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Private Company Investing - A Socially Constructive Form of Alternative Investing

Financial & Investment Education Symposium

San Diego County Employees Retirement Association (SDCERA)

San Diego, California USA - Why bother thinking about alternative investing? Wouldn't it be better to just invest funds in the traditional and conventional ways - mutual funds, stocks, bonds, saving accounts? Isn't it well understood that it is safer to do "it", whatever "it" is the same way as others have always done?

These and similar questions are much the same as entrepreneurs and explorers have to ask themselves before embarking on a voyage across uncharted seas. It can be argued that were not a Columbus prepared to do something differently that none of us would be here today.

Before starting let me give you a bit of my background as it is relevant to the subject of this talk.

I entered the securities business in 1954, after being discharged as a Korean Recon Company, U.S. Marine Corps Sergeant, as a trading desk clerk and stock trader for Bache & Company, the firm now known as Prudential Securities. I then studied (at Columbia University at night), learned and migrated to a number of firms, always dealing with financial institutions, rather than individual investors, until starting my own firm, Arthur Lipper Corporation, in 1967.

In 1972, I retired as a New York Stock Exchange member and concentrated on investment banking. In 1982, believing a new bull market was commencing, I co-founded New York & Foreign Securities Corporation, another NYSE member firm.

Arthur Lipper Corporation served, as a broker and advisor to a large number of institutions. We had as our primary area of research focus; mutual funds and investment company performance. The reason for this was that one of our major clients invested in mutual funds and there were no other firms competing effectively in the area. Fifty years ago mutual funds were like the big and sleepy banks in that they said just give us your money to invest and we will do the best we can and let you know every three months or so how well we have done.

When Arthur Lipper Corporation started to publish a weekly ranking of mutual fund performance many in the industry said to me Arthur, you are going to destroy the fund business by prompting us to compete with one another and therefore force us to make short term versus long term investment decisions. I should tell you that at the time there were only a few thousand funds and only several hundred mutual fund managers. Indeed, the bulk of the industry was probably represented by fewer than 25 companies and now there are more than 30,000 funds.

Yes. I believed then, as I do today, the essence of successful investing is intelligently comparing alternative values and, in the case, funds, the value is and was consistency of superior performance. And, yes it is a horse race and I believe that to be constructive for investors, as striving to excel is what competition is all about.

Once the weekly Lipper Mutual Fund Performance Analysis service was established as the standard ranking service my younger brother, Michael Lipper, assumed responsibility for its operation and further development. A couple of years ago Michael sold the statistical part of the business and it is now a subsidiary of Reuters, Inc.

One of the rules of Arthur Lipper Corporation which I imposed was that no employee, including myself, could own securities other than mutual funds, as I believed there to be an irreconcilable conflict of interest in the case of we who were paid to provide service and our clients. Although I had previously financed a few ventures (including, one of the first printed circuit board companies and an AM radio one wore in their ear) it was in 1967 that I first started to think seriously about professionally investing in private companies. Incidentally, the management of the printed circuit company made a really bright decision to limit the amount of business they would accept from IBM, their largest customer, as they didn't want to become dependent on IBM. The company made great technological progress but never made a lot of money and was eventually bought by a younger and smarter competitor. The ear radio company never went anywhere, though the product worked pretty well. People would say, this was before Walkmans, "who would want to listen to a radio when walking around".

These experiences, buttressed by many others, led me to conclude that those investing in privately owned companies had better have some pretty sensible rules or every experience is likely to be tuitional and tax deductible.

Why bother considering alternative investing? "To do better than..." is the clear and obvious answer. Better than funds invested traditionally in stocks and bonds, better than real estate investments, better than speculating in commodities or stock options. Better than something else.

In private company investing the investor has another benefit and that benefit is the fact that successful companies, even not yet successful early stage companies, create benefit for others than just the owners of the companies. New companies; rent offices, hire people, create and transfer skills, buy things and even sell things. The things they sell are better than other products as otherwise they wouldn't be bought.

However, investing in early stage, private companies is an activity which is risk ridden and one either does it well or one loses their money. It is that simple.

The primary problem to be understood in private company investing, especially where there is technology involved, is that being ahead of the market is not a good idea or place to be unless the company is really well financed and can wait for the market demand for the product or service to catch up. Company after company has learned that science in search of a market results in equity dilution to keep the company funded and therefore viable and always to collect more capital than believed to be necessary as everything takes longer and therefore cost more than originally anticipated.

