How to Invest in Private Companies
Investing in private companies can likely yield high returns, but they're often inaccessible. So what are your options? Read on.
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Here are 7 ways to invest in private companies:
Imagine being an early shareholder of a startup like Spotify. At a minimum, you could have doubled your money post-IPO.
However, not everyone can be a shareholder of a private company. It's even more unattainable if you're a non-accredited investor.
In this guide, learn the best ways to access this exclusive market, including the platforms you can use to buy private stocks.
Invest in Private Companies
- Invest in pre-IPO companies through an EquityZen fund.
- $10,000 minimum investment
- Available to accredited investors only
Invest in High-Growth Startups
- Access Hundreds of Startups at Past Valuations
- Diversify Your Portfolio with High Growth Startups
- Invest in a Previously Inaccessible Asset Class
What is a Private Company?
A private company is a company that is not listed on the stock exchange. This means that you can't easily buy or sell its shares on your typical stock trading app.
Unlike public companies, private companies don't disclose their financial details, making private investing much more challenging.
Ownership is typically limited to founders, venture capitalists, institutional investors, and accredited investors.
Sometimes, employees of these privately held companies or startups also get compensated with private stock through employee stock options (ESOs).
How Investing in Private Companies Work
To invest in private companies that are not listed on the stock market, you need a broker who will give you access to them. However, these platforms mostly accept accredited investors only.
In general, here's how investing in private companies works:
- Find a platform, broker, or network
Unless you have personal connections, the only way you can buy private company stocks is through a private equity broker or a secondary market platform. - Review the company's fundamentals
Private companies are not required to publish their financial reports. As a retail investor, this puts you at a disadvantage. Make sure to research well before you invest. - Invest and hold
For a chance to own physical shares through funds, you'd need at least $10,000. If you want to buy the shares directly, you need $100,000 or more.Be prepared to lose this cash on hand for a long-time as private stocks tends to be illiquid.
- Realize your gains or loss
Wait a couple of years for an exit event such as an IPO, M&A, or share buyback so you can liquidate your shares.Depending on the investment method you choose, you could either receive physical shares or just cash equivalent. If a company shuts down, you lose all your investment.
In private equity, you can either get multi-bagger stocks or 100% loss. This is why only accredited investors are usually accepted as they can handle such high risk financially.
Ways to Invest in Private Companies
Remember, only invest money that you are willing to lose.
If you still want to invest in private companies despite the high risk, here are several ways to do it, starting from the most accessible option to the least accessible one.
In the United States, only accredited investors and institutions can buy private company stocks directly. Accredited investors meet specific financial criteria, like having a net worth of at least $1 million or an annual income of $200,000 for the past two years.[3] But, there are multiple ways to gain exposure in private companies.
Indirect Investments
| Minimum Investment | $0 |
|---|---|
| Exit Distribution | Not applicable |
| Accredited Investor Required | No |
The only way non-accredited investors can invest in large private companies is through an indirect investment in its major shareholders. You don't get private shares, but you are exposed to its risk instead.
Since you can buy the shares of some of these major shareholders in stock exchanges, you don't need a lot of money as many brokers allow a minimum deposit of $0.
For example, you could consider buying shares of TCEHY: Tencent for having a 40% stake in Epic Games. You could also buy MSFT: Microsoft shares as they are entitled to receive the majority of OpenAI profits.
Then again, the investments of these major shareholders in these private companies are just a small portion of their entire portfolio. So while it does give you some exposure, some would argue that it's too insubstantial.
Pros + Cons
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Crowdfunding Platforms
| Minimum Investment | Depends on the company, as low as hundreds |
|---|---|
| Exit Distribution | Shares or Cash |
| Accredited Investor Required | No |
You can invest in early-stage startups through crowdfunding platforms like StartEngine. The minimum investment varies but in some offerings, it starts as low as $40.[4]
On March 8, 2023, StartEngine published a list of 40 startups that had achieved successful exits after securing funding rounds on StartEngine or SeedInvest.[5] Although, there's no assurance that your pick will reach this stage too.
Both non-accredited and accredited investors can fund startups in their platform, but there is a limitation. The maximum investment for non-accredited investors will depend on the percentage of their annual income or net worth.[6]
To get started, you just need to sign up on the platform, search for the available deals for funding, and invest. After funding, you cannot refund or withdraw your investment until an exit event.
To address illiquidity, StartEngine provides a secondary market where you can sell your shares to other investors on the platform.
Pros + Cons
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Private Equity Funds
| Minimum Investment | Starts at $20,000 |
|---|---|
| Exit Distribution | Cash |
| Accredited Investor Required | Yes |
Private Equity Funds pool money together from various investors to invest in a diversified portfolio of private companies.
Since private equity funds are actively managed by a fund manager, as an investor you only need to invest at the start and wait until the end of the fund, typically for 5 or more years.
