What To Research Before Investing In a Private Company: The Investment Risks (Part IV)

This is the fourth and final installment in our series on making a private secondary investment (Parts I, II, and III are available here, here, and here). This week, we'll discuss Investment Risks.

As eager as you may be to pull the trigger and make secondary investments, we urge you to consider some of the risks of any investment. We'll cover them in detail below.

1) Investments are NOT guaranteed

As we've written about before, late-stage private companies still carry a large element of risk, and can go to zero (or sell for a pittance). Recently, two such examples were Fab (previously worth $1 billion) and Gilt Groupe (also $1 billion). Remember that though the success rate of these investments is certainly higher than Angel- or Seed-investing, you can still lose all of your money.

2) Time to exit (by way of acquisition or IPO)

Sometimes, things just don't go as planned. Companies have even been known to talk about a future IPO many years before it actually happens: Eventbrite's CEO talked about their next round of financing being an IPO in June 2012 (they have since raised $190 million).

3) Liquidation Preference
Most secondary transactions will involve common stock. Venture investors are usually issued preferred stock, which comes with structural seniority to common stock (more about his here). As a result, in certain acquisition scenarios (especially small ones), common stock shareholders could be left with less of a distribution than that of the preferred shareholders (and sometimes nothing at all). Get Satisfaction, a customer-service platform, was acquired by Sprinklr and its Founder wrote about how he and other employees received absolutely nothing.

Consider the scenario that in fire-sales, your equity investment may not be worth anything.

4) Future Dilution

Your investment could be diluted should the company opt to raise more capital. This will lower your effective percentage ownership in the business, though hopefully your slice of the pie has grown in size. Remember also that an IPO will dilute your ownership, as most IPOs involve a significant raise of capital. In the example of Etsy’s IPO, current shareholders will be diluted by about 13%.

5) Market Risk

Private investments are subject to the same market risk of public stocks. New competitors, a slumping economy, interest rate hikes, and myriad other market factors can impact the valuation of private investments.

Conclusion

Secondary investments offer a great opportunity to diversify your portfolio and get exposure to venture-backed companies before they hopefully go public or get acquired. However, keep in mind that these investments still carry large amounts of risk, which should be assessed before making any investment.