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Overall, it is much easier to invest in a publicly traded firm than a privately-held company. 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 analysts' 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. Generally, 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 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 investors with large ownership stakes. (See also: 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, 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 it is a nearly trillion-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, more than half of angel investments fail. 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 discussed above. Family businesses may also prefer privacy and the handing of ownership across generations. These are important matters to be aware of when deciding to invest in a private company.

How to Invest in Private Companies

Early-stage private investing offers the most investment opportunities but is also the riskiest. 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, and there are 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 they can be purchased by any investor. A number of mutual funds can also offer at least some exposure to private companies. (See also: 3 Mutual Funds That Invest in Private Companies.)

Other Considerations

Overall, it is important to reiterate that private companies are not liquid and require very long investing time frames. Most investors will 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 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 investors or qualified institutional buyers (QIB) when it is an institution.

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. While investing directly is not a viable option for most investors, there are still ways to gain exposure to private firms through more diversified investment vehicles. Overall, an investor definitely has to work harder and overcome more obstacles when investing in a private firm as compared to a public one, but the work can be worth it as there are a number of advantages.

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