The Secrets of Private Company Investing

According to 20-plus years of data collected by Thomson Financial, early, or seed stage, private equity investing has over the long-term, outperformed all other investment classes -- with average annual returns of over 20.6%.

Individual, or "angel" investors are the largest source of seed and startup capital. In 2007, angel investors infused $25.6 billion into private companies, almost as much as the $26 billion invested by venture capital funds. Venture capitalists only invested in 4,000 U.S. businesses while angel investors invested in more than 51,000 companies. According to the best available statistics, in 2007, there were approximately 234,000 active individual, private company investors and approximately 49,500 private companies received funding from individual investors.

Many of these investors’ experiences are frustrating. Strong evidence indicates there are a small number of individual investors in private companies that do very well while the significant majority do not. From Growthink's advisory experience of working with hundreds of early-stage companies financed via "friends and family" and angel investors, the following three investment challenges are often present:

Diversification. Private equity investing is inherently variable -- with a relatively small percentage of companies building themselves to successful exits and investment harvesting. Most individual investors in private equity significantly under-diversify their portfolios -- investing in one or only a handful of companies and thereby greatly increasing their risk profile.

Valuation. Pre-and early-revenue traction private companies often raise money at valuations far above fair market given their early stage and risk factors.

Monitoring. The real progress of small, closely-held companies is extremely difficult to monitor and measure. Communications between private company management and their investors too often is mostly of a promotional form -- with investors rarely getting a balanced review of the growth and profitability challenges of the companies.

Our view on the secret of successful private company investing is:

• Invest in a portfolio of companies, not just one or a handful
• Do so at favorable, negotiated valuations
• Post-investment, make sure that monitoring dynamics -- an independent board for example -- and access to high level professional service partners are in place.

While of course the outsize potential returns of private company investment requires an understanding of the risks involved and should only be undertaken by accredited investors capable of withstanding a loss, when done following these guidelines (and with fortune smiling on you), the return on investment can be both breathtaking and life-changing.

Click here to download our report on private investing: The 9 Secrets of Angel Investing.