It’s much easier to invest in a publicly traded firm than a privately-held company. Stock in public companies, especially larger ones, are easier to set a value to and and can easily be bought and sold on the open stock market. When it comes to a private firm both the price and valuation need to be negotiated between the owner(s) and the investors. can again be sold and prices must be negotiated between the seller and buyer.

Public companies must file financial statements with the SEC or Securities and Exchange Commissions on both a quarterly and annual basis thus making the state of their financial condition fairly transparent. Private companies aren’t required to follow similar regulations and rarely disclose their financials to the public.

Investing in a private company versus a public one comes with several benefits; first there is no pressure for “Quarterly Capitalism” which refers to being focused on quarterly performance rather than a on long-term performance which could harm the long-term performance such as using cash to boost the stock price rather than investing in new product development or technology to make the company more efficient. Private firms can be better focus on the long term as they are out of the eyes of Wall Street. When a public company is taken private, management can set its priorities and not be under the scrutiny of out outside analysts.

A private firm has more flexibility when it comes to distributing profits since it isn’t beholden to distribute money to shareholders a dividend at a particular rate. A private firm also has more flexibility when it comes to budgeting for expansion or other investments.  

Types of Private Companies

For investing purposes, a private company is defined by its stage in development. When a company is just starting out and is in its Startup phase it requires angel investing which often comes from friends, family or even the entrepreneur’s own savings (also called Bootstrapping). The next phase is during rapid growth where a more savvy investor might provide venture capital since the firm is now viewed as a viable business.

The next stage which consists of a mix of equity and debt is referred to as mezzanine investing. In the event the company can’t meet its interest payment obligations in which case the debt is converted to equity. The last stage in private investing is simply referred to as private equity.

[Update] 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. Although the goal of many private firms is to eventually go public and provide liquidity for company founders or other investors, other private businesses 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

Obviously the early-stage of private investing offers the most investment opportunities but it 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. 

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. As 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.SPONSORED

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