank.

However, iIn this emerging crowdfunding ecosystem, funding portals (like Equifund) does serve a similar function as a pseudo-investment bank in these types of transactions – Issuers seeking to raise capital “hire” a portal to help them create their offering, and then present market that offering to buy side investors.

However, unlike investment banks and broker dealers, crowdfunding portals cannot purchase securities from an issuer and then resell them directly to an investor.

In fact, the Portal cannot have any ownership in any offering prior to listing (although portals can acquire shares through performance-based compensation)

And even though there isn’t a syndicate of crowdfunding portals that help to promote an offering…

We can see plenty of examples of pseudo-syndication programs as publishers of investment newsletters are now offering their subscribers an opportunity to get access to private market opportunities.

Because these publishers have an organized group of investors who are interested in getting access to deals in exchange for a fee…

In many ways, these groups act as an “intermediary” in the sense that they introduce opportunities to investors.

One of the main advantages of these groups is that – in exchange for an annual membership fee – members often do not have to pay the traditional “2 and 20” fund fees and can instead purchase the security direct from the issuer.

It’s kind of like the Costco model – members get access to products as close to “at cost” as possible to give customers the lowest prices possible in exchange for an annual membership fee. that helps stabilize cash flow and pay for operating expenses along the way.

And perhaps more importantly, for individual investors who simply don’t have the ability to perform underwriting and due diligence, “hiring” a group of professional investment analysts and researchers can help bridge the gap and provide some level of confidence in the deal flow you’re getting access to.

But how do you determine if the type of deal flow you’re getting from your intermediaries fits what you’re looking for?

We’ll save that for Part 2 of this series in the upcoming Weekend Edition.