Wednesday, 01 June 2016 12:04

Shareholder due diligence – protecting shareholders from personal risk

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In one of the final scenes of iconic movie Forrest Gump, Forrest discovers he’s a shareholder in “some kind of fruit company,” and that he “don’t have to worry about money no more.”

He unwittingly bought shares in Apple Computers, and if for argument’s sake he’d spent $100,000 in 1977, his shares today would be worth close to $7 billion dollars.

Of course, we all want to get as lucky as Forrest, but it’s pretty rare to blindly wander into a fortune. Becoming a shareholder can be a useful way to diversify your portfolio, and many people enjoy the experience. In our experience, many people in NZ become involved as a shareholder in a small company with a few other mates or acquaintances with a great idea and the best of intentions.

Over 80% of NZ registered companies are small to medium sized and do not offer shares to the public.

Things can and do go wrong however, so before you jump in with investing in a company, it’s important to conduct due diligence to protect your investment and ensure you’re safe should something go wrong.

Conducting Shareholder Due Dilligence

When you come into a business, there are several key drivers you should investigate. First of all is the relationship you have with the other owners. If things are uncomfortable now, they could become toxic at the first sign of trouble. Secondly, you should have some understanding of the industry. Is it in a growth market, or on the decline? What is the market saturation/share? What’s the product’s reputation with consumers? Having inside knowledge of the market can help you see opportunities and add value, as well as avoid disasters.

As part of due diligence, you need to assess the returns from the proposed investment. The expected return may not always be financial, but often it will be. For example, one company we know of asked shareholders to inject a couple of million dollars into the business to allow it to continue to trade. Many factors were considered during the due diligence process, but the decision came down to the fact the particular industry worked on slim profit margins, the company concerned did not have a track record of profitable trading, had many competitors, and it would’ve taken the company approximately 20 years to repay the initial investment.

In that case, when comparing the costs of the shareholders either borrowing the funds or what they could get as a return on the same money elsewhere, the shareholders decided against making the additional investment

The company was placed into liquidation as a result of the shareholders’ decision. From what we have seen the prospect of liquidation should funds not be introduced had been one of the factors that the company directors had asked the shareholders to consider. Which leads to another due diligence point, that you need to consider the common grounds and potential conflict points between shareholders’ interests and those of the directors as they may be different people, and what agreements are in place to deal with these.

Forrest clearly didn’t involve any due diligence techniques, but it is a movie and he got lucky. In the real world, you can’t count on Forrest’s luck. If you’re looking at investing or becoming a shareholder due diligence is important. You must know about the people and company you’re about to enter into business with.

Due Dilligence Checklist

Here are elevan simple questions to ask when conducting due diligence for a shareholding. Finding the answers could save you big time in the long run:

  • - Does the business own all its key assets, including property, vehicles, and IP?
  • - What obligations and liabilities will impact on your buy in? (Check the contracts!)
  • - When will either value or a regular return on investment be available?
  • - Does the business have any upcoming or current court proceedings for lawsuits?
  • - Has the business been to court in the past? What for? (This may highlight potential weaknesses).
  • - What are you expected to bring to the table? Skill? Ideas? Money? All of those?
  • - Can you and do you want to commit to the resources expected? Or are you conflicted?
  • - What are the company’s revenue, profit, and margin (RPM) trends?
  • - Do you trust the managers and board? Research profiles and past business histories.
  • - What risks (both industry-wide and company-specific) do you expose yourself to?
  • - Will your reputation be harmed by associating your name with this company?

Investing in a company is a bit like hiring an employee. With a formal process to work through, you will usually end up with a solid, dependable asset. But without that process, you are gambling based on instinct and first impressions, and that’s not ideal. There are always fish hooks when becoming a shareholder – disputes can ruin a business – but by following the process outlined above, you’ll avoid the majority of potential problems.

If you haven’t gone through due diligence, or you need some advice on what to do next, come and talk to the McDonald Vague team and they can help guide you toward a confident decision.

If your company is experiencing financial difficulty, download our free guide for NZ Companies to discover your different options.

Read 3842 times Last modified on Friday, 10 March 2017 12:51

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