Why Private Investments Like Non-Public Companies are High-Risk Investments

Many investors want to get in on the heightening social media action, but haven’t been able to incorporate these companies into their investments. Despite the fact that companies like Facebook and Twitter are immensely popular and highly valued, they haven’t been listed for public offering.

There are avenues that allow investors get a piece of private companies, however. But is it a good idea to put your money behind a company that lacks a proven history of success? Are these high risk investments that should be avoided?

Private Companies Allow Trading Among Select Investors

In recent times, the idea of investing in private companies has become popular. This is because some very successful companies are actually allowing investors to buy shares, even though they are not officially offering any to the public.

Facebook and Twitter are among the successful companies that are valued so highly that investors can’t help but get in on the action. As of Jan. 2011, Facebook’s net worth was listed at $50 billion and some say Twitter is valued at $8 billion.

However, because of the private nature of these companies, they only allow select investors to trade with them. They are known as “accredited investors” and are required to have a net worth of around $1 million or an annual income of more than $200,000–definitely not the everyday investor.

The exclusivity is perfect for individuals looking to make the big bucks in an arena where most others aren’t allowed. But is this type of investment too risky to ever pay off?

MarketWatch Video: Public Investors in Privately Held Companies

Is it Wise to Invest in a Non-Public Company?

The question of whether trading within private investments is worth the risk has been grappled with for years, but now that companies have emerged to make trading simpler for accredited investors, fewer individuals are questioning the risks involved.

For instance, some choose to work with a private investment company called SecondMarket, which provides a means to buy shares sold by insiders at private firms. Company shares include Facebook, which according to the SecondMarket, was last year’s most actively traded private company.

Many investors utilize companies like SecondMarket in hopes of snagging a piece of what they think will be the next Microsoft, Google or Apple–before they open up to public investors. The only problem is that investors often don’t consider the risks involved, which include:

• Potential lack of financial information: Unlike companies that trade publicly in the stock market, private companies don’t have to release their financial information. In fact, they are often so set against releasing their books to outsiders that they clamp down on employee stock sales due to the risk of the company’s internal information being released to the public.
• Questionable stability: Because financial information doesn’t have to be released, investors go into this type of market blindly, leaving themselves highly vulnerable to loss if the company falls apart.
• The threat of a lower IPO: Investors in private companies are able to get in on trades before their initial public offering (IPO), which leaves them vulnerable to the IPO being priced lower than the shares they purchased through the private trade.

Despite the downsides that could deter investors, some believe the estimated valuation of some companies make trading in non-public companies worth it.

Related: Top 3 Risky Stock Investments

The SEC Cracks Down on Private Trading

Though investors have been showing enthusiasm over trading with major private companies, especially internet-based companies, it’s hard not to remember the Dotcom Bubble of the early 2000s. That bubble ruptured when investors got excited about immensely popular internet companies that had no income and high valuations, fueling stocks that were essentially worth nothing.

Some think investors in private companies, as well as those who will want to jump on private equity investments like IPOs if the companies go public, are suffering from the same delusions. This is why the SEC is choosing to step in and take a closer look at this type of secondary market trading.

Back in December, the SEC sent information requests to individuals involved in buying and selling stocks in Twitter, LinkedIn (which has since gone public), Zynga and Facebook to find out how the private companies are valued, how shares are priced and how many shareholders they have.

Currently, the SEC requires companies with over 500 traders to disclose financial information to the public. That means by keeping their exclusive trading group to a lower number, they can avoid registering with the agency and providing this information.

So far, the outcome of the SEC’s investigation has also remained private as the agency chooses not to comment to the media about this issue. This means those who choose to invest in private companies will have to use their own judgment based on known risks to decide whether this is a safe investment for them.