Should You Be Investing Directly in Private Companies?

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This year has been a banner year for companies going public, with well-known institutions like Uber or Slack or Pinterest making their shares available to anyone. As investors looks at IPOs skyrocket in value out of the gate, many feel a small sense of regret. Why could I not invest in those companies when they were lesser valued? I knew they were going to do well.

 

But any investing move looks obvious in hindsight. The fact is that private companies are harder to invest in compared to public companies, and are often far riskier. Here are some of the most important considerations for how to do it and what to watch out for.

 

How to Buy and Invest

The first thing to remember is that “private companies” is a very broad categorization. In fact, the National Bureau of Economic Research states that “publicly traded companies constitute less than 1 percent of all U.S. firms,” though they make up a third of U.S. employment. There is a huge difference between investing in your brother’s side business which he runs out of a garage and well-known private businesses such as Koch Industries and Ernst & Young.

 

And the reality is that the side business is the business which you will have access to, because you almost certainly do not have access to what large private companies are doing. Access is key to both being able to invest in the private company as well as knowing whether it is the right decision. Without access, you have limited knowledge. And with limited knowledge, that interesting private company might as well be faking blood tests for all you know.

 

Doing the Legwork

 

If you are looking at investing or becoming part of a small private company, they are a few things you should pay attention for.

 

An important step is to make sure that this private company is a limited liability company. The reality is that most small private businesses are going to fail, and you need to protect yourself from that scenario. A limited liability clause ensures that investors will not lose any more money than they sunk directly into the business, and thus will not need to give up assets to pay off the company’s debt.

 

Talk to the business’s leaders, forge strong connections with them, and get an idea of how they plan to keep growing and what their finances are like. But do not get too close and avoid investing in a close friend or relative’s business idea. Personal feelings should not cloud rational judgments, and the acrimony caused by a failed business can devastate even the strongest bonds.

 

What is the Exit Point?

 

So you have brought a portion of a private business which you believe will be successful. But even if you are correct, cashing out of your wise judgment is far more difficult than with a public business. You cannot just sell private stock shares on the open market.

 

Three are three methods for turning your equity into cash. A company can decide to buy you out, it may go public, or another company may choose to buy the company and your shares out. But that may not happen for years. Many of Uber’s or Pinterest’s early investors were willing to sit on their equity for years before cashing out recently, which further shows that private investment is primarily a game for the wealthy and well connected.

 

Why Private Beats Public

 

Everything listed above should make it clear that investing in private companies holds some significant disadvantages over public companies, so why invest in private companies at all? There is the obvious advantage of getting in on the ground floor for private companies, but there are also a few other advantages.

 

Possibly the biggest reason why companies stay private is because they do not have to worry about the quarterly report and irrational market expectations. Private companies have an easier time making tough short-term decisions that may pay off in the long term.

 

Furthermore, we are in a market where the rewards from going public are smaller than ever. The money earned from an IPO is siphoned away by underwriters and existing shareholders, and it is easier than ever for private companies to raise money from private investors. According to Business Insider, a Goldman Sachs report found that “the biggest newly public companies would’ve created more value for themselves by staying private.”

 

Hard Work May Not be Worth the Reward

 

But while those are reasons for companies to stay private, those are not reasons for why you should invest in them. And unless you are someone who has wealth and connections, the reality is that it can be hard to find good private companies. You may find private companies nearby, but it can be hard to gain access to relevant information and such small businesses often fail completely.

That bitter feeling of missing out on a company in hindsight may feel harsh. But understand that while you have missed out on that hit, you also avoided dumping money on far more many misses.

 

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