It's much easier to invest in a publicly traded firmrather than a privately held company. Public companies, especially larger ones, can easily be bought and sold through online brokers and trading platforms. They have superior liquidity and a quote market value. It can be years before a private firm can be sold again, and prices must be negotiated between the seller and buyer.
Key Takeaways
- Private companies aren't required to provide information to the public so it can be almost impossible to accurately gauge their finances.
- You'll have more direct input into a private company's financial decisions if you have a significant ownership stake.
- A private company's stage of development can shed insight into how risky it is as an investment.
- Securities laws make it difficult for retail investors to buy shares of private companies, except in certain circ*mstances.
- Private companies can require very long investment timeframes.
Private Companies vs. Public Companies
Public companies must file financial statements with the Securities and Exchange Commission (SEC) and this makes it easy to track their highs and lows on a quarterly and annual basis. Private companies aren't required to provide any information to the public so it can be extremely difficult to determine their financial soundness, historical sales, and profit trends.
There are nonetheless a handful of advantages to be found in a company not being public. A major criticism of many public firms is that they're overly focused on quarterly results and meeting the short-term expectations of Wall Street analysts. It can cause them to miss out on long-term, value-creating opportunities, such as investing in a product that may take years to develop. This can hurt profits in the near term. Private firms can be better managed for the long term.
Being an owner of a private firm means sharing more directly in the underlying firm's profits. Earnings may grow at a public firm but they're retained unless they're paid out as dividends or used to buy back stock. Private firm earnings can be paid directly to the owners. Private owners can also have a larger role in the decision-making process at the firm, especially investorswith large ownership stakes.
Types of Private Companies
A private company is defined for investment purposes by its stage in development.
Angel Investing
Entrepreneurs usually receive funding from a friend or family member on very favorable terms when they first start a business. This is referred to as angel investing. The private company is known as an angel firm.
Venture Capital Investing
Venture capitalinvesting comes after the start-up phase when a group of more savvy investors offers growth capital, managerial know-how, and other operational assistance. A firm is seen to have at least some long-term potential at this stage.
Mezzanine Investing
Mezzanine investing can come next. This consists of equity and debt that will convert to equity if the private company can't meet its interest payment obligations.
The Private Equity Stage
Later-stage private investing is simply referred to as private equity. It's a roughly twelve-trillion-dollar business with many large players.
A private company's stage of development can help an investor define how risky it is as an investment. Up to 70% of all angel investments lose money, but the risk drops as a private company becomes more developed and profitable. The goal of many private firms is to eventually go public and provide liquidity for company founders or other investors but other private businesses may prefer to stay private given the benefits.
In the United States, securities laws restrict private companies from selling equity securities to the general public. However, there are certain exemptions for employees, low-scale crowdfunding, and accredited investors.
How to Invest in Private Companies
Early-stage private investing offers the most investment opportunities but it's also the riskiest. Joining an angel investor organization or investment group may be a good idea as a result. It can help make the process easier and potentially spread the investment risks across a wide group of firms.
Venture funds also exist and they solicit outside partners for investing capital. There are small or private business brokers that specialize in buying and selling these firms.
Private equity is also an option. Ironically, a number of the largest private equity firms are publicly traded so they can be purchased by any investor. Several mutual funds can also offer at least some exposure to private companies.
Other Considerations
Private companies aren'tliquid and they require very long investing timeframes. Most investors willneed an eventual liquidity event to cash out. These can include when the company goes public, when it buys out its private shareholders, or if it's bought out by a rival or another private equity firm. As with any security, private companies must be valued to determine if they're fairly valued, overvalued, or undervalued.
It's also important to note that investing directly in private firms is usually reserved for wealthy individuals. The motivation is that they can handle the additional illiquidity and risk that goes with private investing. The U.S. Securities and Exchange Commission calls these individuals accredited investors or qualified institutional buyers (QIB) when they're institutions.
What Is the Role of the Securities and Exchange Commission (SEC?)
The SEC indicates that its mission is "to protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation." It has no control over private companies unless they sell securities because it regulates securities.
What Is Venture Capital?
Venture capital raises money for projects, ideas, and new businesses that might not be able to receive financing from other sources. This typically includes businesses that may not turn a profit for a good many years or those that are providing new or unique products or services.
What Does It Mean When a Company Isn't Liquid?
A company isn't liquid when it doesn't have ready access to cash or assets that can be easily converted into cash. These can include bonds, accounts receivable, certain marketable securities, and money market accounts. Accounts receivable may or may not be considered liquid assets depending on how easily or regularly they can be collected.
The Bottom Line
It's easier than ever to invest in private companies but an investor still has to do their homework. Investing directly isn't a viable option for most investors but there are still ways to gain exposure to private firms through more diversified investment vehicles. An investor definitely has to work harder and overcome more obstacles when they're investing in a private firm compared to a public one but the work can be worth it because there are several advantages.
