Investing in private companies

© SARINYAPINNGAM / iStock A man contemplating his investments

The goal of investing is to grow money for long-term goals like retirement, and do it strategically so that it can work for you while you’re out living your life.

There are a variety of strategies when it comes to investing — and it’s important to get as much information as possible so you can decide what would be the best fit for your life and goals. And, just as there are several different ways to invest, there are also different types of companies that you may consider investing in.

Broadly speaking, there are two types of companies: public and private. And while you are likely more familiar with public-company investments — stocks traded on stock exchanges — there are also investment opportunities to be had with private companies.

There can be benefits that come with investing in privately held companies. Depending on your current circumstances, risk tolerance and financial goals, you will likely approach the types of companies you consider investing in differently. And it’s important to understand that there are significant risks involved and to develop your expectations accordingly.

Read on to learn some basics of investing in both public and private companies, pros and cons of investing in private companies and more.

Related: A beginner’s guide to investing in your 20s

The difference between public and private companies

Typically, when most people think about investing they think about the stock market, where the companies are publicly held.

A public company has undergone an initial public offering (IPO), which means that it has publicly issued stock in hopes of raising more capital and making more shares available for purchase by the public. IPOs are usually underwritten by an investment bank — or broker dealers — which purchase shares from the company and then sell them to investors. As a general rule of thumb, until a company has an IPO, it’s considered private.

The world of private investment often seems exciting, and there can certainly be some big payoffs. Some investors might lament that they missed the chance to invest in a company like Uber back in its early days when it wasn’t yet public. After all, the transportation giant had an estimated valuation of over $80 billion at its IPO.

Unlike the world of public investing, private investing happens off of Wall Street and takes place anywhere new, buzzy ventures are cropping up. However, for every company that hits it big, there are several companies that go bust. Take, for example, the blood-testing startup Theranos, which in its heyday was worth $9 billion and is now worth nothing.

Public companies, especially ones that are bigger, are more easily bought and sold on the stock market, and individuals are able to invest in them. These companies are also regulated by organizations like the Securities and Exchange Commission (SEC).

The SEC is a government body that makes sure these businesses stay accountable to their investors and shareholders, and it requires publicly traded companies to share how they are doing, based on their revenue and other financial metrics.

In contrast, a privately held company is owned by either a small number of shareholders or employees and does not trade its shares on the stock market. Instead, company shares are owned, traded, or exchanged in private.

The landscape of investing in private companies can sometimes be mystifying, in part because private stock transactions happen behind closed doors. But even though private companies may be less visible than their public counterparts, they still play an important role in the economy and can be a worthwhile investment.

Investing in a private company can also be incredibly risky, and it’s important to understand some of the pros and cons of investing in this landscape.

Pros of investing in private companies

Before considering the potential benefits of investing in private companies, it’s important to understand how venture capitalism works, and what a venture capitalist is. Essentially, a venture capitalist (VC) is an investor with capital, be it an individual with wealth to spare, an insurance company, a foundation and so on.

These investors may contribute money to a venture capital fund, usually led by a management team. Together, a committee of members led by investment managers will choose businesses to invest in — often ones with high risk, but also a high potential for payoff (It’s important to note that individual investors often have amassed a large amount of wealth, and can invest a large amount into the firm).

Because private companies are often smaller businesses, they may offer investors an opportunity to get more involved behind the scenes. This might mean that an investor could play a role in operational decisions and have a more integrated relationship with the business than they could if they were investing in a large, public company.

In an ideal scenario, if you invest in a private company, you’ll get in earlier than you would when a company goes public (Note: This is the ideal scenario). And getting in early can potentially produce impressive results — if you’ve made a sound investment decision.

Another possible benefit of investing in a privately traded company is that there is generally less competition for equity than with a public company. This means you could end up with a bigger slice of the pie.

Investing in a private company might also mean that you are able to set up an exit provision for your investment — meaning you could set conditions under which your investment will be repaid at an agreed-upon rate of return by a certain date.

