Private Venture Investing: "Questions an Investor Should Ask"

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This information is intended as a general guide to the investor contemplating an investment in a "private company or project". It summarizes key questions to ask and issues to deal with before investing. This type of investment does not typically have approval by a securities regulatory body nor a prospectus.

There is a wealth of information available on investing in public companies and mutual funds. There is also an abundance of capable professionals who dispense advice on these matters. Much of what follows is applicable to evaluating any type of investment opportunity. This fact sheet is written with private company investment in mind and is referred to as "a private venture" investing.

Nothing contained herein is to be construed as specific investment advice regarding any investment opportunity, nor should the reader rely on the contents of this fact sheet for any purpose other than as general information. Investing is, by its nature, risky and anyone contemplating any form of investment should seek out qualified experts to advise on specific matters. Therefore, the interpretation and use of this material rests solely with the reader.

The development of this fact sheet was jointly funded between Alberta Agriculture, Food & Rural Development and Manitoba Agriculture. It was written by Cam Crawford from Coakwell Moore Chartered Accountants-Management Consultants of High River, Alberta, with the assistance of Sue Bannerman from INT Associates Inc.-Management and Training Consultants of Olds, Alberta.

A special Manitoba review committee made up of Manitoba Agriculture Specialists and Staff, along with representatives from Industry reviewed the material to ensure its applicability in Manitoba.

In cooperation with: Alberta Agriculture, Food and Rural Development

Private Venture Investing - An Overview

There are a number of factors that have contributed to an increased interest in private venture investing in recent years.

• money market returns are at historical low levels and many investors are seeking out higher returns with private venture investments.
• a consolidation of equity is occurring as the parents of baby-boomers transfer accumulated wealth to their sons and daughters.
• certain local and regional economies are vibrant and growing; apparent opportunities abound. Interest and enthusiasm among entrepreneurs is very high in some locals.
• public equity markets have produced significant gains for investors, some of whom are looking to diversify by investing profits into private venture investments.
• significant amounts of labour sponsored venture capital funds (e.g. pension funds) have built up in recent years encouraging entrepreneurs to pursue ideas in the hope of attracting this and other sources of venture capital.

• Why am I considering this investment?
• Who is making the sales pitch?
• Is there a business plan?
• Who will manage the venture?
• What is the legal structure of the investment?
• Who will own and control the venture?
• What is the investor liquidity strategy?
• What is the current financial position?
• Have you completed a formal review of the details of the opportunity?

• What are my objectives in making the investment? Are these objectives consistent with other shareholders?
• What do I expect to gain? What is the probable return on my investment (ROI)?
• How much could I stand to lose? Is the risk of loss offset by the potential for return?
• is there a balance between risk and return?

1. Have a clear set of objectives in considering an investment.
2. Write your objectives down, if only to force you to seriously address this aspect.
3. Beware of "can't lose" deals which just happen to find you. Remember, an experienced venture capitalist will review all ten deals before considering one, and only one in ten of those is likely to be pursued. That works out to roughly one-in-a-hundred investments made from opportunities reviewed.

• Are there any fees being paid to the people making the sales pitch?
• Are those fees contingent on success of the money raising efforts?
• Why are they talking to you?
• How long has the opportunity been offered to others?
• Who else is contemplating an investment?
• Can you team up with other investors to review the opportunity together?

1. Never respond quickly to an investment proposal; high pressure tactics that suggest a tight time deadline should be avoided.
2. Find out who else is considering an investment in the project and ask to talk to them. This may not always be possible, but if the promoters of an investment will let you talk to other potential investors, do so. If they won't let you do this, at least find out why they won't.

• What are the key aspects of the business plan?
• What are the competitive advantages of the business or project?
• What is the stage of the business or project: concept only, start-up, growth, turn-around, buyout?
• How much money is being raised?
• What will the money raised be used for? What amount of this money will be spent on tangible vs. Intangible assets (e.g. operating and start-up expenses)?
• How much income will the company make if the business plan is successfully implemented?

