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The following was written by guest blogger Bruce Roberts, Founder and CEO of Carofin.
It’s hard enough keeping this baby in running condition.
But, to get the best performance, you work with your mechanic closely, asking additional questions, avoiding risks where you can. While you rely on your mechanic, it just makes sense for you to have a deeper understanding…
The same should be true of your investments.
Here are a few guidelines to help keep your alternative investments from “ending up in the ditch.”
What is Due Diligence When It Comes to Private Placement Investing?
Before making an alternative investment, Investors should analyze and verify information provided to them by the Issuer. Typically, an Investor will be presented with the Offering Documents, such as a Private Placement Memorandum or other Summary Offering Material (SOM). But due diligence involves diving more deeply into Offering materials. Investors should understand all areas of the business — and the backgrounds of the key individuals managing the business – before proceeding.
Defining due diligence
Due diligence regarding investments in private companies means investigating all aspects of the business and the Security being offered. This includes independently evaluating whether the statements in the Offering Documents are complete, consistent, and accurate, with no material facts omitted. It takes more work by the Investor…but it’s worth it!
Why is due diligence so important?
If you haven’t read “Perspectives on Private Investments and Crowdfunding,” you might refer to it for more background. But, in short, the Securities Act of 1933 has fraud provisions which require the Issuer and its representatives to disclose all material facts accurately and fully.
If Issuers are not willing (or not able) to discuss their business in greater detail than is provided in the Offering Documents, even when under the protection of a Non-Disclosure Agreement (NDA) between the Issuer and the Investor, they should be treated with great caution.
The information that has been collected during the due diligence process (i.e. before the investment is made available to Investors) should also be readily available to potential Investors. With the internet, this is relatively easy to do. This information often is provided to prospective Investors via a web-based portal, enabling them to make more informed decisions.
Do you really know the issuers?
The SEC publishes a questionnaire under Rule 506 section of Regulation D (Reg D) called Rule 506 Disqualification Questionnaire (also informally called the “Bad Actor Questionnaire”) which key persons are required to complete.
A background search for the Issuer’s key persons (as defined in the Bad Actor Questionnaire) should include:
- Searches regarding bankruptcies, outstanding Liens and judgments, and criminal background history
- Searches pertaining to each person’s related businesses for bankruptcies and outstanding Liens and judgments
- An internet search for negative news for each key person
- Litigation searches for each key person
- A search of Office of Foreign Assets Control’s (OFAC) sanctions lists for each person and entity.
What other information should you have about the issuing company?
Areas for analysis include company overview (product/service opportunity), financing overview, market overview (customers/competition), management, Investors, employees and related parties, financial information, corporate documents of the company and subsidiaries, previous financings and capital structure, material contracts and agreements, litigation, property/intellectual property, taxation, insurance and liability, acquisition, partnership or joint venture agreements, governmental regulations and filings, and operations.
While the emphasis during a due diligence analysis will naturally be more heavily weighted to the specifics of the potential investment, areas that may originally seem less significant can ultimately have a significantly detrimental impact on an investment if they are not addressed properly.
To learn about specifics within each of the categories mentioned above, please read on.