Potential Versus Peril: Evaluating Closely Held Companies

Welcome to the March 2019 edition of our newsletter!  In this issue, we’ll examine how corporate governance and reliance on internal oversight mechanisms may not enough to protect investors from fraud.

View from the Outside: The Value of Looking Into Closely Held Companies

As Silicon Valley assesses the fallout from some of the high-profile frauds among technology startups in recent years, including many headline-grabbing incidents, important lessons are coming into focus for potential investors, suppliers or others looking to do business with the “next big thing.”  Although an experienced board of directors can help – and is meant to serve as a check on an overly ambitious founder, as is often the case with startups – directors are people too, and thus subject to the same manipulations and misconceptions that can doom any of us.  The same can be said, to some degree, of outside regulators, whose oversight duties can vary wildly from industry to industry.

Yet the promise of astonishing potential – which can act as a siren song to all involved parties – should not be ignored, and various independent measures exist to help understand the risk, even in technically dense, opaque fields.  Examining the makeup of advisory boards or board of directors is a good start – did the founder stack it with early investors and supporters, more likely to have blinders on toward positive reinforcement and group think, or are there industry veterans who may be supportive but also skeptical if something doesn’t seem right?  Although young, closely held companies are often loath to provide detailed sales data and other internal information, they all have to compete somewhere, and with someone.  Calling competitors about a company’s reputation can be useful, although it should always be viewed skeptically since the competitor may seek to undercut a potential investment in its rival.  If themes and trends emerge after several conversations with competitors and other industry experts, however, it’s much harder to dismiss those as simply a perspective skewed by competitive bias.  Additionally, although regulators can be far from perfect – and may take excessive time to even begin oversight of a particularly new technology – their enforcement files and correspondence can be invaluable for identifying any red flags before funds are committed.

Nascent technologies – or those which don’t yet actually exist except as concepts – often represent promise and peril, a “black box” largely controlled by a company’s founder.  But the right amount of persistent due diligence — especially about the level of checks and balances that exist to keep a company from being tethered too closely to its founder and each of his or her human frailties – can create an environment where risks are better understood.