Investing in Private Companies: Opportunities Abound, But So Do Risks

More retail investors than ever are investing in private companies, but doing so can be "high-risk" and "more opaque" and private companies tend to be a magnet for fraud, according to the Wall Street Journal.  "More opaque" means "more secretive"--subject to lesser regulatory oversight and fewer obligations to disclose to the public how their business is performing.  Also problematic is that it can be hard to sell investments in private companies, which means that buying private companies can "tie up your money for a long time."  Sometimes, selling an investment in a private company can be subject to penalties or fees, which may not have been disclosed or understood when the investment was first made.  Investments in private companies are sometimes referred to as "private placements" and include stock and limited partnerships.

Also of concern is that tens of billions of dollars a year in securities in private companies are being sold by securities firms with a checkered past, including investor complaints and other red flags suggesting potential misconduct, according to the Journal.  Investments in private companies also tend to pay higher commissions, creating an incentive for securities professionals to overlook or justify risk in return for a larger commission.  The result is that investors facing the special risks associated with private securities are too often receiving recommendations from registered representatives at securities firms less prepared (or willing) to provide suitable recommendations and to aggressively supervise securities professionals making recommendations to buy private securities. 

Private placement memoranda and sales materials given to investors sometimes contain inaccurate statements. In addition, some materials omit information necessary to make informed investment decisions, and some firms fail to conduct an adequate investigation of the issuer to determine if the private placements were suitable for their customers, according to the Financial Industry Regulatory Authority. 

The Journal also reports that the Securities and Exchange Commission is planning to increase the number of people allowed to buy private companies, even though that population has "already grown 10-fold since the 1980s."   An investor typically must be "accredited" to buy stock in private companies, which requires an annual income of more than $200,000 ($300,000 with a spouse) or a net worth of more than $1 million (excluding the investor's primary residence).  But those thresholds were set more than 30 years ago in 1982.  "If the limits had been adjusted to keep pace with inflation, an accredited investor would now need an annual income of about $515,000--more than double the actual $200,000 limit--and a net worth of more than $2.5 million," according to the Journal.

To put it bluntly, $200,000 isn't the same income it used to be.  Nor does a net worth of $1 million automatically put someone in a position to make speculative investments.  A few years ago the Commission provided these examples of people who would generally be considered "accredited" investors:

• A single working parent of three children with an annual salary of $205,000, and likely with a home mortgage to pay;
• A recent widow who inherited $1 million, but is not earning a separate income; and
• A senior retiree who has accumulated over $1 million in his or her retirement account and needs that money for the retirement years.

Other "accredited" investors include people who have suffered catastrophic injuries and received payments as a result of personal injury claims.  But, such persons should not be assumed to have the "financial sophistication and/or investment experience to be able to assess whether any particular investment is appropriate for them," according to the Commission. 

Of course, "each year, companies raise billions of dollars selling securities in non-public offerings that are exempt from registration under the federal securities laws. These offerings . . . can be a key source of capital for American businesses, especially small or start-up companies."  But for retail investors who receive recommendations to invest in private companies, consult the Financial Industry Regulatory Authority's list of tips and cautions before buying--the gist of which is look very, very carefully before leaping.