Of the many lessons I have learned, the most important is that Id rather negotiate a small piece of the companys revenue, in the form of a royalty, than a large position in the companys equity. This Revenue Participation basis for investing has become a hallmark of mine and I truly believe it to be the most logical basis for accepting the risk of making illiquid investments.

As one learns more from mistakes than successes, following are some of the mistakes Ive made in investing in private companies:

I've learned a great deal during the past 49 years regarding what to do and, more importantly what not to do, within the private company investment process - if earning an extraordinary risk related return is the investor's primary objective. Although I frequently make the same mistakes over again I also have an ability to find and make new mistakes to add to the list. This segment of this talk suggested to my wife and some of my other friends that the length of the presentation could well be much longer than intended by those who honored me by arranging for my appearance here today and you would clearly have stopped listening before I stopped talking. Also a fuller cataloging of the mistakes made would; 1) deter most of you from ever investing in a private company, which is not my intention and 2) lessen my inventory of horrors which I use when charging client companies a consulting fee.

Investing in private companies is enormously important for the country as a whole and for every community therein. Private company investment is an activity which should be favored, rather than penalized, by all governments in terms of tax relief and other legislation.

Incidentally, I believe we'd have a better functioning government if it were required that at least one-third of all elected representatives have been business founding employers (law firms being excluded) otherwise known as entrepreneurs. Incidentally, the exclusion of law firms is not on, as you might suspect, grounds of morality, rather it is due to my perception of the result of the professional training of attorneys, which is to seek comfort only in finding precedent and therefore not being comfortable in planning for future events.

Mistakes made and lesson learned:

Not understanding my own motivation - for being involved in a relationship without really knowing why. Why was I considering making an investment in a private company, any private company? Was it because I am an incurable opportunity and excitement junkie (as my wife would assert)? Probably so. Could it be because I really wished to help whoever was pitching me the opportunity? Possibly so. In any case, whatever my motivation I damn well should understand what is driving me to become involved, as it is difficult for all and impossible for me to passively invest in private companies and therefore the investment should be expected to be more than just money. This is, of course, especially true as the recapture of the funds invested is usually dependant on the business succeeding. In the book Venture's Financing and Investing In Private Companies I list some of the reasons why people invest in private companies, other than to make a high return. It is surprising to me how few angels, those who spread their wings and open their wallets to entrepreneurs, are really only profit driven. Most have other than only profit on their agendas. Angels are frequently quite wonderful and interesting people and must be protected as were they to become extinct, due to more frequently than not, being the recipients of capital punishment, their losses become our losses, if their losses prompt them to abandon the exercise and leave the game.

Non-defining of success in considering an investment - For any of us to succeed we have to define success and to define success we have to have a clear vision of that which we are trying to achieve.

Do we crave power or a feeling of power and/or do we have a hope for recognition? Do we want to be a father-figure for an entrepreneur or his employees? Do we want to have an activity into which we can throw ourselves? Do we want to be in a position of the entrepreneur and others becoming dependant upon us? What do we want and how much of this want is responsible for our being willing to lose money?

I don't wish to suggest what anyone's motivation should be, I have just learned that we all would do a better job of investing to achieve an objective if we understood precisely the objective we were trying to achieve.

Not treating my money as if it weren't my money - Lots of times I have made the mistake of forgetting or failing to articulate what my objective was and have just gotten swept up in the challenge of making the deal - rather than continuing the decision making process, up until the time of closing, if I should do the deal. That's when I've been investing my own money. I have not made the same mistake when I have been acting as a fiduciary. Therefore I urge all investors to pretend they are responsible for acting on behalf of others when making investments, especially in private companies. I promise you that a much better quality decision will be made if you think of yourself as a fiduciary.

Fear - and allowing my fears to unreasonably determine the deals that I will and won't do and how they are structured. What am I most fearful of in making investments in private companies? Losing the money invested? No. I am prepared to lose that which I invest and I recognize that losing all of the money invested in any single private company, especially those which have the greatest early stage potential, is a reasonable possibility. That which frightens me most is that I may become liable for more than has been invested by virtue of investing more money in the deal to save or protect the money originally invested and probably more accurately "already lost". I describe such follow-on investments as "investment hostage" or ransom payment investing, being the practice of investing new money to recapture or resuscitate already lost, dead, capital. I have seen but a very few instances where follow-on investments, prompted by disappointing results, have yielded a satisfactory result or return. Usually they just increase the ultimate loss of the investor. I am also concerned with the possibility of becoming so involved in trying to assist the company in which I've invested that I end-up putting myself in a position where it can be asserted that I have incurred personal liability. For instance, no one wants to have a director's liability in a company having or causing environmental problems or employee and/or customer harm.