• a one or two page executive summary of the entire business plan.
• history of the business/project to date.
• people profiles and an indication of their status (i.e. Board members, management, full-time and part-time employees, etc.) And company culture.
• a clear description of the product or service, how competitive advantage will be established in the marketplace, and an analysis of the competition.
• details of the marketing plan:
• target market segments (groups of people that are potential customers), customer profiles,
• market size (potential number and size of identified segments), geographic location,
• penetration strategies (how will the product or services be advertised and promoted to a new or expanded market), integration, company size and rank,
• start-up and promotional costs, etc.
• have all regulatory requirements been met (environmental regulations, zoning requirements)?
• is there an independent study of the technology or product? SWOT (Strengths, Weaknesses, Opportunities and Threats) analysis may be appropriate.
• full details of legal structure and ownership.
• full description of the ownership structure after the investment is completed.
• details and sources of project financing requirements.
• an analysis of risk.
• full projected financial information for the venture including balance sheets, income statements and cash flow statements for at least 3 years.
• details of the assumptions utilized in the projections (particularly the basis for revenue projections); this could be compared to some industry standards.

1. There are numerous books and other informational material on business plans, including some excellent brochure-type publications provided by financial institutions and professional firms. Learn what a good business plan should contain.
2. Prior to being provided with a detailed business plan you may be asked to sign a confidentiality and non-disclosure agreement. This is a standard practice, but if you are not sure exactly what you are signing, ask your lawyer to review it with you and get a legal opinion.

• Who are the key implementers of the business plan?
• Do they have significant accomplishments in their past?
• What are the terms of employment for these people? Who makes up the management team? (I.e. who is actually going to be running the business and how much experience and background do they have?) What is their level of management ability?
• Are they full-time? Part-time?
• Are there or will there be employment contracts in place with key people?
• What will be their remuneration?
• Is any of their pay made up of contingent remuneration?
• Who are the current shareholders, officers and directors of the company?
• Who are the key professional advisors to the project? Consultants? Lawyers? Financial?
• These are important people to a venture.

• limited company
• partnership
• limited partnership
• joint venture

• How is the investment legally structured?
• Is there a formal offering document?
• Are there upper and lower limits for the offering?
• What happens if not all the required investment capital is raised?
• Are you investing in debt or equity?
• If equity, is it subordinated debt? Convertible debt?
• Is some or all of your investment going to be secured by assets?
• Could you be legally required to put up more money in the future?
• Do you know all classes of ownership and how shares are paid?

1. At a minimum there should always be a subscription form for an investment.
2. Never simply hand over a cheque to someone promoting an investment.
3. Have the subscription form reviewed by your legal and financial advisors before you sign. In addition, there is some protection available by paying your investment into a lawyer's trust account, pending the closing of an investment and possible other conditions. This practice is often followed, but make sure you understand the conditions of trust placed on the lawyer who receives the funds. The lawyer is often working for the company raising the money and once the trust conditions are met, the funds can be released from trust. Or an investor may want clarification when they deposit the money in trust and have their own conditions placed on the funds or they may want to have their own independent legal advice involved.
4. Make sure that you understand what will happen if all of the funds are not raised. Will you get your money back, or will you become an investor in an underfunded project? In addition, make sure you understand whether you will have a legal obligation to put more money into the project in the future.

• Founders of early stage projects are usually entitled to a lesser carried interest than founders of more mature projects.
• The greater the potential for return from a project, generally the greater the entitlement of the founders to a carried interest.

• How much cash have the founders invested in the project?
• Are the founders getting ownership in the business to compensate them for their non-cash investment of time and effort?
• How much will your investment be diluted as a result of the founders getting an interest for their sweat equity?
• Who will control the venture after the money has been invested?
• Is there room for negotiation in the project structure, or is it fixed?
• Will you be entitled to representation on the board of directors?
• Do you want to be on the board of directors?
• Are you expected and do you want to make a contribution beyond money (e.g. professional advice, time, etc.)?
• Do you have valuable contacts or knowledge that could improve chances of the project's success?
• Do the founders have warrants and/or provisions on the investment and how do these affect control of the investment?

1. Many of the above and other related issues are dealt with in an unanimous shareholders agreement in a private venture investment. This is a critically important document that details the agreement (in advance) by the shareholders as to how certain important issues will be dealt with.
2. Seek out competent professional advice if you do not understand the exact workings of the provisions of the Unanimous Shareholders Agreement.
3. Being a director can be a great way to know everything that is going on and possibly influence direction. But directorship also has a significant potential downside. Make sure you understand this downside before accepting an appointment as a director.
4. Often it is a good idea to structure the investment such that founders start out with a lower relative equity position, but can earn a higher proportion of ownership, usually via a share option arrangement, if an when the business produces profits. A founder may want full value for their investment and anything beyond this through a "bonus".

