Investing in private companies can be very lucrative, but when compared to public company equity investing, it is a completely different animal, and so you need a completely different approach
1) The Amount of Work
Investing is a lot of work in both situations, for private companies it can be more because of the lack of readily available information
There is a lot of work that goes into investing. When you invest in a public company, you typically read their financials, their annual report, and brush up on the market competitors. For a private company, those documents are not so easily available. Usually private companies will have prepared financial statements for investors, however, many times they will not include the most recent quarter and so they will be out of date. Private companies will almost never have an annually updated report with a Management Discussion and Analysis section like all public companies are required to have, and so all company information will need to come from direct discussions with management. Finally, in many situations private companies operate in fairly undeveloped markets, with no market reports and a number of unknown competitors. A few days researching an undeveloped market can be equivalent to a few minutes of researching a developed market.
All of this translates to a ton of work. It can take weeks of information request and discussions to get the same information for a private company that a 10(k) filing would give you for a public company.
2) Document Reliability
- Private company documents are not audited, so due diligence is required to verify their validity
Public companies are all audited to make sure that the financial statements are accurate. Private companies do not have that requirement, and most do not have internal or external audit functions to verify the accuracy of their financial documents. This means that once you receive financial documentation from a company, you cannot fully trust the financial statements. It’s important to conduct due diligence to verify the key information reported in their financial statements, both looking backward and looking forward.
Key information that needs to be verified includes: Past Revenues, Future Revenues, Large Expenses, Equity Capitalization Table, Customer Pipeline, Cost of Goods Sold Estimates, etc. These can be verified by key people inside the company, suppliers, current customers, and future customers and it involves several discussions.
- Private company equity can't be bought or sold quickly. It takes time and connections
Public company equity can generally be bought and sold very quickly. This is not true for private companies. While transactions on stock changes take seconds to close and up to 3 days for paper transfers, it can take weeks for private company equity sales to close.
Additionally, once you invest in a private company, it is not fast nor easy to sell your investment. Ideally, your portfolio company will be purchased by a larger company or it will go public, and then it is easy to exit your investment. However, most times this is not the case. Typically, early investors will sell their shares to later investors in order to capture their gains. This requires connections to large investors and institutions so that the sale can be made.
4) Analyst Opinions
- Private companies have few, if any, third party opinions for a quick gut check
When investing in a public company, it is easy to get a second, third, and forth opinion regarding the company that you are investing in. Analysts are constantly publishing opinions on the public companies that they follow. This serves as a gut check and helps you find out if you are missing any key information.
With private companies, this gut check is simply not available, and it takes a practiced hand to make sure that all of the key information has been found and considered when making the investment decision. This is a skill that can only be developed with years of private company due diligence experience.
5) Investment Amount
- Private investments tend to require large amounts of money unless the investment is structured correctly
For public companies, it is common to invest small amounts of money and purchase just a few shares. For private companies, often this is not possible. Since the investment process can be so time consuming for both the investor and the company’s management team, founders typically require a sizable investment. Further, later stage investors tend to dislike complicated capitalization tables with many investors listed, which further prevents smaller investors from participating in private company investment opportunities.
Companies that take on a number of very small investors can, in fact, be harmed in subsequent investment stages by the process conducted by most crowdfunding sites, due to the resulting complicated capitalization table. We are different, we set up funds that keep our capitalization tables simple, which allows smaller investors to participate in private company opportunities, without some of the issues that would otherwise hinder the process.
- Private company investment returns can be a lot more volatile than most public company investments
When you invest in a public company, the valuations tend to be relatively high due to consistent cash flows and high market share. This translates to relatively consistent but extraordinary returns.
With private companies there is a lot more variation. Many private companies fail before they get to scale, but investments in young giants can lead to extraordinary returns. An early Facebook investment would have led to millions, while an early investment in Diaspora would have led to a complete loss.
- In private companies, you can provide a significant positive influence to the company, which in turn helps your investment
When you invest in a public company, you are literally one of thousands, or even one of millions. Unless you are investing billions of dollars, you have little to no influence on the company that you are investing in. On the flip side, particularly with startups, you can have a significant positive influence on the company’s overall outlook. When we invest in companies, we connect them with new customers and with business expertise to help them grow. In time, this benefits us, as our investments become more valuable.