The investment terms will depend on each fund. Some have lower minimum investment and shorter holding periods than others.
Here are some examples of private equity funds where you can sign up and invest:
- YieldStreet's Bonaccord Private Equity Fund I
Minimum investment: $25,000 - EquityZen's Multi-Company Funds
Minimum investment: $20,000 - Equitybee's Venture Portfolio Fund
Minimum investment: $100,000
However, these funds typically charge annual management fees or carry fees which can add up to your cost. Plus, even though these funds give you 100% exposure to private companies, you can only receive cash equivalents and not actual stocks.
Pros + Cons
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Stock Option Funding
| Minimum Investment | $10,000 |
|---|---|
| Exit Distribution | Cash |
| Accredited Investor Required | Yes |
Stock option funding platforms like Equitybee connect accredited investors with start-up employees who lack the means to exercise the stock options granted to them.
Through this method, investors get exposure in the private markets and employees get the money they need to exercise the stock option during an exit event. Take note that the stock ownership remains with the employee.
Employee stock options are often priced at a discount compared to the market value. So ideally, when an exit event occurs, you will earn from that price gap. To start investing, simply sign up at Equitybee, browse its listing, and sign a funding agreement.
But here's the catch: there's no assurance that the company will have an exit event. There's also no secondary market where you can sell your funding rights to other Equitybee investors.
Lastly, you face a counterparty risk where the employee breaches the contract. All of these means you could lose your entire investment.
Pros + Cons
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Employee stock option is a contract that gives employees the right to buy company stock at a set, often discounted, price (strike) at a specific time in the future (exercise date). Companies use these as a form of compensation instead of giving employees direct shares of stock. The options allow employees to profit if the stock price goes up.
To exercise your stock option is to buy the share at the strike on its exercise date.
SPV or LLC Funds
| Minimum Investment | Starts at $10,000 |
|---|---|
| Exit Distribution | Shares or Cash |
| Accredited Investor Required | Yes |
Special Purpose Vehicles (SPV) are bankruptcy-remote entities created by firms to execute a specific financial transaction. In the context of private equity, they are used to invest in a single private company on behalf of a group of accredited investors.
Platforms like EquityZen create a unique SPV through an LLC to securitize private company stocks. The LLC owns the stock and they are transformed into an offering or a fund.
When investors buy the shares of an LLC fund, they do not own the stocks of the private company yet. They need an exit event such as an IPO, M&A, or buybacks before they can receive their pro-rated share whether in the form of stocks or cash.
To invest in an EquityZen Single-Company Fund, you need at least $10,000. The fee is only 5% upfront and this is only open to accredited investors.[7] They also have a secondary market where you can sell your shares to other EquityZen investors if you can't wait for the exit to liquidate.
Just like other private equity platforms, you could lose all your money when a company fails to go public, get acquired, or buyback.
Pros + Cons
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Direct Share Acquisition
| Minimum Investment | Starts at $100,000 |
|---|---|
| Exit Distribution | Shares or Cash |
| Accredited Investor Required | Yes |
If you want a no-frills way to invest in a private company, then you should go with direct share acquisition. Just like what its name suggests, you can buy the shares directly through a broker with this method.
However, this is the most expensive online option for accredited investors. Some brokers only need a minimum of $100,000 while some require $200,000 or more.
To start, you could sign up at a private marketplace like EquityZen or Forge Global. After you confirm your accredited investor status, you can reach out to their investment specialists to assist you with your preferred purchase.
Since these platforms have a diverse investor base, they can effectively source the shares of the company you're interested in. They would also do all the necessary legal processes to transfer the shares to you. However, they will charge you fees for it which typically start at 5% upfront and additional fees apply.
Then again, there's no assurance that your desired transaction can push through as it will depend on the available supply of sellers on the private market. Still, this can be a better option than doing everything by yourself.
Pros + Cons
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Angel Investing Networks or Connections
| Minimum Investment | Depends on the terms of the deal |
|---|---|
| Exit Distribution | Shares or Cash |
| Accredited Investor Required | Yes |
The best, but probably the most inaccessible, way of investing in a private company is through a personal connection to the owners and founders.
Early-stage startups tend to do pitches at angel investor groups for funding. So to be an early shareholder, you need to be a member of those groups. However, most angel investing groups are invite-only.
If you don't know how to become an angel investor, you can check the resources at Angel Capital Association (ACA). ACA is the largest professional association of angel groups and private investors that invest in high-growth, early-stage ventures.
According to ACA, people you should contact or network with include:
- Entrepreneurs supported by angels or venture capitalists
- Lawyers specializing in equity investment banking
- Accountants and business counselors
At this point, you should have a large capital on hand that you can shell out for investments. Initial investment amounts can range from thousands to millions of dollars.
