Most people when they look at a deal – they look at the upside potential first. In my opinion, this is the incorrect approach.
During my 20 years in legal practice – I have found that the most successful entrepreneurs and investors have identified the downside risk BEFORE the upside potential.
When you know what the risks are and what is the maximum potential loss – it is only then that you can consider whether the project makes sense. If you are willing to take a loss at the calculated maximum, then you can look at what the potential upside is and whether it is worth taking the risk.
The next question then becomes – how can the risk be substantially reduced or eliminated? There are a number of instruments and strategies that can be employed to reduce the risk – these include Option Contracts, both Put and Call Options, Contracts that have clauses that provide for rescission in the event of certain events. For example, if there is no DA Approval, then the Contract can be rescinded. There is also the possibility of Joint Venture arrangements where the risks can be shared.
There are many ways to reduce or eliminate risk – the key is to know what is the “exit strategy” before going into the deal. If you know the exit strategy, you can then structure the deal to allow for an exit if and when required.
You should only go into a potential deal or acquisition if you have properly assessed the downside risk and maximum potential loss. If you are comfortable with losing the calculated maximum loss, then consider the deal further.
When calculating the downside risk – investors need to not only look at what amounts are going into the deal, but also what are the potential liabilities of the deal. For example, you might only put down $20,000 deposit on a purchase,and you believe that is your maximum loss if you don’t proceed – However, there may be a clause in the Contract that provides a positive covenant for you to undertake certain activities like provide certain infrastructure. If you fail to provide that infrastructure, then damages may flow from that breach. In these circumstances the liability could amount to hundreds of thousands, not just the $20,000.
Look at the downside risk FIRST – then consider the upside.
Build a team to assess all the risks of any purchase.
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Solicitor Director | Acquisitions