If you can’t spot a bad deal, then you will not be a successful investor. Developing your abilities in this area is crucial to maximizing returns while minimizing losses. By the end of this post, readers should be able to spot some key indicators of a bad deal.
Evaluating a deal is the most fundamental skill an investor could possess. Analyzing an investment opportunity in a publicly traded firm is about as straightforward as it can get. Financial statements, ratios, and stock price performance are a click away. Corporate webpages are often filled with biographies of key executives, organizational data, and potentially several years of annual reports. Let us also remember all those talking heads on CNBC and the plethora of analysts following any given stock ticker.
There is no shortage of information on investment propositions like that. Where things get trickier is when you are dealing with an opportunity that is non-public or in a niche that is not well covered by the mainstream financial press. You are unlikely to hear much about peer-to-peer lending and oil production royalty deals on CNBC. Stocks, funds, and bonds dominate the average American portfolio.
If you are looking at something a bit more exotic such as a private equity deal, lending, or some other cash flow producing opportunity then you need to do more digging than the average investor.
- Never agree to a deal you don’t understand
If you don’t understand it, you shouldn’t be investing in it. Warren Buffett is famous for this philosophy and his avoidance of tech companies. This philosophy should apply not only to the company’s sector, but also to the structure of the deal itself. What does your equity stake mean? What personal liability are you incurring? What are the tax implications of going through with this deal? You don’t have to figure this stuff out on your own. That’s why God created accountants and attorneys.
- Run, don’t walk, when financial statements are irregular or non-existent
If you remember nothing else, remember this rule. Financials rule all things in business. If you are thinking about getting involved in a business of any kind, you should be able to review and understand their financial position. Recently I was negotiating a deal where a software developer was seeking investment, but couldn’t produce his financial statements. When pressed, he said they did not have these because of the absence of revenue and the fact that they just used an excel spreadsheet to track expenses. This is the wrong answer. If the company’s revenue is zero, then just put that in the appropriate location on the income statement and balance sheet. There are still assets, liabilities, payables, and investor cash-flows that investors need to look at.
- Don’t do business with shady people
Unfortunately we live in a world loaded with shady people. I firmly believe that most people are basically honest, but there is a segment of the population that exists solely to prey on their fellow man. This is certainly the case in the world of business and investing. The only way to avoid these people is to take due diligence seriously. Due diligence means researching every aspect of a deal and people are a critical element in that equation. Does a key person have a criminal or civil litigation history? Do they have vices or habits that could make them unsavory partners? Who are their friends? Who are their enemies? What do these people have to say about them? When doing due diligence you have to look at each aspect of the deal as an onion that has many layers; all of which need to be peeled back. In the course of doing due diligence on a deal that was brought to me, I learned that the prospective business partner had a criminal history that included a sex crime and SEC securities fraud investigation. Clearly this is information that you would want to know before ever writing an investment check to someone.
Conclusion
You will look at more bad business deals than good ones. No one ever lost their shirt by erroneously passing on a good deal, but there is a hell of a lot of ruined people who have fallen victim to a bad deal. Adhere to the aforementioned rules and maintain a healthy skepticism when evaluating opportunities.
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