The risk of investing in private and unknown business

Investors can directly buy stocks of reputable companies both in Singapore and overseas through online trading platforms, so they should always think twice if they want to put money in private, unlisted companies.

Investing in such firms comes with higher risk because it is hard for the average investor to even determine if information about the companies is genuine or otherwise.

Worse, investors are often so blind-sided by promises of huge returns that they forget to check whether the deal is worth paying for.

Even if the investment is genuine, small investors are often put at disadvantage because they usually do not get a full picture of the business and how it is run.

What this means is that they may not get any returns on their investment if the company’s management chooses not to declare any dividend for shareholders. Unhappy investors may also find it hard to cash out if the owners refuse to buy their shares.

Here are two cautionary tales about investors who went to the High Court over disputes related to their stakes in private businesses.

Lured by rosy numbers

A housewife invested $300,000 to buy a 5 per cent stake in a fitness company that was supposedly worth $16 million even though she was an unsophisticated investor who seldom bought shares on the stock market.

She put money in this company because her daughter introduced the “investment opportunity” to her after learning about the firm from a “close friend”.

They were shown presentation slides and documents claiming that the stake they were buying was at a hugely discounted price as it was purportedly worth $800,000. The pair paid up, and they discovered something was amiss only about a year later when company documents were sent to them as a shareholder.

The daughter then saw that the company had a paid-up capital of only $900,000 – at this amount, her mother’s 5 per cent stake would be worth about $45,000. She also saw financial statements showing that the company made only $97,000 in profit in 2018 and a loss of about $22,000 in 2017.

As they failed to get their money back, they sued the owners of the company for misleading them into the deal.

The High Court found that the stake of the loss-making company was worth only about $1,500, so the mother and daughter had overpaid by an astonishing $298,500. Fortunately, they kept good records of the purchase and they got back the sum.

Risk of share dilution

The investor in the second case had put $30,000 into a pub thinking she would be the biggest stakeholder with 30,000 shares, while her two partners had only 5,000 between them. That holding technically gave her an 85.7 per cent stake, making her the majority shareholder.

But she was caught out barely a year later when the partners implemented a “stock split” of one-for-54 for their original holdings, a process that increased their total shares to 270,000. The pub would have 300,000 shares after the split, meaning the young investor’s stake was reduced to just 10 per cent.

The woman, who did not get involved in the pub’s operations or ask to be appointed a director, naturally cried foul over the dilution of her stake that turned her into a minority shareholder.

As she also did not receive any returns on her investment, she sued her partners in the High Court, claiming that they had run the business in a manner that was “oppressive”, without considering her interests as a shareholder.

She lost the case after failing to prove that the partners had intended for her to become the biggest shareholder solely on her $30,000 investment because this sum was probably not even enough to cover two months of the pub’s operating costs.

More importantly, when she signed a partnership agreement at the time of her investment, she knew that the number “10 per cent” was written next to the sentence that stipulated her share in the partnership.

The lesson from these two cases is that if you are serious about wanting a decent return from investing in a private business, make sure you choose one that suits your risk profile and that you have the proper documents to show for it.

Source: Straits Times © SPH Media Limited. Permission required for reproduction.

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