• How and when will you get your money back out of the investment? Is this disclosed in the shareholders' agreement?
• Have you analyzed the investment from the viewpoint of investors exiting and newcomers entering?

• Are audited historical financial statements available?
• What is the current financial position of the business?
• Is it operating now?
• Is it making money?
• If it is losing money, how much money is being lost each month? What is the burn rate? What is the turn-around strategy and who controls it?
• Has a reputable firm of accountants issued an accountant's report on the financial statements?
• Is the venture up to date on tax and other required filings?
• When is the business expected to become profitable
• What is the expected return on investment (ROI)?
• What is the payback period for the investment?
• If the business plan is successful, how much will my investment be worth? How will profits be paid out (e.g. retained earnings, etc.)? How does the business compare to industry standards for (1) returns; (2) leverage; (3) and payables and receivables? (Industry standards publications are available at your local library.)

1. Look for a report appended to historical financial statements by independent accountants, recognizing that the credibility added by independent accountants varies based on the nature of their report on the statements, as well as from firm to firm.
2. The above points have been simplified for purposes of illustration, there are many additional factors that can impact the completion of a value analysis on an investment. You should seek out qualified assistance in analyzing and interpreting all financial information pertaining to a prospective investment.

• Have you formally confirmed representations made during the sales pitch and investigation phases?
• Have you been lied to or have claims been exaggerated by the promoters?
• Have all legal documents (contracts, agreements, leases, etc.) been reviewed?
• Are all tax filings (income tax, payroll, GST, etc.) up to date and have these filings and related assessments been reviewed?

• BComm (University of Calgary - 1976)
• CA (KPMG - 1976)
• CMC (Coakwell Moore - 1988)
• FCA (Coakwell Moore - 1997)
• Cam specializes in management and consulting, specifically in the areas of business planning, financing and growth strategies, for a variety of clients many of which are in the agri-business and related sectors.
• Cam is also a founding director and chairman of the board of AgriVest Capital Corporation, a Calgary based privately funded venture capital company specializing in agri-business projects.