Fear of loss in investing is probably a good thing to have as long as the fear is not at such a level as to immobilize the investor. A key lesson taught and learned at Paris Island and later in Korea was "move, don't freeze, when receiving fire". Investing successfully in private companies has some of the same elements as combat and the investor has to be prepared to be in motion, and not just stay in a fox hole of inactivity, waiting for it all to pass or for the "one he never hears". I've learned not to be afraid to take affirmative action to protect the invested assets for which I am responsible.

In structuring transactions I've learned to first determine my investor candidate's priorities. If I am structuring an investment opportunity for truly affluent investors, not just those purportedly qualifying as accredited , I focus on risk analysis and abatement as rich people do not want to be embarrassed by losses as they recognize they have no monetary motivation to expose themselves to risk. If I am attempting to appeal to a broader range of investors then I focus more on the possible magnitude of gain and favorable risk/reward relationship. After all greed is but a fear of not profiting to a maximum level, much as being obsessed with physical fitness reflects a fear of being sick and frail.

Being greedy - resulting in my embracing the entrepreneur's vision of success and future profits. We all want to win, however we define the win and, as I've noted previously, it is vital that we do define for ourselves the definition of the win.

Why have I accepted sales and earnings projections which require the acceptance of the entrepreneur's product or service without the company having made the level of marketing investment similar to that of other comparable and competitive companies? Why have I not required the entrepreneur to respond to a series of "what if" questions such as what if; you die or become an alcoholic, are faced with a patent infringement action, lose your key engineers or salespeople, the primary vendors on whom you are depending for components go out of business, the primary sales prospect decides not to buy, the bank doesn't do that which you expect them to do and finally, it takes twice as long to develop the product and/or make the sales envisioned? Why? Because I wanted to make the investment, gain a participation in the project and get rich as a result.

Being lazy - too lazy to thoroughly check the background of the entrepreneur, even though I had the opportunity to do so. Few of us really enjoy the process of prying into the lives of others. However, as once money has been committed to private company investment it become a captive of the process. Therefore, it is vital that we really know who it is we are, all too frequently, giving our money to. Many of us know what to do and simply fail to do it when it comes to researching an investment opportunity.

Being cheap - as in being unwilling to recognize that making investment decisions requires the expenditure of funds. A professional background check on an entrepreneur will cost in the area of $1,500 if more than a litigation and credit check is involved. It is money well spent.

In one case recently an associate of mine and myself paid $7,500 for the preparation and distribution of a newspaper insert marketing effort on behalf of a company whose product interested us. If the insert drew as few as 150 responses in a 22,500 business journal distribution then we'd get our $7,500 back and know that we would make money by rolling out the service nationally. If we didn't recapture the marketing money then we'd have learned something which would save us a lot more than the $7,500. We lost our $7,500 and saved a far greater amount that we would have invested. First loss is the best loss.

In another case, I recently advised and arranged for a client to have a background check run on a charismatic individual having proposed a joint venture. The background of the individual it was learned included several jail terms and lots of litigation. Needless to say, the relationship did not occur as had been originally contemplated, though there may be a different form and level of relationship.

In some cases, professional investors seek to recapture from a funding (and sometimes even without a funding occurring) their legitimate due diligence expenses through the imposition of an investigation fee or reimbursement agreement. My approach has been to require the entrepreneur to pay the entire cost of our due diligence if we uncover significant factual data which is in opposition to that which the entrepreneur presented to us or which is relevant and negative and should have been disclosed. It is going to cost, one way or another, at least $5,000 to $10,000 to professionally reach a decision of whether or not to invest in a private company assuming the proposition is not rejected out of hand. Private company investors must either be willing to spend the money or trust to their intuition, experience-based judgment and/or luck. Again, were you investing as a fiduciary you'd probably spend the money - and obtain a better overall portfolio result.

One of my friends who is an active and experienced smaller enterprise consultant, who assists companies in organizing themselves, prepare a business plan and obtain financing, reminds me that one of the aspects of both being cheap and of denying the ever present and efficacy of Murphy's Law is being under insured. Also too few entrepreneurs are pressed by those investing in them to set aside, beyond their control, amounts sufficient to assure the expense of remaining in "good legal standing" for subsequent years after the investment is made. If the company fails to maintain its legal standing then it can loose its right to litigate or even effectively contract. Strange and murky things happen when companies get into trouble and some of them can be guarded against by experienced investors overriding the entrepreneurs super abundance of confidence that all will be well because that's the way it has to be (in his eyes).

