The Risks and Rewards of Investing in Private Companies

November 16, 2023

Investing in private companies has become an increasingly popular way for investors to diversify their portfolios and seek substantial returns. However, it also comes with significant risks that need to be weighed carefully before jumping in. This type of investing differs significantly from traditional stocks and securities, so it’s essential to understand what you’re getting into.

What Exactly is a Private Company Investment?

A private company is a business that is not publicly traded on a stock exchange. Investing in a private company generally means acquiring equity shares directly from that company. This allows you to potentially profit as the company grows and increases in value over time. Private companies tend to offer investment opportunities in their early stages to raise capital for growth.

The Lack of SEC Oversight Makes it Risky

One significant risk with investing in a private company is the lack of Securities and Exchange Commission (SEC) oversight. Public companies are heavily regulated by the SEC, which acts as a referee to protect investors from fraud. Private companies do not have this level of scrutiny or reporting requirements, making them vulnerable to misrepresentation and even fraud in some cases. There are no “referees” here, so you must conduct extensive due diligence.

The Potential for Substantial Rewards

However, the upside is that getting in on a private company in its early stages means you can realize massive returns if that company explodes in growth and value. Once a private company goes public or gets acquired, early investors have the potential for huge rewards if they select a winning company. But you must identify and invest in that company long before the public has access.

For example, if you had invested $10,000 in Facebook when it was still private, that stake could have been worth over $500 million once Facebook went public! While an extreme example, it illustrates the power of investing early in a successful private venture.

How to Invest in Privately Held Companies

If you’re wondering how to invest in a private company, there are a few options to consider:

Angel Investing: Investing in startups at their early stages, often before they are even incorporated.
Venture Capital: Pooling funds with other investors to support high-growth potential businesses.
Direct Investment: Acquiring shares in a company through private rounds or employee stock options.
Equity Crowdfunding: Participating in a collective investment in exchange for equity, often through online platforms.

Tips for Mitigating Risks When Investing in Private Companies

Here are some tips for reducing risks when investing in private companies:

Only Invest What You Can Afford to Lose – Private company investments should be considered speculative, high-risk capital. Only allocate money you are comfortable losing entirely.
Conduct Extensive Due Diligence – Go beyond just what the company provides. Research the space, competitors, management team backgrounds, etc.
Diversify Across Multiple Private Investments – Don’t put all your eggs in one basket. Invest small amounts in multiple private companies.
Understand Illiquidity is Likely – You won’t be able to sell your shares right away. Prepare to hold for 5-10 years.
Seek Experienced Guidance – Consider investing through an experienced professional like a venture capital firm.

The Bottom Line

Investing in private companies offers the lure of significant rewards but also substantial risk given the lack of SEC oversight. Mitigate risks by following the tips above, but recognize that significant losses are very possible. Maintain a long-term view, diversify across multiple private investments, and don’t over-allocate your portfolio to this speculative asset class. Done strategically and with open eyes, private company investing can boost portfolio returns and provide access to unique opportunities not available in the public markets.

Reach out to Wiss for expert advice and guidance tailored to your investment strategy. We’re here to help you make informed, confident decisions.