New and established investors are familiar with the ease of investing in a publicly traded company. They tend to be larger companies that can trade easily on the stock markets.
But, private companies are more elusive and not just everyone can invest in private companies or will be comfortable with the risk that comes along with it.
They can provide a great investment opportunity. In fact, the private market has been experiencing rapid growth in recent years. Read below to explore what a private company is, how to find investment opportunities, and how to become a qualified investor.
What Is a Private Company?
A private company, just as its name suggests, is a company that is under private ownership. This means that the company is under ownership of either company members, a non-governmental organization, or a small number of shareholders.
Stocks for private companies are not available to the public. If available, it is done privately among shareholders.
Companies of all sizes can be private. Sole proprietorships, partnerships, and even large corporations can be private.
As long as they are not offering shares on the public market they would fall into the category of private companies. This, however, does not mean that they will allow you to invest in them.
You’ll need to find private companies that are taking on investors for private equity, private real assets, private lending, and venture capital.
Can Anyone Invest in a Private Company?
Many private investments require you to be “accredited”. What this means is that individuals must meet income, net-worth, and other qualifications in order to meet the criteria to invest.
The rule is seen under the SEC’s Rule 501 of Regulation D. There are other private investment opportunities however, that do not require you to be accredited.
You can buy private shares if you are “sophisticated” — a term used by the SEC that refers to people who are aware of the risks of a private stock and/or who have hired a representative that has that knowledge. If you are a sophisticated investor you can purchase shares through a “private placement”.
You can also purchase private equity ETFs on the market if you do not meet the other investment qualifications.
Stages of Investing in Private Companies
Private companies of all stages might require investments. The most common stages of private companies are:
- Start Up: This stage is for newly established businesses that have been registered with governing institutions but yet to develop.
- Seed Stage: Companies in this stage are early in the developmental process doing market research, product development, and creating business plans and management teams.
- Early Stage: This stage is when companies might require financing but they have already begun their business operations. Most businesses in the early stage have been operational for up to three years.
- Growth Stage: The growth stage is when companies have started to see accelerated growth and become an established company.
- Mezzanine: The mezzanine financing step is the bridge between expansion and filing for initial public offering. It is often done through debt financing.
- Late Stage: Private companies are in the late stage when their sales have ramped up and have demonstrated significant revenue growth.
Angel investing is when an individual — typically of high net worth — invests in a startup company to fund the operation in exchange for either equity or royalties (or a combination). These investors can be the entrepreneur’s family and friends, or other individuals who want to help get the business off the ground.
Investing in the start up stage can be a risky decision. Therefore, many angel investors do not invest more than 10% of their portfolio into this type of investment.
But, they do use it as a way to see higher returns (in most cases) than other investment opportunities.
Venture Capital Investing
Similarly to angel investing, venture capital investing provides private equity to startup companies — as well as to small businesses that have the potential for long-term growth. The biggest difference is that with venture capital investing, a pool of investors put up funds.
These investors can be individuals, investment banks, and other financial institutions. In venture capital investing, large portions of ownership are created and sold to investors through established limited partnerships from venture capital firms.
Mezzanine investing is when a pool of investors finance growth, acquisitions, management buyouts, or recapitalization for private companies. It is a hybrid mix between debt and equity — although on the company balance sheet it is treated as equity.
Mezzanine investing typically takes the form of preferred stock.
What Is Private Equity?
Private equity is a form of financing where capital (money) is invested in a private company in exchange for equity (stock). Private equity can be found in businesses of all sizes.
There are numerous large businesses that are not on public exchanges — like PetSmart, Ancestry.com LLC, and Panera Bread. Instead, all of these companies are backed by private equity.
Investing in private equity is not as easy as investing in publicly traded companies. Instead, investing is done through private funds run by private equity firms.
Investing in private equity is out of reach for most investors because of the high minimum contribution requirements. How high is it? Some private equity firms will allow you to buy in for $250,000, while others have minimums that start at $2 million.
These funds are typically only available to accredited and institutional investors who understand the risk of investing in securities that are not regulated by the SEC.
Private Equity ETFs
If you are not an accredited or institutional investor, there is another way that you can invest in private equity. A private equity ETF (exchange-traded fund) can provide you with an opportunity to invest in private companies.
A private equity ETF consist of private companies. It seeks to track traditional strategies of private equity.
These investments can trade on an exchange like other ETFs and stocks. You do not have to meet accredited or institutional investor status.
Special Purpose Acquisition Companies (SPAC)
Special purpose acquisition companies (SPACs) are companies that have no commercial operations and instead are to raise capital through an IPO (initial public offering) with the goal of acquiring an existing company.
Investors in SPACs range from the general public to private equity firms.
Do All Private Companies Plan on Going Public?
While some private companies plan on going public in the future, there are many others that will choose to stay private. Companies that want to avoid government and regulatory scrutiny might choose to go public.
Shareholders, the government, and regulators all put public companies under the microscope. These companies, by law, have to release their financial statements quarterly, annual reports, and other SEC requirements.
On the other hand, private companies have the option to keep their financial status private. There is no legal obligation for them to release reports to the public — although they must keep accounting records and make financial statements accessible to shareholders.
Another reason some companies choose to stay private is to keep ownership within the family. Many large companies are family-owned and have been passed down from generation to generation.
If the company went public, they would have to answer to a large amount of shareholders and could possibly have to select a board of directors that did not include members of the founding family.
What Are the Benefits and Downsides of Investing in Private Companies
While publicly traded companies offer an endless array of options for investors — many find the appeal of private companies intriguing. Before moving forward it is important to understand the benefits and downsides of investing in private companies.
First we’ll start with the benefits of investing in private companies:
- Potential for high returns.
- Diversification to portfolio.
- Potential for private company to become public, increasing rewards.
- Options to work closer with company management.
With all the good comes the downsides that you should consider:
- Not as liquid as other investment options.
- Many opportunities require substantial capital up front.
- Not as transparent as publicly traded companies.
- Not easily accessible to average traders.
Consult a Financial Planner to Discuss Private Company Investments
Investors that are looking to add private equity to their portfolio can see higher returns than the public market, but these investments do come with higher risk. If you are looking to diversify your portfolio and are considering investing in a private company you should consider consulting your financial planner.
They have a full picture of your financial portfolio and can help guide you to make the best investment decisions based on your ideal investment opportunities while considering your risk tolerance.