Understanding how to invest in a private company is the first step to having a huge stake when the company starts generating profit and decides to go public.
For example, imagine if you had invested in Apple before its IPO in December 1980, then your investment would be worth a lot today.
As an experienced investor, you’d agree that investing in publicly traded companies is a safer and more secure way of investing your money.
Public firms can be bought and sold on the stock market, and have a higher liquidity and market value.
However, private companies do not offer these benefits. In fact, it would take years for a private firm to be sold before it can generate profit as expected.
Regardless, a well-managed private firm with enough funding can still make it through the start-up stage, and eventually go public.
So, if you want to be part of the first investors of a private company, who’d enjoy its rewards when the time comes, then it’s important you understand how to properly invest in a private company.
It’s your lucky day as this article explains just that.
About Investing in Private Companies
Investing in a public company is seen as a better and safer way of investing your money, which guarantees returns than private companies.
Usually, public companies must file financial statements with the Securities and Exchange Commission (SEC), which makes it easier to track their profits and losses on a quarterly and annual basis.
Private companies on the other hand are not required to provide any information to the public. This makes it difficult to determine their financial state, historical sales, profits and losses.
Although these are unarguably true, there’s still a handful of benefits attached to investing in private companies.
Private companies can be better managed for a long period of time to produce adequate earnings as long as they are away from public eyes.
More so, they can be focused on creating long-term opportunities that create value for a long time. This is unlike public firms, as they are more focused on meeting quarterly and annual targets.
Also, earnings from a private firm can be shared directly with the owner. In a public firm, earnings may grow but its either paid back as dividends, used to buy back stock, or simply retained to continue operations in the firm.
Additionally, private firm owners can have a larger role to play in the decision-making process in the firm, especially when they have large investment stakes.
In general, investing in private companies is filled with lots of risks. But to think of it, investment as a whole is full of risk. So, knowing how to properly invest in private companies is the first step to reducing such risks.
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Investment Stages in Private Companies
For investors, knowing when to invest in a private company depends on its development stages.
For an entrepreneur who just started out, has an idea and needs funding, he or she usually receives funds from family and friends. This is known as Angel Investing, and the firm is known as an Angel firm.
As the company grows past the start-up stage, it moves into the Venture Capital Investing stage. This is the point where the firm attracts more investors who offer more money for the growth of the business, managerial know-how, and other forms of assistance.
At this stage, the firm is seen to have a higher potential of succeeding.
Moving forward, the firm gets to a stage called Mezzanine Investing. This investment consists of debt and equity. The company’s debts can be converted to equity if it can’t meet its interest payment duties.
The final stage investing is known as the Private Equity. Here, the firm has lots of investors and is worth about a trillion dollars.
Generally, investors pay attention to the stage of development a private company is in to determine if it’s a risk worth taking or not.
For instance, lots of angel investors are 5times more likely to lose their money than other investors. Because most start-ups don’t make it through the first 5 years of business. The risk level reduces as the firm grows.
While the goal of many private firms is to eventually go public and provide liquidity for company founders or other investors, others still prefer to stay private and enjoy the benefits of being a private company.
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How to Invest in Private Companies
Investing in private companies usually starts from the earliest stage, also known as angel investing as described above.
You can decide to be an angel investor for a private company just starting out and trying to find its roots. There are lots of angel investor organizations, that offer the opportunity to invest alongside other angel investors.
While this may seem to be a good option, you should know that it is the riskiest stage of investing.
Conversely, you can opt for venture funds capital investing. There are lots of small or private business brokers that specialize in buying and selling such firms.
Private equity is also an option. However, a large number of private equity firms are publicly traded, so it is open to any investor.
The key is finding which investment risk you are willing to take and going for it.
Pros and Cons of Investing in Private Companies
Although the goal of investing in private companies is to benefit from their future growth, you should know that it doesn’t always end well.
There are lots of risks associated with startups and you have to be certain it’s a risk you’re willing to take.
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Pros of Investing in Private Companies
Below are the advantages of investing in private companies.
- Investing in private companies require a minimal amount. You can invest with as low as $1.
- You can diversify your portfolio as they are not listed on the stock market.
- All the legal documents are published at your disposal, and not public. Hence, you can understand the terms and conditions of your investments.
- In most cases, the private offerings close only when the minimum goal of capital raised is reached. When it does, you will receive your investment.
- You can manage and track your investments on some platforms.
Cons of Investing in Private Companies
As I’ve established, private companies, especially start-ups are associated with lots of risks.
Below are a few bad things that could happen with your money.
- You could lose your capital
- Because they are privately traded companies, they have a short financial history that can be used to monitor their financial performance.
- There is the risk of dilution if the companies decides to have other fundraising rounds in the future.
- Since its not publicly traded, you cannot liquidate your investment.
- In most cases, you do not receive dividends.
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Factors to Consider Before Investing in a Private Company
Private investing is usually described as a “High risk, High reward” investment. It’s a long road full of profits and heartbreak because of several factors.
So, before you get your own fair share of heartbreak, here are some things to take note of when investing in a private company.
- Visit the Company: One of the ways to know what you’re putting your money into is to see what you’re investing.
- Observe the Yellow and Red flags: Before you invest, do your research well. Look through the perfect picture the entrepreneur(s) are showcasing, and get to the root of things.
- Check for the losses behind the growth: Although growth is good, there are still some sacrifices that led to it. Check if these sacrifices are borne out of desperation to grow. For instance, the company could be giving out a service worth $10 for $5. This act will have a negative effect on the company but will be seen as growth because lots of customers are patronizing the firm.
- It’s who you know (and who they know): Naturally, there’s a big difference for investors who have a direct connection to the owners of the firm than those who just decided to invest from an organization.
- Choose the right company: Find a good private company worth your investment and time. Not all private companies who pose as solid, have actual solid plans that will help them grow.
Other Considerations
It is also important to know that investing in private companies requires lots of patience. This is because they are not liquid and hence, require lots of investing time.
To receive the rewards from your investment, the company will need to liquidate. This can happen when the company decides to go public, buy out private shareholders, or is bought by another private equity firm.
More so, as with any other security, private companies need to be valued to determine if they are fairly valued, overvalued, or undervalued.
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Bottom Line
Investing in private companies is for wealthy individuals. This is because they can handle the losses/risks that come with investing in private companies. And the illiquidity that comes with the investment as well.
The SEC defines these wealthy individuals as accredited investors or qualified institutional buyers (QIB) when it is an institution.
Regardless, an investor needs to do his or her homework well before investing in a private company.
Although investing directly isn’t a good option for most investors, there are still other ways to make the most out of your investment, through more diversified investment vehicles.
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