The internet has revolutionized the world of retail stock investing by making vast amounts of financial information quickly and easily available to individual investors. And though still in the early stages, the advent of digital information exchange is also making it easier for more individuals to invest in privately-held companies. Just as eBay has put buyers in contact with sellers of collectibles that used to collect dust on attic shelves, today private companies are much more able to seek out buyers of their securities to allow them to raise capital.
TUTORIAL: Advanced Financial Statement Analysis
The drawback to vast amounts of information is the difficultly in knowing what to focus on. Below is a comparison of private companies to public ones, overview of private company types and varieties, investment options currently available for interested investors, and a survey of other considerations to make when investing in private companies.
Private Companies versus Public Companies
Overall, it is much easier to invest in a publicly-traded firm. Public companies, especially larger ones, can easily be bought and sold on the stock market and therefore have superior liquidity and a quote market value. Conversely, it can be years before a private firm can again be sold and prices must be negotiated between the seller and buyer.
In addition, public companies must file financial statements with the Securities and Exchange Commission (SEC), making it easy to track how they are doing on a quarterly and annual basis. Private companies are not required to provide any information to the public, so it can be extremely difficult to determine their financial soundness, historical sales and profit trends.
Investing in a public company may seem far superior to investing in a private one, but there are a handful of benefits to not being public. A major criticism of many public firms is that they are overly focused on quarterly results and meeting Wall Street analyst short-term expectations. This can cause them to miss out on long-term value creating opportunities, such as investing in a product that may take years to develop, hurting profits in the near term. Private firms can be better managed for the long term as they are out of Wall Street's reach. An annual report by the World Economic Forum has detailed that productivity increases when a public firm is taken private. They can also create more jobs when run more efficiently and profitably.
Being an owner of a private firm also means sharing more directly in the underlying firm's profits. Earnings may grow at a public, firm but they are retained unless 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 those with large ownership stakes. (To learn more, check out Why Public Companies Go Private.)
Types of Private Companies
From an investment standpoint, a private company is defined by its stage in development. For instance, when an entrepreneur is first starting a business he or she usually receives funding from a friend or family member on very favorable terms. This stage is referred to as angel investing, while the private company is known as an angel firm. Past the start-up phase is venture capital: investing where a group of more savvy investors comes along and offers growth capital and managerial know-how and other operational assistance. At this stage a firm is seen to have at least some long-term potential.
Past this stage can be mezzanine investing, which consists of equity and debt, the last of which will convert to equity if the private company can't meet its interest payment obligations. Later-stage private investing is simply referred to as private equity and is currently a multi-billion dollar business with many large players.
For investors, the stage of development a private company is in can help define how risky it is as an investment. For instance, approximately 40% of angel investments fail and the risk falls the more developed and profitable a private company becomes. And although the goal of many private firms is to eventually go public and provide liquidity for company founders or other investors, other private business may prefer to stay private given the benefits given above. Family businesses may also prefer privacy and the handing of ownership across generations. These are important matters to become aware of when deciding to invest in a private company. (To learn more, see What Is Private Equity?)
How to Invest in Private Companies
Early-stage private investing offers the most investment opportunities but is also the most risky. As a result, joining an angel investor organization or investment group may be a good idea to make the process easier and potentially spread the investment risks across a wide group of firms. Venture funds also exist and solicit outside partners for investing capital.
As noted above, the internet has quickly become a central source to find these types of organizations, while other websites have sprung up to fill a void and put buyers and sellers of many types of private companies together. Online sources also have made it easier to at least locate basic information on a private firm. This can be done by visiting the company's websites, and reading online blogs and articles that discuss the firm and its industry.
Other resources that can be used include small or private business brokers that specialize in buying and selling these firms. Private equity is also an option, and ironically a number of the largest private equity firms are publicly traded so can be purchased by any investor. A number of mutual funds can also offer at least some exposure to private companies.
Overall, it is important to reiterate that private companies are illiquid and require very long investing time frames. Most investors will also need an eventual liquidity event to cash out. This includes when the company goes public, buys out private shareholders, or is bought out by a rival or another private equity firm. And just like with any security, private companies need to be valued to determine if they are fairly valued, overvalued or undervalued.
It is also important to note that investing directly in private firms is usually reserved only for wealthy individuals. The motivation is that they can handle the additional illiquidity and risk that goes with private investing. The SEC definition calls these wealthy individuals accredited investor or qualified institutional buyer (QIB) when considering institutions.
The Bottom Line
It is now easier than ever to invest in private companies, but an investor still has to do his or her homework. Investing directly is still not going to be a viable option for most investors, but there are still ways to gain exposure to private firms through more diversified investment vehicles. Overall, an investor definitely has to work harder an overcome more obstacles when investing in a private firm as compared to a public one, but they work can be worth it as there are a number of advantages to be gained by investing in private companies. (For more, see For Companies, Staying Private A Matter Of Choice.)
Stock AnalysisWal-Mart is the largest company in the world, with a sterling track-record of profits and dividends. So why has its stock fallen sharply in 2015?
EntrepreneurshipLearn how to make a successful pitch to investors. Regardless of your industry, size or market, there are some questions all investors need to have answered.
Investing NewsThe force is strong with Disney stock, as it continues to make gains going into the launch of EP7. But is this pricey stock a good buy at these levels?
EntrepreneurshipLearn how these multibillionaires built their fortunes to stand out from the crowd of the countless ultra-rich who call Los Angeles home.
Investing BasicsThe reality TV shows "Restaurant Impossible" and "Kitchen Disasters" offer lessons not just for restaurateurs, but for all business owners.
Investing NewsSpace enthusiasts are in for an exciting time as Silicon Valley startups take on the lucrative but expensive final frontier.
SavingsHave your paperwork in order and be sure to shop around.
SavingsIt shouldn’t be too hard to do, provided you have the appropriate documentation and forms. But be prepared for lots of paperwork!
MarketsLearn about the leading private equity firms operating in India and which companies and industries are attracting foreign investment dollars.
Mutual Funds & ETFsLearn about the differences between Vanguard's mutual fund and ETF products, and discover which may be more appropriate for investors.
Mutual funds can invest in private companies, which may come as a surprise to many investors. It is rare for a fund to have ... Read Full Answer >>
An economy grows in only a few specific ways. People might find new or better resources, as with the discovery of oil wells ... Read Full Answer >>
The Vanguard mutual fund family is one of the largest and most well-recognized fund family in the financial industry. Its ... Read Full Answer >>
Mutual funds in India work in much the same way as mutual funds in the United States. Like their American counterparts, Indian ... Read Full Answer >>
Like most financial assets held by institutions such as banks and investment firms, UTMA accounts can be escheated by state ... Read Full Answer >>
While the specific dormancy and escheatment rules for stock accounts vary by state, all states provide for the escheatment ... Read Full Answer >>