Becoming dependant - upon the entrepreneur as an individual. Investing in private companies is a people assessment exercise as much as a financial analysis. I and most other private company investors usually know within a very short period of time, minutes or perhaps even seconds, if the entrepreneur is a person with whom a business relationship is wanted. However, I have paid the price of losing money by not requiring that there be more than one individual worthy of my admiration in a company being financed. Aside from the fact that entrepreneurs, though many would dispute the fact, are mortal, there should be in place a team of credible people on whom the investor can rely. If the entrepreneur being financed only attracts and recruits people of lesser quality and ability than he or she then there is a problem. Successful entrepreneurs frequently say the secret to their success was in hiring or attracting people who were smarter and better qualified than themselves. One of the distinctions between those having an entrepreneurial mind-set and those who think of themselves as inventors is that of the inventor being typically reluctant to share in the development of the intellectual property whereas the entrepreneur wishes to capture the resources and efforts of as many people as possible for his benefit.

Being non-diversified - in the creation and management of a portfolio of private company investments. None of us are so smart and experienced as to be able to predict which of the truly promising opportunities we are exposed to, and with which we become involved, will be winners. We know that most will fail to achieve the initial objectives of the entrepreneur and some will actually fail. Therefore we should put ourselves in a position of "sprinkling money amongst talent" rather than restricting our investment to one or two private company investments, if we wish to be serious in the effort of making money. However, I and I hope you, recognize that, again - it all goes back to the investor's motivation.

Being unrealistic - as to the absence of competition for the product or service being financed. Entrepreneurs all too frequently are either uninformed as to competitive factors or so very sure of themselves and secure in their vision that they minimize or discount the threat of competition. The result of such disregard of margin shrinking or revenue reducing competition is typically one of under estimation of the amount of funding required. Entrepreneurs typically under estimate both the amount of time, and therefore money, required in reaching a point of being cash flow positive.

Being too tough - in the structuring of transactions. The essence of structuring a transaction is the shifting disproportionate amounts of reward to the stronger party and risk to the weaker party. The reality is that the stronger party, the one with the resource needed by the entrepreneur, has to be fair and make certain the entrepreneur understands why the deal is fair. In cases where the entrepreneur perceives that he is being taken advantage of a destructive and investment threatening attitude can develop. The investors should protect himself on the downside and be prepared to be generous with the entrepreneur on the upside. For this reason I prefer to provide risk capital in forms of other than equity.

Falling in love - with an investment. Frequently there are opportunities for the investor to recapture his investment while still retaining an interest in the enterprise. In most cases when I have had such opportunities my greed and need for vindication of initial judgment has prevented my taking advantage of the opportunity. Structuring transactions with an exit strategy is important and the difference between a professionally negotiated deal and one made by and with amateurs is the presence or absence of an exit. A frank and open discussion with the entrepreneur, prior to the making of the investment, is desirable in order the entrepreneur understand the investor's need to recapture and recirculate capital. The investor in private companies should not confuse his role with that of the entrepreneur. We all have to know who we are in any given situation.

I hope the foregoing, perhaps all too revealing, disclosure of some of the mistakes I've made will allow you to avoid making the same mistakes. As noted at the beginning of this talk, I seem to have a wonderful ability of not only making some of the mistakes repetitively but of also finding new mistakes to make in investing in private companies.

Investing in private companies, when they become successful, is about as rewarding and satisfying an experience as one can have when dealing with money matters. I urge those of you who can now or will be able to do so in the future to sprinkle money amongst talent by investing in a range of private companies, especially those, which if successful, have the scope to make all involved wealthy. It doesnt pay to invest in private companies having limited horizons such as single restaurants or retail establishments whereas investing in retail businesses having the potential of franchising could be an excellent idea.

Thank you for allowing me to share with you some of the lessons Ive learned. I hope the memory of them may be of benefit to you at the point you are considering embarking on your private company investing adventure.

- 30 -

Originally presented to: Financial & Investment Education Symposium
San Diego County Employees Retirement Association (SDCERA)

A9 British Far East Holdings Ltd. All rights reserved.

Arthur Lipper arthur@pobox.com 858) 793 7100

Author/Correspondent's Profile: Arthur Lipper III, Chairman, British Far East Holdings Ltd.