Pros + Cons
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Angel investors are individuals who use their own funds to invest or provide capital in startup businesses in exchange for an equity stake.
Why Invest in a Private Company?
Here are a few reasons why you should invest in private companies:
- Potential for high returns
Earn significant returns if the private company successfully grows in the future and you bought its stocks at a discount or undervalued price. - Early access to promising opportunities
Be one of the first investors of a potentially revolutionary project. If you have a large enough stake, you can even partake in key management decisions. - Impact investing
Help fund startups that could create a positive social or environmental impact on the world.
Risks of Investing in Private Companies
On the other hand, here's why you might want to avoid investing in private companies:
- High risk
Approximately 75% of venture-backed startups fail.[10] Even a company that raised $1.7 billion in funding can shut down.[11] In private equity, you can lose all your invested money. - Illiquidity
You may have to wait a long time to exit your investment since private company shares are not easily sold. - Lack of transparency
It can be difficult to assess the risk of private companies as they are not required to disclose their financial information to the public.
What if the Private Companies Go Public?
What if the privately held company you invested in becomes a publicly traded company? Here are some things to consider:
- Lock-up period
After an IPO, there is typically a lock-up period of 90 to 180 days. During this period, shares cannot be sold to help stabilize the stock price. So if you bought pre-IPO, you might need to wait a few months before you actually receive your shares or cash. - Easier to liquidate
When the company becomes publicly traded, you can easily sell the shares on the stock exchange, and you won't have to deal with a ton of paperwork just to liquidate. - Share dilution
In an IPO, additional shares are issued to both institutional and retail investors through the stock market. So, if you don't buy new shares, yours will be diluted, reducing your ownership percentage and voting power. - Tax concerns
When you cash out your shares, take note of the capital gains taxes you'll need to pay. If you need any help, reach out to your accountant.
Tips & Tricks on Investing in Private Companies
Before you invest in a private company, remember these tips:
- Look out for the fees
Watch out for high fees, as they can make it harder for you to break even on your investment. Before proceeding with the transaction, make sure your broker has explained all the fees involved. - Plan your exit
Knowing when to exit an investment is just as important as knowing when to get in. Planning your exit in advance can stop greed from ruining your investment strategy. You can decide to exit when the share hits a certain price level or when an event occurs. - Only invest money that you are willing to lose
Investment opportunities in private equity can result in either massive gains or total loss. To protect yourself mentally, only invest money that you are willing to lose. This way, it won't affect you as much if you end up losing everything. - Research well before investing
Private companies don't have to share their financials, so it's crucial to research the company thoroughly through news articles and company blogs. - Verify the legitimacy of the platform you're using
Many private stock transactions happen through secondary platforms, so make sure you're using a legitimate one. Check the ones listed in this article to avoid scams and protect your money.
What the Experts Say
CreditDonkey asked a panel of industry experts to answer readers' most pressing questions. Here's what they said:
Bottom line
Investing in a private company has the potential for high returns. However, there is no guarantee that the company will go public or its stock price will rise after it does, making it a high-risk investment.
There are multiple ways for you to invest in private companies. You can invest through indirect methods, funds, or direct share acquisition.
Invest in Private Companies
- Invest in pre-IPO companies through an EquityZen fund.
- $10,000 minimum investment
- Available to accredited investors only
Invest in High-Growth Startups
- Access Hundreds of Startups at Past Valuations
- Diversify Your Portfolio with High Growth Startups
- Invest in a Previously Inaccessible Asset Class
Regardless of what you choose, it's important that you fully understand the risks involved. Avoid investing money that you cannot afford to lose.
References
- ^ Zoom. Historic Price Lookup, Retrieved 04/14/2024
- ^ Zoom. Zoom Announces Pricing of Initial Public Offering, Retrieved 04/14/2024
- ^ U.S. Securities and Exchange Commission. Accredited Investor, Retrieved 04/14/2024
- ^ StartEngine. Currently Raising, Retrieved 04/14/2024
- ^ StartEngine. Crossing the Finish Line, Retrieved 03/28/2024
- ^ U.S. Securities and Exchange Commission. Updated Investor Bulletin: Regulation Crowdfunding for Investors, Retrieved 04/14/2024
- ^ EquityZen. Compare Investment Solutions, Retrieved 04/14/2024
- ^ Harvard DASH. Private Equity's Diversification Illusion: Economic Comovement and Fair Value Reporting, Retrieved 03/28/2024
- ^ Bloomberg. Private Equity Won't Diversify Your Portfolio, Retrieved 03/28/2024
- ^ Harvard Law School Forum on Corporate Governance. Startup Failure, Retrieved 03/28/2024
- ^ Bloomberg. Quibi Leaders' $1.7 Billion Failure Is a Story of Self-Sabotage, Retrieved 03/28/2024
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