Privately held company proprietors usually have most of their wealth held in their business. These owners know how challenging it is to raise capital or convert their illiquid assets to cash… unlike public companies where the procedures to raise funds aren’t hard, such that they can easily raise funds from the public by selling shares through an exchange.
This article is meant to highlight the difference between public and private securities. This will help owners to better understand stock ownership and the challenges faced with turning their illiquid business stock into cash.
What’s a Private Company?
According to Investopedia “A private company is a firm held under private ownership. Private companies may issue stock and have shareholders, but their shares do not trade on public exchanges and are not issued through an initial public offering (IPO). As a result, private firms do not need to meet the Securities and Exchange Commission’s (SEC) strict filing requirements for public companies. In general, the shares of these businesses are less liquid, and their valuations are more difficult to determine”
Note: Companies choose to remain private because of the high costs of an IPO. Privately held firms may issue stock and have shareholders, but their shares do not trade on public exchanges and are not issued through an IPO.
Types of Private Companies
- Sole proprietorship; is a company that is run by one person. According to the law, a sole proprietorship isn’t its own legal entity; its assets, liabilities, and all financial obligations are owned by the individual. This, however, gives the individual the advantages of having full control in decision-making processes, but at the same time, it also raises risk and makes it harder to raise money.
- Partnerships; are another type of private company structure. All partners share the unlimited liability aspect of the sole proprietorships but include at least two owners.
- Limited liability companies (LLCs); most times have multiple owners who share ownership and liability. This structure merges some of the benefits of partnerships and corporations. It also includes pass-through income taxation and limited liability without having to incorporate it.
- S corporations and C corporations; have similar features to public companies, consisting of shareholders. But these companies can still remain private and do not need/or require to submit quarterly or annual financial reports. S corporations can’t have more than 100 shareholders and aren’t taxed on their profit, but C corporations can have an unlimited number of shareholders but are double taxed.
No Existing Market for ‘Illiquid’ Shares
The lack of an open market where shares can be traded for cash is the difference between ‘liquid’ and ‘illiquid’ company shares
Shares traded on an exchange are owned by the investing public. Liquidity is achieved through this exchange trading platform as the owners of those shares can cash in at any time, based on the current market price.
Privately held businesses do not have this luxury that the public securities have. The owners of the privately-held company need to make extra effort to create their own market for them to be able to sell their shares. Buyers need to be identified and a valuation will be set, based on negotiations from both parties.
Total Control, Private Ownership: Though there is a sacrifice of liquidity for private business owners, the advantage is being able to enjoy total control over your business.
Private companies usually don’t report the performance or activities of their business to anyone except for the government and maybe their bank. Contrary, if your business was publicly traded there would be requirements to report on a regular basis the company’s performance to non-controlling shareholders.
- Read: How To Make Use Of Insurance To Effectively Protect Your Assets [+Market Analysis About The Industry]
Portfolio Diversification is Limited by Private Business Ownership
Personal risk is the price paid by the private business owner to have more control over their business. They have more of their personal financial risk within one investment, their business.
Public shareholders by contrast can buy and diversify their holdings, creating an investment portfolio that insulates their wealth from industry/segment-specific fluctuations.
Lifestyle vs Investment
The difference between public and private ownership is in the management system of a business.
The management system of a public company is fairly simple; produce the highest possible profit through value creation which leads to an increase in the stock price that then leads to an increase in the shareholder wealth. The shareholders invest in a public company to get dividends paid to them and an increase in the value of their initial investment.
A private company is more of a lifestyle than a public company which is an investment.
Private company managers and owners are usually the same. It’s a personal wealth builder. For example, the private manager sometimes has the course to reduce the company’s profitability for him to manage his or her personal tax liability.
The owner enjoys benefits such as transport (a company car), compensations, vacations, other premium benefits plus the personal satisfaction that comes with complete control over the entity.
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Balancing Private Ownership Benefits with Need for Liquidity
While the owner of a private firm has the advantages of control and privacy over the company, however, the assets are illiquid. This disadvantage comes to effect when it is time to design and execute an exit plan from the business.
At this point, to attract buyers of the company’s shares, the daily operation of the business will need to be disclosed.
This includes the good and bad parts of your company’s management, strategy, and finances.
Just as every beginning has an end, so it is for some businesses(often some private companies that are acquired). So you(as the owner) need to accept the fact that the business operations will come to an end someday.
It’s a great challenge for many of these private firm owners(you) to share with others how your business is run.
The process is usually not a comfortable one as you will get to sell your life’s earned value/enterprise. This business is home to you and selling it seems like selling your family home.
You can balance the privacy that you enjoy with the need for future liquidity by setting the plan for your future exit and understanding how and when certain items will be disclosed.
Ensuring your private business is marketable; the exit planning process entails finding out the needs and demands of your business’ potential future owner so that you can prepare yourself and your business for this transaction and transition.
Both the benefits and limitations of private business owners are considered when carrying out an effective exit plan.
An owner who is well-prepared will understand these differences, and also be able to explain it to a future buyer, the same way that public firms disclose their business operations. This will help you to protect and preserve the wealth that is ‘trapped’ within your privately held business.
Question: What other steps can you take to get prepared to sell your private company?
Thank you for reading at WealthOnPoint!
I’m the cofounder of WealthOnPoint. Business has always been where my interest lies. If you have any business, finance or investment related issue, feel free to contact WealthOnPoint via email [email protected]
Our team is more than happy to help you out.