May 22, 2024

How to Invest in Private Companies

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Investing in private companies can likely yield high returns, but they're often inaccessible. So what are your options? Read on.

How do you invest in private companies before they go public?
Here are 7 ways to invest in private companies:

  1. Indirect Investments
  2. Crowdfunding Platforms
  3. Private Equity Funds
  4. Stock Option Funding
  5. SPV or LLC Funds
  6. Direct Share Acquisition
  7. Angel Investing Networks or Connections

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.

Have you ever invested in a private company?

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:

  1. 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.

  2. 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.

  3. 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.

  4. 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.

Zoom is an example of a successful private company investment, reaching an all-time high of $568.34 on Oct. 19, 2020.[1] That's a whopping 1,478.7% gain from its IPO price of $36 on April 18, 2019.[2] However, there are also cases, such as Convoy, where startups fail despite backing from Jeff Bezos and Bill Gates.

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.

Can anyone invest in a private company?
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.

What type of private companies are you most interested in investing in?

Indirect Investments

Minimum Investment$0
Exit DistributionNot applicable
Accredited Investor RequiredNo

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

  • No minimum deposit
  • Very accessible
  • Indirect exposure only
  • No private shares or cash equivalent

Crowdfunding Platforms

Minimum InvestmentDepends on the company, as low as hundreds
Exit DistributionShares or Cash
Accredited Investor RequiredNo

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

  • Secondary market
  • Receive physical shares
  • High risk of failure
  • Investment ceiling

Private Equity Funds

Minimum InvestmentStarts at $20,000
Exit DistributionCash
Accredited Investor RequiredYes

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:

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

  • Diversified portfolio
  • Professionally managed
  • Costly fees
  • Cash equivalent only

Stock Option Funding

Minimum Investment$10,000
Exit DistributionCash
Accredited Investor RequiredYes

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

  • Direct exposure
  • Past valuation prices
  • Counterparty risk
  • Cash proceeds only

What is an employee stock option?
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 InvestmentStarts at $10,000
Exit DistributionShares or Cash
Accredited Investor RequiredYes

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

  • Get shares after exit
  • Access to tech startups
  • Delayed stock ownership
  • Accredited investors only

Direct Share Acquisition

Minimum InvestmentStarts at $100,000
Exit DistributionShares or Cash
Accredited Investor RequiredYes

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

  • Direct purchase
  • Assisted by specialists
  • High minimum investment
  • May not have enough supply

Angel Investing Networks or Connections

Minimum InvestmentDepends on the terms of the deal
Exit DistributionShares or Cash
Accredited Investor RequiredYes

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

  • Early opportunities
  • Valuable connections
  • High minimum investment
  • Typically invite-only

What is an angel investor?
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.

There is a common notion that private equity is beneficial in terms of diversification. However, some opinion articles by analysts and working studies argue that private equity remains correlated with the stock market. They suggest that investing in private equity could make your portfolio riskier, not safer.[8][9]

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's your biggest concern about investing in private companies?

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.

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

  1. ^ Zoom. Historic Price Lookup, Retrieved 04/14/2024
  2. ^ Zoom. Zoom Announces Pricing of Initial Public Offering, Retrieved 04/14/2024
  3. ^ U.S. Securities and Exchange Commission. Accredited Investor, Retrieved 04/14/2024
  4. ^ StartEngine. Currently Raising, Retrieved 04/14/2024
  5. ^ StartEngine. Crossing the Finish Line, Retrieved 03/28/2024
  6. ^ U.S. Securities and Exchange Commission. Updated Investor Bulletin: Regulation Crowdfunding for Investors, Retrieved 04/14/2024
  7. ^ EquityZen. Compare Investment Solutions, Retrieved 04/14/2024
  8. ^ Harvard DASH. Private Equity's Diversification Illusion: Economic Comovement and Fair Value Reporting, Retrieved 03/28/2024
  9. ^ Bloomberg. Private Equity Won't Diversify Your Portfolio, Retrieved 03/28/2024
  10. ^ Harvard Law School Forum on Corporate Governance. Startup Failure, Retrieved 03/28/2024
  11. ^ Bloomberg. Quibi Leaders' $1.7 Billion Failure Is a Story of Self-Sabotage, Retrieved 03/28/2024

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Equitybee

Invest in High-Growth Startups

Equitybee gives accredited investors access to high-growth, VC-backed startups. By funding employee stock options, accredited investors can gain investment exposure to private companies at past valuations. In exchange for funding the options, you will receive a percentage of future proceeds from any successful liquidity events. Subject to availability. Investments involve risk; Equitybee Securities, member FINRA


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