Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Private Company

What it is:

A private company is different from a public company in that its stock is not traded on public exchanges like the New York Stock Exchange, Nasdaq, American Stock Exchange, etc. Instead, shares of private companies are offered, owned and traded privately among interested investors.

How it works (Example):

Private companies are run the same way as public companies, except that ownership in the company is limited to a relatively small number of investors. Some of the most famous companies in the world are private companies, including Facebook, Ikea, agriculture giant Cargill, and candy maker Mars.

Though private companies come in all sizes, a vast majority of private companies are small businesses. Investors in private companies tend to be those who are closest to the founders: family, friends, colleagues, employees and angel investors.

If a small private company needs to raise outside money to grow, the next round of financing often comes from venture capital (VC) firms who specialize in providing capital for high-risk, high-reward opportunities. Another option is to get financing from a few large institutional investors via a private placement

If a private company is able to grow large enough, it may eventually decide to "go public," meaning it issues shares via an initial public offering (IPO) and shares are then traded on public stock exchanges. To learn more about the process of going public, click here to read about The Three Most Popular IPOs of 2010.

The reverse process can happen if an investor wants to "take a company private." In that scenario, a large investor, usually a private equity (PE) firm, buys a large portion of the outstanding shares of stock and then tells the SEC that the shares will be delisted at some future point in time. To learn more, click here to read Flip Flops: Going from Public to Private.

Why it Matters:

Owners of private companies are entitled to profits and dividends, just like the owners of public companies, but there are some major differences between being a shareholder in a private company versus being a shareholder in a public company.

First, shares of private companies are often illiquid, meaning it may take a lot of effort to find buyers or sellers of a private company's stock. This becomes extremely important if an owner wants to exit and cash out his or her shares. Often times, figuring out the price of the shares becomes a one-on-one bargaining exercise with the person who wants to buy the stock.

For this reason, coming up with a correct valuation of a private company is much more challenging than for a public company. Because shares don't trade very often, it's difficult to determine how much a private company is worth at any given point in time.

Finally, because its shares are not available to the public, a private company does not need to file the same paperwork with the Securities and Exchange Commission (SEC) as its publicly traded counterparts. This makes the financial position and operation of a private company less transparent, with the trade-off being that the private company is not exposed to as much government or regulatory interference.

Certain companies stay private as a matter of choice. They tend to be more entrepreneurial because their management has greater leeway to make decisions without the public or regulators looking over their shoulders. However, this freedom also means that private companies can be riskier operations than their publicly traded counterparts because they're subject to less oversight.

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