Smaller, privately-held companies often have to operate with a close watch on their cash flows as they balance outstanding receivables and payables. The extra cash is needed to fund growth and new product innovations, among other things. This, coupled with the fact that smaller private businesses have historically had problems accessing new capital, enhances opportunities for private investment in these companies.

For the purposes of this article, a privately held business (PHB) is one whose shares are not publicly-traded. PHBs may be owned by a founding entrepreneur, his or her family members and/or a few investing partners; they are almost always closely held.

Such companies may take any number of legal forms, including a sole proprietorship, a limited liability partnership or corporation or an S-corporation, and the decision-making power usually rests with the individual or small group holding the majority of equity in the firm.

Investing in PHBs
PHBs may offer a variety of types of investment, both for angel investors acting on their own, or for investors who access them through a venture capital firm. Having chosen your access route, there are still a variety of choices to make regarding your level of investment.

For example, you can choose to be an "arm's length" investor with no active participation in the operations or decision making within the PHB; this is much the same as owning a few shares of a publicly-traded company. With a small or family-owned business, however, you may be employed in the management of the company; in other words, your investment might come with a job. With an investment of significant size relative to the total capitalization of the company, you may be expected to participate as a member of the company's board of directors (to advise on the policies and direction of the firm and to review management performance). With a family-owned firm (if it's your family), other family-oriented considerations may dictate your level of participation and authority within the firm.

How Much To Invest?
After taking into account the considerations above and making a decision to go forward, you must decide on whether you are looking for a minority position or a majority ownership position and the responsibilities and risks that go along with being the principal owner, if applicable.

Business Targets
As you assess your investment targets, you will want to evaluate the business category occupied by your candidates, and the risk/reward characteristics of each. There are many business categories and some of them overlap, but those considered here are representative:

  • Startups: Startups tend to be high risk with no management track record or proven business model. Four out of five startups fail in the first five years, according to the National Business Incubation Association. On the other hand, startups with no proven track record or business model that are operating in new paradigms have produced many millionaires. Superstars such as Microsoft, Google, Amazon and Apple are good examples.

  • Second-Level Capital Acquisitions: This category includes companies that have gotten off the ground with their first capital infusions, but now need more capital to grow. These companies have a performance record, and while they are usually less risky than a startup, investment debt or equity may be subordinate to that of the original investors.
  • Turnaround: Companies requiring turnaround are in failure mode. If cash flow and the business model and fundamentals are good, however, bad management decisions can be fixed, and you as an investor can make it happen. If cash flow and fundamentals are bad, prospects for recovery are extremely limited. Successful turnarounds offer high return on investment.

  • Growth Opportunity: Companies whose growth is being stymied by a lack of capital may be good investment targets if their fundamentals, track records and resident management are capable of handling the growth. The markets for the growth need to be assessed to determine the feasibility of the growth plan and potential.
  • Bankrupt: Bankrupt firms can provide great value at a low price. Here, the question is "why did the firm go bankrupt?" If the market in which the firm operated and the fundamentals and cash flow potential are good, the reason could be bad management, lack of expense control, receivables collections, productivity, etc. This is a high-risk investment that can require high personal involvement. It can be very lucrative or devastating.

The Pros and Cons
We have looked at the types and categories of investment in PHBs and can now review some of the overall pros and cons of investing in privately-held businesses versus publicly-traded companies.

The pros include the following:

  • Investing in a PHB allows you to set an upfront exit provision for your investment. It can be made on the condition that it must be repaid by a certain date and at an agreed upon rate of return. It may also be set as an option to exit or continue at a number of option dates.
  • PHBs are usually small enough for you, as an investor, to get your arms and mind wrapped around what the business is and who the management people really are.
  • PHBs provide the investor early-in opportunities, which can produce extraordinary returns.
  • The business trend information of the average PHB is more easily accessed and discerned from their relatively simple financial reports and bank statements.
  • In a PHB, you are more likely to be a significant investor and, as such, can influence operational decisions.
  • In PHBs, there is less competition to buy equity than with a publicly-traded company.
  • When investing in a PHB, you can negotiate the rate of return required for you to invest, apart from company performance.