• The purpose of this lexicon is to provide context for some of the terms used in this document. These are not intended to be precise definitions.
• Board of directors
  The group of people, elected by the shareholders of a company, who make major decisions regarding the conduct of the company's business. Directors have a duty to shareholders to manage the affairs of the business in a prudent manner. Control of the board of directors is often a key issue in private venture investing.
• Burn rate
  The amount of overhead and other costs in excess of revenue that a business will incur, usually considered on a monthly basis. Typical of a start-up business, the burn rate is extremely critical for the investor, as it will dictate how long the business or project can survive on available cash resources. The burn rate should be established in advance and monitored very closely.
• Business plan
  In a nutshell, the business plan should clearly explain the what, why, when, who and how of the project. It should be a comprehensive explanation of the opportunity, the people involved, the money required to implement the plan, where it will come from and what financial results the opportunity is likely to produce.
• Carried interest
  A term often used to describe the interest that the founders will be given in a project. This is to recognize the value of the idea and concept behind an opportunity. It also should identify the non-cash contributions the founders have made to the project. Investors in a project should carefully consider the extent to which their investment, usually paid for with cash, will be diluted by the carried interest (usually issued for non-cash consideration).
• Closing of an investment
  The specific date and process by which cash is invested, share certificates (or other documents evidencing the investment) are issued and agreements are signed. Often conditions are set by both sides in the course of negotiating an investment, and dates by which the conditions must be met or waived are set, allowing for a more orderly negotiation. Any questions or uncertainties about making an investment should be resolved prior to closing.
• Common shares
  The class of shares in a company that typically carry the voting rights to elect the directors and participate in the growth of a company; although other investment vehicles (preferred shares, convertible debt and others) can have the same features. In the event of a liquidation of a company's assets and for other purposes, common shareholders always rank behind other types of shares. They also provide the ability to make claims on residual assets after everyone else has made their claims. The trend in venture investing today is to move away from investment strictly in common shares, towards some sort of "hybrid instrument" (see below).
• Competitive advantage
  Perhaps one of the most important aspects of a business plan. How will the product or service gain market share, recognizing that it is not good enough to be only as good as the competition, it will have to be better. However, in commodity-based investments like agriculture, competitiveness may be viewed more from an internal point-of-view than external. Claims of competitive advantage should be fully reviewed and challenged.
• Confidentiality and non-disclosure agreement
  A formal agreement that potential investors are often asked to sign prior to being provided with information about a business opportunity. This is a standard practice that a potential investor should expect, as long as what is being signed is clearly understood. The potential investor should be particularly cautious in signing this type of agreement if the investment project is in any way related to an existing business that the investor may own.
• Contingent remuneration
  That portion of future remuneration (to be paid to a founder for example) that will be based on profitability of the project or business. It is often used to deal with a situation where the founders want a larger carried interest than the investor is prepared to agree to. Contingent remuneration can be paid in cash, equity, or some combination thereof, with the common thread being the fact that it is based on future achievement, usually the accomplishment of predetermined milestones or level of results.
• Convertible debt
  A term used to describe debt financing that has a feature allowing the debt to be converted to equity, often at the option of the investor, in the event of a default on repayment terms. Other times the conversion feature can be granted as a "sweetener", providing the investor with the option of converting debt to equity if results are good. Sometimes the investee company can have the option to convert the debt. There is often little distinction between certain convertible debt and certain types of preferred shares, both often referred to as "hybrid investment" vehicles.
• Debt
  Typically an investment that is written on terms similar to a bank loan. The debt will usually specify the nature of security for the debt, an interest rate and repayment terms. Straight debt is not often used in venture investing. If debt is used in venture investing, it most often contains terms and provisions that make it a hybrid of debt and equity.
• Due diligence review
  The formal process of validating representations made during an investment investigation. Lawyers often are involved to perform company searches and background checks on the founders. Accountants often review historical financial statements and tax filings, as well as review the accuracy and suitability of financial projections that form part of the business plan.
• Employment contracts
  A very important aspect of a venture. Investors in particular want some commitment that key employees are tied to the business or project by contract. Although it is often difficult for the employer to enforce the terms of employment contracts, to make an investment without key employees being committed to contracts would be ill-advised. Employment contracts should clearly define: term, remuneration, duties, confidentiality issues, conflict of interest guidelines, termination provisions and other relevant details.
• Entrepreneurs
  A widely applied term, often used to describe passionate business types that are prepared to go to the ends of the earth to make a business or project succeed. The term also has come to mean almost any business person in any size or stage of company, dedicated to acting dynamically with an open mind in pursuit of a corporate mission.
• Equity
  Funds are typically advanced by investors to a venture by equity, debt or a combination thereof. An investment vehicle that combines elements of debt and equity is often referred to as a "hybrid investment". Equity is the broad term usually used to describe share capital of various types that a company could issue. When used in the context of shareholders equity, the term would include the money paid in for shares plus the retained earnings of a company.
• Formal offering document
  Usually developed in accordance with detailed securities rules, the formal offering document is often complex with serious legal overtones. Most investment opportunities in the public equity markets are accompanied by this type of document. Many venture investments are promoted by an offering document of some sort as well. The offering document is a very important item in any investment, detailing many key structural aspects of the invest opportunity.
• Founders
  A term used to describe the people who have played a key role in bringing an opportunity to the stage of seeking investment capital. Founders are often looking for a carried interest in the venture to recognize the tangible and intangible contribution they have made to the project.
• Historical financial information
  Financial statements, income tax filings and other documents that detail financial history. Financial statements reported on by independent accountants can have varying degrees of assurance added by those external accountants. The assurance depends on whether the accountants have "audited", "reviewed" or simply "compiled" the financial statements.
• Intermediaries
  A term used to describe people or companies that raise funds for ventures, almost always being paid a commission or other form of success fee when the money is raised.
• Internal Rate of Return (IRR)
  A method to analyze investments which reflects and accounts for the time value of money. IRR is the discount rate which makes the net present value of revenue flows equal to zero or the investment equal to the present value of revenue flows. To calculate IRR often requires the use of Present Value (PV) tables which are available in most business management textbooks. A simple example calculation of IRR is:
• A producer is considering making an investment (I) of $500,000 with anticipated annual revenue (R) of $100,000.
  PV = present value
  i = internal rate of return (IRR)
• 1. Calculate the percentage rate (i) or IRR where I=PV.
  I=PV
  I=PV Factor (Annuity) _(L,i) x R
  $500,000 = PV Factor (Annuity) _{(10 yrs., i?)} X $100,000
• 2. Rearrange formula