Generally speaking, investing in a private company can have some strong benefits, including an increased potential for financial gain and the opportunity to become more involved in the future of a business. However, there are also some major risks involved, and it’s important to understand them before handing over your cash.

Cons of investing in private companies

One of the biggest risks involved in investing in a private company is that you may have less access to information as an investor. Not only is it more challenging to get hold of data in order to understand how the company performance compares to the rest of the industry, private companies are also not held to the same standards as publicly-traded ones.

For example, because of SEC oversight, public companies are held to rigorous transparency and accounting standards. In contrast, private companies generally are not. From an investor’s standpoint, this means that you may sometimes be in the dark about how the business is doing.

In addition to this, many private companies may lack access to the capital they need to grow. And even though there may be an opportunity to set up an exit provision as an investor in a private company, unless you make such a provision, it could be a huge challenge to get out of your investment.

Knowing your business categories

If you have decided to move forward and start investing in private companies, a good place to start is by understanding different business categories as well as the risks and rewards involved. Some of these categories include startup, turnaround and growth-opportunity companies.

In broad terms, startups are typically higher risk than other business categories as they are new and may have no track record or effective business model. It’s worth noting that most startups fail, so investing in this space can be tricky.

Turnaround companies are failing companies that need intervention. When it comes to investing in this category, it may be important to identify whether cash flow or poor management is to blame for the difficulties the business is experiencing.

If it’s the former, it may be a sound investment; if it’s the latter, it might be worth further investigation, or just passing on the investment.

Businesses in the growth-opportunity stage are companies that are being stunted due to lack of access to capital. If you’ve done your research and identified that a company and its team are solid and in a good position to handle a growth spurt, it may be a great opportunity for investment.

These are just some of the possible categories you may encounter, and there are many more. Once you have an idea of the type of category you’d like to go after, it’s important to get to know the specific company you want to invest in. This could mean paying a visit to the offices and seeing the operations close up.

It could also mean combing through bank statements, financial reports and developing a thorough understanding of the company team and their track record. Make sure to research the company thoroughly — even if it’s one that you already know you love.

Deciding what type of investor you want to be

Once you have established what type of business you would like to invest in, you may also need to decide what type of investor you want to be and how involved you would like to get.

You will likely also need to decide whether you are looking to be a majority or minority owner, and understand both the risks and responsibilities that come along with each level of involvement. For some context, a minority interest typically means ownership of less than 50% of a company.

Some investors may choose to play a more active role in the operations and decision-making processes of a private company they invest in, others may prefer to take a back seat.

From here, it may also be a good idea to familiarize yourself with the market niche and have a good understanding of the competition that may be involved, as well as trends and projected revenue. All of these pieces of information can clarify the role you may play as an investor in the company.

Understanding the risks involved

Even if the company you are thinking of investing in seems solid, it’s important to have an understanding of the challenges that may come up along the way. There are some red flags to look out for, such as a company whose revenue is earned from just a couple of clients — or just one client — as opposed to several.

In order to make sure you’re staying on top of things and are able to keep an eye on potential risks and build better strategies, you may want to consider building relationships with experts and industry players who can help you optimize your investment strategy.

Investing in what’s right for you

Investing can be a crucial tool in building long-term wealth. So it may be worth familiarizing yourself with different strategies and approaches and find the one that works best for you.

Ultimately, no investment is free of risk, but there are certain steps you can take to make sure you have a good idea of what you’re getting into. The world of private investment isn’t for everyone, but if done properly it might mean the ability to reap greater financial rewards.

Learn more:

This article originally appeared on SoFi.com and was syndicated by MediaFeed.org.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

SoFi Invest®

The information provided is not meant to provide investment or financial advice. Investment decisions should be based on an individual’s specific financial needs, goals and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA/SIPC. The umbrella term “SoFi Invest” refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.

External Websites: The information and analysis provided through hyperlinks to third party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.

Third Party Brand Mentions: No brands or products mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third party trademarks referenced herein are property of their respective owners.

IPOs: Investing early in IPO stock involves substantial risk of loss. The decision to invest should always be made as part of a comprehensive financial plan taking individual circumstances and risk appetites into account.

Continue Reading