Risks: Private Company Investment

Investing in private companies, particularly start-ups, can be very rewarding, however comes with a number of risks.

For this reason, the knowledge and understanding of the potential risks is significant when choosing to go ahead with this type of investment. Familiarising yourself with the risks embedded in private company investment will not only help you in choosing what companies to invest in, but also in seeing the red flags when they appear.

The top risks of private company investment include:

  1. Loss of capital. Many start-ups fail. In fact just about 90% of them do. Due to this, it is more likely that you will lose the capital you invested, rather than receive a return from it. Investors should, hence, be extremely conscious of how much capital they invest in private companies and whether the amount of risk posed by private companies matches their risk profile. Investors should ensure they do not invest more capital than they can afford to lose or that would put them in financial hardship.
  2. Potential for fraud. Private company investment is less stringently regulated than other financial market transactions. For this reason, not all the information may be given to investors that is usually required for public equity transactions. Fraudulent activity can occur in the form of company providing misleading and deceptive information to investors.
  3. Dilution. Any investment in private companies is subject to dilution, meaning the decline of your percentage ownership of the business. Dilution may occur if the business decides to raise additional capital in the future, issue new shares to investors and give the option of grants to employees. This often means that the value of your shares in the company will decline, as dilution decreases the initial value of your investment.
  4. Illiquidity. Investment in private companies is highly illiquid. As there is no secondary market for private company shares, it is unlikely that you will be able to sell. Shares can only be sold if the business is bought by another company or floats its shares on the securities exchange.
  5. Rarity of dividends. Dividends are rarely payed by private companies. If you invest in a private company, even if the business is successful, it is unlikely you will receive profits or return until you are able to sell your shares of the business.

The awareness of the potential risks in private company investments is key to an investment process that is safe in nature. Avenues that facilitate private company investment, such as equity crowdfunding platforms, do not offer a guarantee that investors will be protected from the risks. For this reason, diligence on the behalf of the investor is vital in order to ensure the investment choice was an informative one.

Despite the numerous risks listed above, investors should not disregard private companies as an investment avenue. All investments are characterised by different risk-return characteristics and like any investment, private companies have their benefits. Private company investment is definitely not for everyone, but for those who choose it, knowledge is undeniably an essential ingredient to success.

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