If investing in the stock market isn’t producing the kind of lucrative returns you were hoping to see, then it might be tempting to go looking to other alternative investments such as private company equity. While there’s nothing inherently wrong with investing in a private company (all public companies were private at one time), there are numerous risks and requirements that need to be well understood. Here’s everything you need to know about how to invest in private companies.
What Is A Private Company?
Just as the name implies, a “privately held company” is one that is privately owned. Control of the business is owned by individuals or other companies, usually through private shares of stocks. In addition, financial information does not have to be disclosed to the general public.
When compared to a “publicly held company”, the setup is entirely different. Shares of public companies can be bought and sold in the open stock market through common shares. Financial information is readily available and regulated by the SEC (Securities and Exchange Commission), a government agency that heavily monitors publicly traded companies and imposes several regulations on their accounting and reporting practices.
When most people think about big-name companies in the world, generally public ones like Apple or AT&T come to mind. But surprisingly less than 1 percent of the 27 million businesses in the U.S. are publicly traded on the major exchanges. That means the vast major of companies are privately held.
Why Invest In Private Companies?
Without the backing of the SEC to confirm their financial reporting practices, you might be wondering why anyone would want to invest in a private company at all.
The answer, in one word, is “opportunity”.
Though there will always be some bad eggs, the grand majority of privately held companies have the same exact objectives as public companies – to grow and make money. Some, especially when they are just getting started, have the potential to become huge industry game-changers. If you can find one of these companies and get in on the ground floor, then it could be an opportunity for a major payoff.
Take, for example, the early days of Facebook. Back before everyone (including your grandma) had an account, Facebook was just another tech startup ran by a bunch of college-aged kids. Investor Peter Thiel recognized its potential and became one of Facebook’s first big investors putting $500,000 into the company. Ultimately, that was a risk that paid off HUGE! Not long after Facebook’s IPO (initial public offering), he ended up selling most of his stake for more than $1 billion in cash.
Some experts would argue that not having to deal with the regulations of the SEC or answer to Wall Street analysts actually allows the company to do a better job focusing on their core offering and growth strategy. Private owners also are able to play a larger role in the business and be more active in the decision-making processes.
Qualifying As An Accredited Investor
Typically to invest in private companies, you have to become what is known as an “angel investor”. An angel investor is someone who puts money into the company in exchange for partial ownership. A comparable example to an angel investor would be any one of the judges on the hit ABC TV show Shark Tank. Entrepreneurs come on the show, pitch their idea and explain why they need the cash, and one of the “sharks” offers to give them the funding they need.
In the very early days of a start-up, nearly anyone can be an angel investor; your parents, friends, coworkers, etc. But as the company starts to grow and divide more ownership, the SEC places limitations on who can invest in it according to something called Regulation D.
Generally speaking, you have to be what’s known as an “accredited investor”, meaning you’ve got:
- A net worth of $1 million in assets or more (not including your home)
- Reported $200,000 of income each year over the past two years (or $300,000 if you file a joint tax return)
… And that’s just to qualify to become an investor. On the other side of the equation, if you’d like to sell your private shares, there’s then another set of requirements where the company will have to qualify for an exemption of registration with the SEC.
Investing Using Equity Crowdsourcing
If you really want to invest in a private company but don’t quite make the financial requirements of being an accredited investor, the good news is that it is still possible to do so.
Back in 2012, the Jumpstart Our Business Startups (JOBS) Act changed the federal restrictions for how private companies can raise capital and made one very appealing option open to regular investors: Equity crowdfunding.
You’re probably familiar with public crowdfunding sites like Kickstarter where people will often donate to charitable causes. With equity crowdfunding, the idea is similar but it’s more of an investment arrangement aimed at helping U.S. startups.
The way it works is that an equity crowdfunding firm will purchase shares of the private company. Those shares are then divided up among the participating investors on a proportional basis (sort of like a mutual fund). Some popular crowdfunding sites are:
As the company grows, those shares grow with it. Ultimately, if the company ever makes it to an IPO, then just like our story earlier with Facebook, those investors might see a handsome return on investment. If, on the other hand, the private company folds, then the shareholders might lose their entire investment.
The Risks Of Investing In Private Companies
As you might guess, investing in private companies is a big risk, big return arrangement. While you might be fairly wealthy and consider yourself to be well educated in business matters, the reality is that 70 percent of angel-backed firms lose money.
On top of this, without any oversight from the SEC, the accounting records of private companies won’t be scrutinized which means there could be potential issues with financial transparency.
Finally, investors in private companies must often be prepared to buckle-in for the long haul. Unlike publicly traded stocks where you can sell at the first moment of distress or even a market downturn, an investment in a private company is almost always completely illiquid and cannot be pulled out until the IPO.
Final Thoughts: Investing In Private Companies
Throughout this guide you’ve learned what it takes to invest in private companies. While investing in private companies can present great opportunities, it’s important to remember there are many other investing choices out there that you can also look into. You can invest in stocks, index funds, or municipal bonds as well. In general, it’s also much easier (and likely safer) to simply invest and work with the stocks of publicly traded companies. To paraphrase the old saying: It’s best to just invest in what you know.