These days, you don’t have to be Warren Buffet to invest in a private company, although that certainly doesn’t hurt. While large, direct investments in private companies are still only available to the wealthy, there are secondary avenues available to the average investor. For the investor who can tolerate a higher element of risk in return for a potentially substantial gain, the door has opened to the world of private equity investment.
When most of us think of being a shareholder it is in the context of a publicly traded company, but there is another option. Privately held companies can also have their own version of shareholders. How those shares are acquired and determining the company’s liquidity (or lack thereof) are just two of the many differences between public and private shareholding. Understanding exactly what is involved in buying and owning shares in a private company is critical before deciding to participate.
From the Hearst Corporation, Ernst & Young and IKEA to Publix, S.C. Johnson and Mars, private companies have a lot to offer an investor, if you can get in. The easiest way to become a private company shareholder is by investing in a start-up. Of course the risk is higher but someday, your little company that is working out of a garage could become Apple. There are also some more established companies that invite outside investors to participate when they are seeking an infusion of capital for expansion or product research. There are also companies that are having financial difficulties and are seeking investments to turn the company around.
With opportunity comes risk. Private companies are not subject to the same stringent financial reporting obligations that publicly-traded companies are so it can be more difficult to monitor the financial performance of the company. It is also important to keep in mind that the shares are not as liquid as public shares of a company. With a public company, you simply sell your shares on the open market. With a private company, getting out isn’t as easy as getting in. Many financial advisors will caution individual investors on these types of investments and encourage them to participate in a less direct way that involves professional management, such as through an ETF or mutual fund that specializes in venture capital projects.
The stage in the lifecycle of the business can help provide some insight into your level of risk. The start-up stage clearly has the biggest opportunity but also the largest risk. As a start-up investor, you can become a major shareholder but because the business hasn’t entered the market yet, the risk is huge. Once the company has entered the market and survived the start-up stage, investing in these businesses is referred to as the early stage. At this stage, the opportunity is smaller because the risk has been lowered. The company has proven that it has the potential to go for the long haul and capital infusions are generally needed to help them continue to show a positive growth pattern. The mezzanine investing stage is really a combination of debt and equity financing that is typically used to expand the company. It’s really more like a loan that will convert to equity shares if the loan isn’t paid back within the terms of the agreement. This type of investing is only available when the company has operated for a period of time and the investor isn’t taking on a huge amount of risk. Ultimately, when a company becomes super successful like the Mars, Inc., the private equity is mainly limited to the wealthy through brokers at that point.
So how do you acquire shares, or an interest, in a private company? Actually, there are several ways for the average investor to participate in a private company’s potential. Many of these options can be found simply by searching the Internet. I have listed some of the most common way below. Each method varies in the minimum investment amount as well as the degrees of separation between you and the company (i.e. going through a fund, ETF or directly with a venture capital firm).
- Mutual Funds – Look for a mutual fund that strictly finances venture capital opportunities. Your risk is less than a direct investment and a fund manager actively monitors and directs the investment. But as with all investments, it is important to study the prospectus and the performance of the fund. How aggressive are they? How much risk do they take? What kinds of companies and industries do they target? What stages of development do they invest in? How does the fund make money? Make sure you understand these details. Finally, the amount to participate will vary greatly so look for a lower rate of share participation.
- ETFs – Look for an ETF (exchange-traded fund) that buys shares in multiple venture capital funds, thereby decreasing your risk and increasing the diversification of the investment. These usually have lower buy-ins as well. ETFs are usually considered very good entry points into the venture capital arena.
- Venture Capital Firm – Look to invest directly in a venture capital firm that specializes in connecting investors with privately held companies looking for an infusion of capital. The venture capital firm will hold shares in the company. As an investor, you hold shares in the venture capital firm, which reduces your risk, for the most part. Some venture capital firms also provide additional supportive services to improve the company’s performance. Keep in mind that buy-in amounts are usually higher if you go directly with a venture capital firm.
- Publically Traded Companies – If you invest in a publicly traded company that acquires shares in a private company through a direct investment, you automatically acquire shares in the private held company, which of course presents little to no risk to you. In fact, if you already hold stock in a publicly traded company, you may also own stock in a privately held company and you don’t even know it! That information is available through public company’s website and annual report.
- Employee Stock Purchase – Some privately held companies actually offer employee stock ownership plans to their employees. That is a great way to buy in to a privately held company. As an employee, you have a great vantage point of how well the company is doing. Privately held stock purchase plans have only one catch, they have a buyback clause that is guaranteed. In other words, you can only sell the shares back to the company, not to anyone else, which eliminates any bidding war that you could potentially create by selling the shares to interested buyers.
Investing in a private company, particularly one very early in its lifecycle should be a long-term proposition. Mars, for example, did not become the candy giant that it is today overnight or even in a couple of years. It took a long time. However, with that said, the success achieved over decades certainly would have made this an excellent investment when it was a start-up. It is now in the top ten private companies in the U.S., with over $30 billion in sales.
In today’s corporate environment, many times these promising start-ups and early stage businesses catch the eye of larger companies. When these larger public companies opt to purchase these starter enterprises, it is often a boon to the owners and private shareholders of the company, but you can’t make a decision based on the possibility. If the starter company has a great product, it is an attractive investment to you and to any potential buyers.
No matter how you wind up with an investment in a private company, especially a very young one, all the same investing rules still apply. Diversify your overall portfolio. Track and monitor the value of your investment. Know when it’s time to cut your losses or reap your gains. Understand the risk/reward ratio. Most of all, realize that not every opportunity will be the next Mars candy company. Many ventures fail, miserably. But in order to get in with the next privately-held Mars success, these are your options on how you do it – unless, of course, you happen to be Warren Buffet!
What does it mean to you? For those investors who want to take on a bit more risk as a trade-off for a potentially larger reward, venture capital companies, funds and ETFs offer avenues to do so. Getting in on the ground floor of a company that eventually becomes a billion dollar company is the dream of every investor. Most start-ups began as private ventures so that’s the critical time to become an investor in their efforts. The hope is, of course, that you are rewarded for that additional risk. If you have the ability to put some money on the line in this riskier area of investing, and you have the stomach for it, who knows? You could one day hold shares in the next Mars candy company and even if you aren’t a millionaire, you may certainly feel like one.
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