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Beware of Risks Involved in Start-Up Company Investing: Avoid Red Flags When Making Private Company Investments – JD Supra

The “Great Resignation” as it has been called reflects the large number of employees leaving the traditional workforce, and many of those departing employees are leaving hourly or salaried positions to start their own new busi…….

The “Great Resignation” as it has been called reflects the large number of employees leaving the traditional workforce, and many of those departing employees are leaving hourly or salaried positions to start their own new businesses. The dramatic increase in start-up businesses has been documented by the Census Bureau, which reports that nearly 5.4 million applications were filed to begin businesses during 2021, the most of any year on record.  In light of this remarkable employee migration leading to the formation of new companies, now is an appropriate time to look at the investment side from the perspective of potential investors in these startups or early-stage new businesses. 

This post reviews some of the important red flags that investors should consider before making a minority (non-controlling) investment in a new or emerging growth, private company. Not every red flag should scuttle the proposed investment in a private business, but prudent investors will want to evaluate all red flags before becoming a minority partner in a private company. The issues that potential investors are wise to consider relate not only to potential problems regarding the operational plan for the new business but should include key provisions in the company’s governance documents, which the minority investor will be required to sign when making the new investment.

Avoid a Management Team Embarking on Its “First Rodeo”

Common sense suggests that the safer bet when investing in new businesses is to choose a management team with a track record of success with start-up businesses. A management team with little or no previous experience in launching a new business will have a steep learning curve. Another way to look at this is that an inexperienced management group doesn’t know what it doesn’t know, which means that the company’s leaders are more likely to make mistakes and miss opportunities that more veteran leaders would avoid or capitalize on at the right time.  

If the management team is new, one way to mitigate this problem is for the majority owners to include senior leaders on the company’s board or on an advisory committee. These experienced board or committee members can then provide important input to company executives on a regular basis and help to mentor them to provide the benefit and wisdom of seasoned leadership. When inexperienced executives decline to surround themselves with more veteran leaders, however, investors may be in for a steep and bumpy ride with their start-up company.

Will the Minority Investor’s Stake in the Business Be Protected from Dilution?

Successful companies need capital to fund their growth, and the cash from the business typically falls short of meeting this need. As a result, it is likely that the company …….

Source: https://www.jdsupra.com/legalnews/beware-of-risks-involved-in-start-up-6624509/

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