Investing in Private Companies

Considerations for the Right Investment

Understanding your investment objectives and aligning them with your investment is the first step in determining the best companies for you to invest in. Here are the critical components you should consider prior to making an investment.

Does the investment time horizon fit with your cash needs?

The investment time horizon is the expected time it may take for the investment to produce a return, if any. Your time horizon is the amount of time before you expect to require the funds from your investment; perhaps to buy a house or to support yourself in retirement. An investment time horizon can be affected by the stage (maturity) of the company, the company’s exit strategy and the speed of the company’s growth. If successful, early stage companies typically have a time horizon of between 5 and 10 years.

Growth investment vs. income investment

The financial return of a private company investment can be categorized as growth or income. A growth investment is one where an investor is looking for the value of the company to grow over time, possibly providing an investor with returns as a result of dividends, a third party purchase of the company, or eventual inclusion on a public exchange, wherein an investor might sell their securities to another purchaser. This is known as capital appreciation, in which the growth of the initial share price increases and the investor sees a return when they sell their shares at a higher price.

An income investment is where the company is paying a recurring dividend or interest payment to the investor throughout the life of the investment. It is important to review the company’s growth and exit strategy to determine how they plan to produce a financial return for their investors.

Importance of diversification

Diversification is a way to allocate your financial resources across several companies. The old saying of “don’t put all your eggs in one basket” holds true when practicing this principle. In order to have a balanced portfolio, one strategy is to invest small amounts in many companies rather than a larger amount in a few, by doing this, you increase your chances of picking successful companies.

How much risk should you be taking on?

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 - but also the higher the risk for losing the entirety of an investment. When deciding what level of risk is right for you, it is important to consider your goals and to ensure that you have sufficient income and cash to withstand the loss of the investment.

Opportunity and Benefits

Before FrontFundr, investments in private companies were restricted to high net worth individuals and family and friends of the company’s management team. Through FrontFundr, Canadians from coast to coast can now become owners in private companies and diversify their investment portfolio with companies that are considered to have the potential for some of the highest returns of any investment opportunity.

Investing in private companies that share your values allows you to influence the direction and growth of different industries. Investing in revolutionary businesses at an early stage gives you the opportunity to be a part of the ‘next big thing’ that changes the world.

Risks to Consider

FrontFundr showcases private companies of varying degrees of risk; however, the main risks involved across these types of companies are the risk of loss, liquidity and dilution.

Loss Risk

The risk of loss is when a company fails and you lose your entire investment. This is a possibility with any investment but is more relevant when investing in early-stage companies. Therefore, it is important not to invest any money that you cannot afford to lose. 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

Liquidity is determined by the ability for an investor to sell their investment. With private companies, there is currently no active marketplace to sell shares of private companies and there are certain securities laws on whom you can sell and transfer the shares to. Thus, there is the risk that you may never be able to sell your shares until there is a company-wide exit. To sell private company shares you may need to wait until the company is either acquired by another company or goes public and lists its shares on an open stock exchange.

Dilution Risk

Dilution risk is a reduction in your ownership percentage as the company raises more money by selling new shares to investors in the future. Companies will typically sell new shares to grow their business and cover the increased costs of expansion and growth. Dilution is very common in an early-stage company, and is often required for the companies to grow and scale faster. As the company accelerates growth by selling more shares, the hope is for a higher valuation of the company - which ultimately means you own a smaller piece of a more valuable company.