  PV Factor (Annuity) (10 yrs., i?) =

  $500,000 $100,000

  = 5.000

• 3. Look up PV table for 5.000 at 10 years to find i (IRR).
  i = ~ 15%
• 4. Therefore, on this investment, the IRR is approximately 15%. Often in making a decision, investors will compare IRR to the cost of capital (interest or opportunity cost) to determine if it is a viable investment or not. Of course, risk must also be factored in when making a decision on any investment.
• As stated above, this is a simple example. When inconsistent or irregular cash flows over time are considered, this process becomes more complex. For this document, the above example illustrates IRR.
• Investor cash calls
  A practice followed with some venture investments whereby investors can be called upon to advance more money into a project, most often upon certain conditions being met or project milestones being accomplished. This is a potential deal structuring concept to be dealt with c cautiously. Structured correctly a staged investment plan can be an effective tool to ensure that the founders are meeting their targets.
• Investor liquidity strategy
  Quite simply, the liquidity strategy details how the investors will get their money out of the venture in the future.
• Joint venture
  A structure often used to pursue a one-time project with a specific target wind up date. A joint venture is generally not recognized as a separate legal entity, as opposed to a partnership which is. Revenues, expenses and asset ownership usually flow through a joint venture to the participants since the joint venture itself has no legal status. Partnerships and joint ventures can appear to be very similar but in fact can have significantly different implications for those involved.
• Limited company
  The most common form of business structure, the limited company is characterized by limited liability for shareholders (i.e. a shareholder's liability is usually limited to the amount of their investment in the company). It is a separate entity for income tax and legal purposes. The company usually elects a board of directors to run the business.
• Limited partnership
  A partnership (see below) in which certain partners are afforded limited liability, with such limited liability usually being the amount of their investment. The partnership is usually run by a general partner who does not have limited liability. Like a regular partnership, this is a separate legal entity but revenues, expenses and certain other financial transactions and income tax related amounts "flow through" to the partners. This type of structure is often used for tax shelter investments.

• Investors put up $4 million
• Over the first three years of operation the company loses $3 million
• In the next two years the company makes a profit of $5 million
  The ROI for this investment at the end of five years is:

Evaluate The Opportunity	Yes	No
I have listed and defined my personal objectives for this investment.
I know my probable return on investment (ROI)
I know the payback period for the investment.
I have discussed this project with other current and potential investors.
I know how long this opportunity has been available.
I understand the financial plan and believe the assumptions and projections are reasonable. If No, has the plan been reviewed by independent professional advisors?
Is the marketing plan realistic?
I understand when the business is expected to become profitable.
I know when I can expect a return on my investment in interest or dividends.
I know how and when I will get my capital back.
If I am purchasing equity, I know what I am purchasing (common shares, preferred shares)
I know if there are warrants or share options attached.
If I am purchasing debt, I know if it is subordinated debt? Convertible debt?

Evaluate The Risk	Yes	No
I know how much I could lose and the risk of loss on this investment.
If the project involves development of a new product, process or other technical innovation, is there independent confirmation that it works?
All the regulatory requirements have been met. (Environmental, zoning, patent searches, etc.)
I know what the funds raised will be used for.
Is the business operational now?
If it is losing money, I know the burn rate.
I know how much my investment will be diluted as a result of the founders getting an interest for their sweat equity.
I think the founders have invested an appropriate amount of cash in the project.
I know what level of involvement is expected of me.
If I want to be on the board of directors, am I entitled to representation?
I understand the legal structure of the investment. If No, I have had professional advice on the subscription form or prospectus.
I know if some or all of my investment is secured by assets.
Could I be legally bound to put up more money in the future?
I understand the legal structure of the venture and the significance of the structure on my current and future risks.
Is adequate insurance in place for assets, key personnel and directors?
Are all tax filings (income tax, payroll, GST, etc.) Up to date and have these filings and related assessments been reviewed?

Evaluate The People	Yes	No
I know and trust the people who are making the sales pitch to me. Or I have confirmed their reputation with credible third parties.
I know what and how the promoters are being paid (if anything).
I know the history of the key implementers of the business plan.
I know the terms of employment, contractual and salary agreements for the key personnel.
I know the reputations of the current shareholders, officers and directors and key professionals to the project.
Has a lawyer conducted corporate and personal searches on those involved in the opportunity?