Owning equity in a private company can be a highly rewarding but sometimes complex endeavor. That is because private company share ownership has different opportunities, risks, and considerations compared to public company share ownership. In this blog post, we explain what it means to own equity in a private company - outlining the potential benefits, risks, and key considerations for shareholders.
What is Equity in a Private Company?
Equity represents a shareholder's ownership stake in a company. For private companies, equity ownership typically takes the form of shares of stock. Unlike public markets, which have liquid exchanges to trade shares, private markets do not offer as many ways to buy and sell shares. This can make liquidity and valuation considerations more challenging for shareholders of private companies.
Secondary markets like EquityZen have become popular for helping individuals buy and sell pre-IPO shares. However, the market is still relatively nascent, especially in comparison to public markets. Owning private company stock should be considered a long-term investment because of this.
Benefits of Owning Equity in a Private Company
1. Growth Potential:
- High Return Potential: When a company experiences significant growth, the value of its ownership can also increase substantially. This provides pre-IPO shareholders with the opportunity to earn a significant return on their equity ownership.
- Participation in Success: Shareholders can benefit from the company's success through dividends, profit sharing, or the eventual sale or public offering of the company.
2. Influence and Control:
- Board Membership: Shareholders with significant equity ownership may have the opportunity to influence the company's direction. Board membership or voting rights are two of the ways a shareholder can exert influence. Typically, companies grant board membership to strategic institutional investors like venture capitalists.
- Strategic Input: Large investors may have a say in major company decisions. These decisions can include mergers, acquisitions, or significant business changes. Employee shareholders contribute to the strategic direction of private companies through their employment. The work they do to help the business grow, especially at an early stage, can make a real impact.
3. Tax Benefits:
- Capital Gains: Shareholders of private companies can benefit from capital gains if they have held their shares for more than a year. Long-term capital gains from the sale of private company stock is often taxed at a lower rate than ordinary income.
Interested in exploring EquityZen's private company marketplace?
Risks of Owning Equity in a Private Company
1. Illiquidity:
- Difficult to Sell: Shares in private companies can be difficult to sell, making it challenging to turn equity into cash fast. While re-IPO marketplaces can help shareholders sell their shares before a company experiences an exit event, most shareholders should consider private stock as a long-term holding.
- Valuation Challenges: Determining the value of private company shares can be difficult, since there are no public market prices. Investors typically value privately owned equity relative to the company's last round of funding. However, the infrequency of funding rounds can lead to uncertainty around valuation.
Luckily, some pre-IPO platforms like EquityZen help shareholders value their equity. We take into account several factors like the valuation of competitors, trading activity, investor demand and overall sector trends.
2. High Risk of Failure:
- Business Risk: Private companies, particularly startups, have a higher risk of failure compared to established public companies. If a company fails, shareholders may lose their entire investment. This is why some private company employees choose to sell part of their ownership stake before the company goes public. Doing so helps them diversify their exposure and reduce risk.
3. Limited Information:
- Transparency: Private companies are not required to disclose financial information like public companies. This leads to less transparency for shareholders. Limited information can make it harder to decide to buy and sell pre-IPO stock, compared to public stock. Tools like EquityZen’s Equity Value Calculator can help provide information on the potential valuation for private company shares.
- Due Diligence: Shareholders should try to understand the financial health, business strategy and future growth opportunities of the private companies they hold stock of. Thorough due diligence can lead to better informed financial decisions.
Important Factors Shareholders Should Know
1. Rights and Responsibilities:
- Shareholder Agreements: These agreements outline the rights, responsibilities, and restrictions of shareholders, including voting rights, transfer restrictions, and dividend policies. They also determine who can sell shares while a company is private and any stipulations related to a sale.
- Preferred vs. Common Stock: Preferred stock often has priority for dividends and liquidation compared to common stock. Companies typically issue preferred stock to institutional investors. Meanwhile, companies typically issue common stock to employees.
A private company's capitalization table outlines the rights and preferences of various share classes. It also shows how these preferences can impact your ownership in various scenarios. This information is important for understanding your stake in the company. It can also help shareholders understand how future funding may impact their ownership and the value of their equity.
2. Exit Strategies:
- Planned Exits: As a shareholder it is important to understand the different exit paths a company may pursue. These can include an initial public offering (IPO), acquisition, or buyout. Each will have a different impact on the value of equity and the timeline for liquidity. For example, after an IPO, shares are typically subject to a lockup period during which private shareholders cannot sell.
- Timing: Regardless of exit strategy, private company shareholders should expect to hold their stock for the long term. Holding periods can range from two to over ten years.
Owning equity in a privately held company can offer substantial rewards, including significant financial returns and the potential to influence the company's trajectory. However, it also carries risks, such as illiquidity, business failure, and limited access to information. Shareholders should conduct due diligence to understand their rights and responsibilities and have a clear grasp of the company's potential valuation growth and exit strategies. By carefully considering these factors, shareholders can make informed decisions and reap the benefits of their equity ownership.
Interested in exploring EquityZen's private company marketplace?
Disclaimer: Not all pre-IPO companies will go public or be acquired, and not all IPOs or acquisitions are or will become successful investments. There are inherent risks in pre-IPO investments, including the risk of loss of the entire investment, illiquidity, and fluctuations in value and returns. Investors must be able to afford the loss of their entire investment.
