Saturday, November 21, 2009

Investing in Private and Public Companies

From time to time I am asked if I would like to invest in someone's private business. Usually the answer is no. The startling percentage of small businesses that fail creates an unacceptable imbalanced between risk and reward. Every once in a while though I am intrigued by the idea and will go on to request a look at the company's financial statements.


There is an important lesson I have learned though from looking at these private company documents. This lesson extends beyond private companies to investing in general. Private and public companies have very different intents, and as such will use all of the legal leniency in their financial statements to achieve these intents.


Private companies will focus all of their might at keeping taxable income down. Public companies have exactly the opposite intent, show investors consistent growth in income.


There are a wealth of perfectly legal ways for either public or private companies to achieve these means. I certainly don't mean to make it sound malicious- it is just businesses. As a result you as an investor should take a Socratic approach to analyzing all financial statements- question everything. Ask the questions where does the money come from, where does it go, and if you don't like the answers keep digging.


I had the opportunity to watch a bit of Michael Moore's recent movie about Capitalism. There was one startling scene in which Michael asked people on wall street to define derivatives. The people he asked bumbled and sputtered and where unable to really explain it with any vigor and yet were likely buying these very financial vehicles. While I accept Michael has an agenda, the whole thing reminds me that you as an investor have a responsibility to dig deep before investing a dollar in any venture. The picture is rarely as clear as it is painted.


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1 comment:

  1. Hello,

    I've had the chance to invest in a few private companies myself. I haven't pulled the trigger on any of the opportunities, for exactly the reasons you have listed. As well as they are general very small companies and as I would not invest enough for majority ownership, it would be all to easy for the principal owner to take earnings out as salary, rent or one of the other many ways they can use to lower their total tax burden. Which in turn, I would have no recourse to stop.

    But, there is one company that I know of, which after gainiing a thorough understanding of the business industry and the company itself, that I would invest in. However, I am underable to due to conflicts of interest with my job.

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