Value and Liquidity in Private Companies (a.k.a. One Big Reason Why Companies Go “Public”)

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There’s been a lot written about IPOs lately, so I figured I’d take a step back and cover some of the drivers of company valuation and why companies “go public”. The reality is, as an investor, a successful investment in a private company usually results in returns much higher than a similar investment in a public company could offer. This is mainly due to the higher growth that private companies usually experience as they gain a public foothold in their respective industry. However, as with any risk/reward tradeoff, there is an added uncertainty that every investor bears when dabbling in private equity.

Although it is possible, in some cases, to sell a stake in a private company (I’m excited to share more about this in a few days!), in most cases the actual value of the company is only unlocked when the company goes public and starts to trade on an exchange. This is typically (though not always) the time for private investors to realize the full potential of the company and make an outsized return on their original investment. Let’s dig into this more.

Value and Liquidity in a Private Company

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One of the key differentiators between private and public equity is that there is no efficient marketplace matching private companies with sources of investment. Institutions such as venture capital firms can find private companies through inefficient means — such as trade journals, brokers, and word of mouth. Individual investors typically do not have the networks necessary to access that level of deal flow.

These investments also typically require a substantial amount of investment capital in order to “buy in”. This can be partially explained by the inability to buy fractional shares of ownership in private companies.

These companies are also notoriously difficult to value since most of them have little to no information available regarding their performance. Private companies are not required to file quarterly or annual financial statements and whatever financial information is available won’t necessarily conform to Generally Accepted Accounting Principles (GAAP). This makes private company valuation more of an art than a science, often calculated using comparable metrics and valuations from public companies in their sector. This method, called comps, is still largely an educated guess, and the lack of valuation translates to an additional risk for the private investor.

Additionally, the lack of transparent company information often leads to valuation and investment decisions made by gut, relationships, and trends. For example, industries such as AI and fin-tech are considered hot right now and therefore able to generate higher valuations than industries that have fallen slightly out of favor, like social networking.

Private investments are also usually considered highly illiquid. While ownership of certain private companies is highly sought after, most private equity holders keep their stake in the company until it goes public, either because they are required to or because the nature of their bet in the investment opportunity requires returns that can only be realized upon public exit. Due to their investments’ illiquidity, investors are very careful before they buy into a private company.

There are limited opportunities to sell private equity in what’s considered a secondary or private sale. Because these opportunities are not public, they are subject to a number of non-market-clearing restrictions. For one thing, these sales affect the private valuation of the company, which has repercussions across a company’s capitalization table. The sale often requires the cooperation of the underlying company, who may have a variety of reasons for blocking the transaction. The buyer also needs to be an accredited investor.

Despite this, private companies are some of the most sought-after investments due to the staggering returns that an early investor can garner through them. Sure, private companies require a few years of additional risk and illiquidity to mature and exit. However, a decent investment in a private company is very likely to outperform even the strongest bull market index. See Softbank’s investment in Uber, which made billions of dollars even though Uber’s IPO was not an unqualified success by any means.

Going Public

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The most common way for a company to “go public” is through an Initial Public Offering (IPO). In an IPO, stock is offered to the general public (mostly institutions to start with) for the first time. IPOs make use of investment banks, who usually take a cut from the sale proceeds for their services, including finding investors as well as stabilizing the stock price.

An IPO ends up generating a lot of hype in the news and it is considered the ‘tried and tested’ method to take a company public. The one major problem for early investors is that they have to sit through a lock-up period once the company goes public. A lock-up period (which lasts at least 90 days) essentially stops early investors from selling their stake in the company. This is to help stabilize its price since a multitude of investors simultaneously selling their stake can flood the market and drive the share price down.

The alternative to an IPO is a Direct Listing. This method was relatively unknown until recently when major tech firms such as Slack decided to go public without an IPO. Investors can realize value much sooner with a Direct Listing since there is no lock-up period. However, there are numerous risks involved with a Direct Listing, the biggest being higher volatility since, unlike an IPO, there is no investment bank to help stabilize the stock price.

Value and Liquidity in Public Companies

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The best way for investors in private companies to cash out is when the company goes public. Once a company has been listed on an exchange, the company’s stock becomes liquid. At this stage (and after the lock-up period), anyone can buy and sell the company’s stock at its current market price.

Once a company goes public, it can also be valued a lot more accurately. Every private company is required to file regulated and audited financial documents with the Securities and Exchange Commission (SEC) before it can go public. Because of this, investors have a lot more information in order to make decisions on whether to buy or sell stock. That transparency, paired with the increased liquidity, reduces the risk level relative to when the company was previously private.

Additionally, the national regulatory bodies (including the SEC and the Financial Industry Regulatory Authority (FINRA)) have jurisdiction over significant aspects of the public market system both from the perspective of the investments and the investor/brokers. This further de-risks individual investors.

That said, even though a ton of value is unlocked when a company goes public, the way that shares are actually sold in an IPO is complicated and doesn’t benefit all investors equally. Typically, the underwriting bank allocates the majority (>80%) of the shares to their clients and other institutional investors like brokerage firms, other investment banks, and occasionally high net worth individuals. This means that most everyday individual investors do not get to participate in an IPO until after the stock hits the open market.

Conclusion

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Investments in private companies are a high risk / high reward proposition. Assuming you are able to gain access to the deal flow and can feel a degree of confidence in the company’s valuation, you can parlay that illiquid investment into a healthy return after the company IPOs. This investment model has handsomely rewarded many Silicon Valley venture capital firms but remains out of reach for everyday investors… . although there are new ways through the use of new disruptive technologies (such as through the Blockchain supported/ Security Token Offering model) that could allow for fractional ownership, easy cross-boarder participation, decentralized stock market ownership rights, etc.

Written by

Hands-on company builder; Founder & Entrepreneur with 3 exits, who enjoys scaling companies 24x7x365; Blockchain Pioneer. Founder and CEO at FanVestor /#Fvestor

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