A Beginner's Guide to Investing in Private Companies

Selena Romero
February 14, 2022
4 minute read
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Investing in the private markets is exactly what it sounds like: investing in private companies aka those that are not listed publicly on a stock exchange. It’s a great way to diversify your portfolio if you’re looking to invest in the early stages of a company that you believe in and have the patience to play the long game to wait and see a potential return.

Previously, the ability to invest in private companies was limited to friends and family of a company’s team, high-net-worth individuals, and large firms in the form of private equity or venture capital. Thanks to legislation changes over the last decade, everyday investors can now back private companies through equity crowdfunding.

A brief history of investing in private companies

Investing in private companies has existed for as long as people have accepted money in return for a stake in their business. However, over time, it’s evolved.

The private equity industry, which consists of firms with large pools of money investing in companies in exchange for equity, can trace its roots back to 1946, with the American Research and Development Corporation. Since then, private equity has continuously grown, including the rising popularity of venture capital for early-stage and growing companies.

It’s estimated that private market fundraising surpassed $1.2 trillion in private equity in the U.S. alone in 2021. That’s a lot of money.

It was only a matter of time before the industry evolved to include everyday investors. Like private equity tapped into a new way to help businesses grow in 1946, crowdfunding, specifically equity crowdfunding, is providing a revolutionary alternative for growing, private companies to access much-needed capital.

How to invest in private companies as an everyday investor

The nature of the stock exchange makes it easy to find companies you want to invest in. Due to the public nature, it’s also possible to see how a company is doing financially. Plus, the fact that it's listed on the stock exchange is an indicator that the company must’ve done something right.

On the other hand, investing in private companies doesn’t have these luxuries. Though it’s legally allowed in Canada—and made even easier thanks to new legislation—equity crowdfunding is still fairly new. How do you find a private company willing to raise money from everyday investors in its earliest stages?

Thankfully, registered equity crowdfunding platforms are on the rise. These websites act as a marketplace to connect private companies looking to raise capital with eager investors who want to invest in businesses that align with their vision for the future. They are regulated, follow strict compliance rules, and will usually have a thorough due diligence process before listing a company on their sites. In short, they do the work to find private companies looking to raise capital from everyday investors so you don’t have to. In Canada, the largest equity crowdfunding platform is FrontFundr, followed by others like Equivesto and Vested.

The risks of investing in private companies

Like any investment you make, there are risks involved with investing in the private markets. Understanding the relationship between risk and return is critical to private company investing. In general, the higher the risk of an investment, the higher its potential return might be. When deciding what level of risk is right for you, consider your goals and ensure that you have sufficient income and cash to withstand the loss of the investment.

When evaluating private companies to invest in, keep these main risks in mind:

Loss Risk

The risk of loss is when a company fails, resulting in the loss of your entire investment. This is a possibility with any investment but is more relevant when investing in early-stage companies. Depending upon your suitability, a general rule of thumb is to invest no more than 10-25% of your financial assets (cash and investments) in high-risk investments.

Liquidity Risk

With traditional investments, an investor can sell their shares/investment. With private companies, this ability is very limited; at this time, there is no secondary marketplace to sell shares of private companies in Canada, and there are certain securities laws that limit the selling or transfer of shares.

Know that there is the risk that you may never be able to sell your shares until the company is either acquired by another company or goes public by listing its shares on an open stock exchange (for example on the TSX or NASDAQ), both of which are not guaranteed outcomes.

Dilution Risk

For early-stage companies to grow and scale faster, they may need to raise money multiple times to grow. This is done by offering and selling new shares to investors, which can impact your investment by reducing the percentage of your ownership. This reduction is called “dilution risk”.

As the company sells more shares to feed its growth, the hope is the company can succeed in increasing its value, or ‘valuation’, which is a good thing, but the selling of more shares to do this also means you own a smaller piece each time a company goes to market. To protect against this, companies may provide previous investors an opportunity to retain their level of interest by purchasing more shares over time.

Though equity crowdfunding makes the private markets accessible to the general public, there are methods in place to prevent people from investing above their means, including a cap on how much a retail investor can invest in a private company every 12 months. Additionally, when you invest on FrontFundr, the suitability of the investment will be assessed.

The benefits of investing in private companies

If you happen to find a private company that you believe in and have the means to invest in, it can be extremely rewarding. Not just because it’s an opportunity to diversify your portfolio, but you play a part in choosing the future. Investing in an early-stage company means you could be a catalyst for the “next big thing.”

Additionally, given the nature of getting your investment in early, if the company you invest in does well, you have the potential to make a pretty solid return. As previously mentioned though, this isn’t a guarantee.

All in all, investing in a private company is an interesting way to diversify your portfolio. While it requires patience to see any returns, it’s about more than expecting a huge payout at the end; investing in private companies allows you to be a determining factor in the companies of tomorrow.

Illustration by Svetlana Tulenina from Ouch!

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Selena Romero