If you are looking to start investing in private companies, you need to understand what happens after the investment and how to manage your portfolio.
What Happens After You Invest?
Depending on the range of factors such as the performance of the startup, the terms of your investment, the terms of any subsequent financing rounds, and the terms of any liquidity event the are a few possible outcomes of your investment which include:
- Total loss of capital invested
- Recovery of some principle but with some losses
- Return of capital
- Return of capital with a small profit
- Significant investment return above the capital invested
Return On Investment.
ROI – a performance measure used to evaluate the efficiency of an investment or to compare the efficiency of a number of different investments. ROI measures the amount of return on an investment relative to the investment’s cost. To calculate ROI, the benefit (or return) of an investment is divided by the cost of the investment, and the result is expressed as a percentage or a ratio. Small business investments typically take at least five to ten years to show a return, so you should only invest capital that you are able to remain invested for at least five years.
Usually companies raise multiple rounds of investment capital to fund their growth. If you are an early investor, then your percentage ownership of the company may be diluted when new investors are granted newly issued shares in the company. Sometimes dilution may be a good thing for your investment when new investors are investing at a higher price per share than your original investment and the additional capital is being used to grow the business. As a general rule, if the valuation of the next round is higher than the round that you invested in, then having your percentage ownership “diluted” is not a bad thing.
If you have pro-rata rights or pre-emption rights, you are granted the right to purchase additional stock in the company through the current fundraising round to maintain your percentage ownership. If you do not have anti-dilution protection or you do not exercise your pro-rata rights, your percentage ownership in the company may be diluted in future rounds. You also should pay attention to the drag along and tag along rights when assessing a company for investment.
Most startups raise multiple rounds of investment but part of the value of an early-stage investment may include the right to invest in future rounds in the same company. You may have a legal right to invest in follow-on rounds through “pro-rata” rights to maintain your percentage ownership or the first right of refusal on a certain amount of stock in future rounds.
Loss Of Capital.
The majority of startup investments result in a total or near total loss of the principal invested in the startup. You should monitor the companies that you have invested in and request updates so that you know when to consider an investment as a total loss. These losses may be tax deductible – you might need to consult with a tax advisor to learn more.
Startup exit usually refers to a liquidity event, acquisition, initial public offering (IPO), secondary sale or recapitalization.
The event of liquidation of some or all of your shares into cash. Some businesses that are successful usually provide a return to their investors through a liquidity event such as an acquisition or an initial public offering rather than through dividend payments.
The returns that investors receive in an acquisition depend in part on the price per share paid by the acquirer and in part on any liquidation preferences which are usually set out in the company’s charter or articles of organization and/or the shareholders agreement. Your shares can be “dragged along” if your shares were acquired along with the rest of the shares in your share class. Acquirer may choose to only purchase some of the shares in a share class but your investment may include the right to have the acquirer also purchase your shares as well (“tagging along”).
Initial Public Offering.
When the company is listed on a public exchange, your shares may become freely tradable and you will be able to sell them in the same manner as any other public stock.
In certain circumstances, you may be able to sell your shares to a third-party. These types of sales may be limited by the terms of your investment, transfer restrictions under securities laws, and/or a lack of willing purchasers. In the future, secondary markets may emerge to facilitate these transactions.
In future rounds of investment, it is possible that a new investor may offer to purchase your shares as part of a capital restructuring or the company itself may offer to redeem your shares through a share-buyback.