The pros and cons of investing in a private company

Is it worth considering investing in a private company?

It is generally accepted that investing in a publicly traded business is easier than a private company. PLCs can be bought in sold on the stock market and so have better liquidity, whereas a privately-held company may take many years to be sold. Also, direct investment in a private company is not a viable option for most; however, there are several indirect methods to invest in private firms.

Having said this, there are a number of advantages to investing in private companies. Let’s take a closer look.

Direct investment in private companies

Although private companies cannot list their shares on the stock exchange (see below), shares can be offered directly to individual investors, such as angel investors.

To invest in a private limited company, the investor will generally need to purchase at least one share for an agreed sum. The type of shares offered is particularly important for investors; preference shares are often the most suitable.

Preference shares have a fixed rate of dividend which is paid out before the other types of shares. This feature provides a higher degree of security for shareholders of preference shares, at least in terms of receiving a return on their investment.

Furthermore, in the event of the company being wound up, holders of preference shares are entitled to be repaid their capital contribution before ordinary shareholders, providing further security.

Indirect investment in private companies

Unlike public limited companies (PLCs) which can list their shares on the stock market, the Companies Act 2006 prohibits private companies from being able to offer their shares to the general public.

However, this does not prevent the general public from investing in private companies indirectly through diversified investment vehicles. Some of the methods are listed below.

Investment trusts

An investment trust or closed-ended fund which is publicly listed can invest in both private and public companies.

Individuals or businesses can indirectly invest in private companies via the investment trust. Some investment trusts, known as private equity trusts, only invest in private companies.

Venture capital trusts

Venture capital trusts (VCTs) are also listed on the stock exchange but, unlike general investment trusts, they tend to focus their investments on smaller private companies in a relatively early stage of growth.

VCTs tend to have a minority stake in the businesses they invest in, whereas private equity trusts tend to have a majority stake. Various tax reliefs are available for those investing in VCTs.

Crowdfunding

Crowdfunding is a method of raising finance for projects, campaigns, charities, and businesses from a large number of individual investors, typically using an online platform.

Private companies can use crowdfunding platforms to raise capital for planned expansion and/or sell shares to investors. It tends to be more of a popular method for tech start-ups but can be used by any company.

One crowdfunding platform – Seedrs – has recently launched a ‘Secondary Market’ which provides a method for private businesses to list their shares, albeit not on a public stock exchange.

What are the advantages of investing in a private company?

More potential for growth

Many private companies, particularly start-ups, have a lot of potential for growth. The return on investment can be a lot more significant compared with buying shares in listed companies which are normally at a far more advanced stage in their business life cycle and therefore have less room for growth.

Furthermore, private companies are generally more agile than PLCs and can change direction quickly, e.g. in response to concerns raised by smaller shareholders and investors.

Business involvement

Investors in small private companies are more likely to be able to communicate directly with the business owners and senior management team.

They will often be able to become actively involved with the business and will have more influence in a small business compared to making the same level of investment in a large PLC.

Negotiation

A potential investor in a small private company will generally be in a better position to negotiate a specific required return on investment.

They have more bargaining power compared to a purchaser of shares in a PLC, since they will be a ‘bigger fish in a smaller pond’.

What are the disadvantages of investing in a private company?

Valuation

One of the most tricky aspects of investing in a private company is deciding on the value of the company.

Whereas the value of shares in a PLC will rise and fall according to the markets, the price of shares in a private company can be somewhat arbitrary. As such, a new investor will need to conduct relevant checks to determine the accuracy of any proposed share price in relation to the value of the company.

Exit strategy

Since the shares of a private company are not publicly listed, selling the shares further down the line can prove more tricky, as a replacement investor may not be forthcoming.

A solution to this potential illiquidity is for the company to issue redeemable shares. These make it easier for the shareholder to return the shares and redeem their initial investment. But irrespective of redeemable shares, it can take a long time to achieve an acceptable return on investment if the company fails to achieve growth.

Less scrutiny of business decisions

Another problem with investing in small private companies is that the founders will often have total control over the direction of the company.

A PLC needs at least two directors whereas only one is required for a private company. If there is just one person who makes all management decisions, they can be more prone to taking risks compared to a PLC with an experienced board of directors, or at least one other director who is able to challenge them.

Less transparency

Although there is the potential for higher rewards, investing in a private company will normally come with more risks. In general, there is less regulation and transparency in respect of private limited companies compared to PLCs.

So there you have it…

Investing in private companies may not be as simple as buying stock in publicly traded firms, and there are obvious disadvantages, such as selling shares further down the line. However, there are several means to invest in privately-held businesses and clearly, there are a handful of benefits enjoyed by investors.

If you have any questions please leave them in the comments section below and I will get back straight back to you.