The cons include the following:

  • It is more difficult to obtain truly comparative performance data and industry benchmarks for PHBs.
  • PHBs are not held to the more rigorous accounting, reporting and transparency standards required of publicly-traded companies.
  • PHBs may have a "Founding Entrepreneur" embedded at the helm, without the requisite management skills needed for the current stage of the company.
  • Private companies often do not have easy or inexpensive access to needed capital.
  • PHBs may have family member issues such as succession, compensation and direction among the principal owners.
  • As a recent minority investor, you may have less influence than the original board or management team.
  • Unless an upfront provision was made, it may be difficult to get out of your investment.
  • PHBs can be riskier than publicly-held companies, as they may retain fewer reserves.

The Bottom Line
When considering an investment in a privately-held business, research your target company carefully, including financial reports, bank statements, market niche, competition, management skill levels and track record, cost trends as a percent of revenues, the principal relationships and why the company needs your investment.

If it all looks good, keep your investment small enough to preserve your portfolio diversity. If you are a minority investor, with or without board or management participation, know the people you are investing with very well, including conducting background checks and a review of any pending/historical civil court cases with which they have been involved. Set the term and the rate of return of your investment on the way in, especially if it is "just an investment." If you do your homework, there is money to be made investing in privately-held businesses.

Related Articles
  1. Stock Analysis

    Why did Wal-Mart's Stock Take a Fall in 2015?

    Wal-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?
  2. Entrepreneurship

    4 Things to Know About Your Company To Make a Successful Pitch to Investors

    Learn 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.
  3. Investing News

    Should You Invest in Disney Stock Before Star Wars?

    The 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?
  4. Entrepreneurship

    Top 4 Billionaires Living in Los Angeles

    Learn how these multibillionaires built their fortunes to stand out from the crowd of the countless ultra-rich who call Los Angeles home.
  5. Investing Basics

    3 Business Tips from Restaurant Reality Shows

    The reality TV shows "Restaurant Impossible" and "Kitchen Disasters" offer lessons not just for restaurateurs, but for all business owners.
  6. Investing News

    Silicon Valley Startups Fly into Space

    Space enthusiasts are in for an exciting time as Silicon Valley startups take on the lucrative but expensive final frontier.
  7. Markets

    The Biggest Private Equity Firms In India

    Learn about the leading private equity firms operating in India and which companies and industries are attracting foreign investment dollars.
  8. Mutual Funds & ETFs

    Buying Vanguard Mutual Funds Vs. ETFs

    Learn about the differences between Vanguard's mutual fund and ETF products, and discover which may be more appropriate for investors.
  9. Mutual Funds & ETFs

    The 8 Most Popular Vanguard Funds for a 401(k)

    Learn about some of the mutual funds in Vanguard's lineup that are popular among 401(k) investors, and find out why you should consider them.
  10. Entrepreneurship

    4 Most Successful Indiegogo Campaigns

    Learn about some of the most successful crowdfunding campaigns on Indiegogo, which raised millions of dollars for everything from electric bikes to beehives.
  1. How liquid are Vanguard mutual funds?

    The Vanguard mutual fund family is one of the largest and most well-recognized fund family in the financial industry. Its ... Read Full Answer >>
  2. How do mutual funds work in India?

    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 >>
  3. Are UTMA accounts escheatable?

    Like most financial assets held by institutions such as banks and investment firms, UTMA accounts can be escheated by state ... Read Full Answer >>
  4. What are the dormancy and escheatment rules for stock accounts?

    While the specific dormancy and escheatment rules for stock accounts vary by state, all states provide for the escheatment ... Read Full Answer >>
  5. Does mutual fund manager tenure matter?

    Mutual fund investors have numerous items to consider when selecting a fund, including investment style, sector focus, operating ... Read Full Answer >>
  6. What happens if property is wrongfully escheated?

    If your financial accounts, such as bank, investment or savings accounts, are declared dormant and the managing financial ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  2. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  3. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  4. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
  5. Black Monday

    October 19, 1987, when the Dow Jones Industrial Average (DJIA) lost almost 22% in a single day. That event marked the beginning ...
  6. Monetary Policy

    Monetary policy is the actions of a central bank, currency board or other regulatory committee that determine the size and ...
Trading Center