Insight provided by Travis Hurley
You have $1 million in liquid capital and need to decide what investment opportunity is the best choice. What do you choose? While trying to balance risk and reward, you examine the alternatives; First, the capital could be privately invested in a business, making you an angel investor or venture capitalist. Second, it could be invested in a public company directly through a stock exchange. These two types of equity investing have a variety of advantages, disadvantages, and key differences that must be considered when deciding which type of investment to pursue.
Private Equity Basics
Being a private equity investor is less common than being a public equity investor due to the investor accreditation guidelines of private investing. Financial contributions provided by angel investors for early stage financing of start-up businesses are the personal funds of the investor. To be considered an angel investor, a net worth of over $1 million—not including the equity in your primary residence—and a recurring annual income of over $200,000 is required. The average deal size in 2015 for an angel investor was $343,390 with the expectation of waiting five to seven years before receiving a return (Sohl 2016).
Venture capitalists, or (VCs), differ from angels in that their average deal size is around $13 million, and they invest capital from a pooled fund provided by the fund’s limited partners rather than investing their own money. The return for their investments is sought through a liquidity event, or “exit”, such as an acquisition or initial public offering. As a result, private equity investors can make a much higher percentage of return if the firm is able to thrive and reach a liquidity event. However, the likelihood for a business to reach an exit is exceedingly low, which causes angels and VC’s to expect the majority of investments to make no return at all.
On the other hand, individual investments are made only in companies with the potential for a return great enough to compensate for the rest of the portfolio. Therefore, angel investors have to be selective in their investments. In 2015, angel investors only invested in 18% of the companies they were pitched (Sohl 2016). An important advantage of investing at this early stage is it usually gives the investor an opportunity to have a seat on the board of directors, which allows for a more active role in the business’s decision making process. However, early stage angel investors run the risk of dilution in their equity because of large amounts being sold to VC firms in later financing rounds. A privately held company can also decide to go public by going through an initial public offering to raise capital, pay back investors, and further promote growth within the business.
Public Equity Basics
Part of public equity’s competitive advantage lies in the fact that investing typically involves significantly smaller amounts per deal or trade, although any amount can be invested. When investing in the public sector, financial contributions into stock are much more liquid than private equity investments. With publicly traded equity securities, investors can cash out any time if needed. Due to this high level of liquidity, prices on the stock exchange can be very volatile and can spike or plummet quickly without much warning. Returns are typically lower than those of successful private equity investments, but are much more consistent. Additional returns can also be acquired in the form of dividends from certain companies. Another advantage of investing in public companies is that they have years of historical revenue data, compared to a start-up that may not have any established revenue yet. In 2012, the average age of companies at the time of their IPO was 9.77 years (Sohl 2012). However, given their already established success, the individual investors will not have a seat on the board of directors and therefore will not have any significant voting rights, unless they are a majority shareholder. Publicly held companies can become private again through a buyback of all outstanding shares of stock. This is uncommon, but could be done in order to stop issuing dividends or to eliminate the need to make decisions that will align with the interests of the shareholders. Public equity is more accessible for the average investor, but it results in lower returns due to a reduced level of risk relative to private equity.
In both public or private equity investing, a few similarities are shared. Investments are notes of confidence in a company stating that the business model is not only viable, but also has excellent potential for growth. Both also provide a varying amount of ownership of the company. Now that both the private and public equity investment opportunities have been discussed, where will you be putting your $1 million?
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