Written by Mark T. Lounsbury, Esq.

BUYING SHARES IN PRIVATE COMPANIES: SHOULD THE SEC DECIDE WHAT’S TOO RISKY FOR YOUR PORTFOLIO? 

 

When most Americans think of purchasing shares in a company, they think of crowded trading floors, stock tickers scrolling across a screen with instant price updates and huge companies with a multi-national presence. But should they? Unlike the vast majority,1 extremely wealthy individuals have another option for purchasing shares that is (or was) exclusively available to them: private companies.  

Investment in private companies is carefully monitored by the Securities and Exchange Commission (SEC) and requires certification as an “accredited investor”. Until just days ago, certification as an accredited investor required an individual to prove an annual income of at least $200,000.00 or with assets worth at least $1 Million. This was obviously a tremendous hurdle for most people, but on August 26, 2020, an amendment to the SEC’s rules lowered that hurdle significantly. Under the new SEC rules one may still become an accredited investor by proving assets or income, but investors now also have the option of becoming accredited by simply demonstrating they are knowledgeable of the market (regardless of available assets). This can be accomplished through basic stockbroker certificationsqualifying job experience, or other means of demonstrating sufficient “knowledge and expertise”. 

Many people reading this article who are not involved in the world of finance and investment may be surprised to even learn they are under such a restriction from buying shares in private companiesSo why should you care about these new SEC rules? Because of one simple phrase, price-to-earnings ratio. 

Understanding a Company’s Price-To-Earnings Ratio 

A company’s price-to-earnings ratio is just that, the stock price divided by the company’s earnings per share. For example, a company that has a stock price of $20.00 and earnings of $5.00 per share would have a price-to-earnings ratio of 4x 

At its heart the stock market is driven by speculation, and examining the price-to-earnings ratio of various companies makes this clear. Those companies the market speculates could raise their earnings dramatically at some point in the future will trade at much higher ratios than those who simply have an established business with stable earnings. This can be seen most clearly in technology and pharmaceutical companies, where the stock price may be based almost completely upon anticipated future earnings rather than any current financial success. To provide perhaps the most extreme example illustrating this point, Tesla has a price-to-earnings ratio that is frequently in the hundreds and has approached 1000! 

Are Shares of Private Companies a Goldmine for Newly Accredited Investors? 

As described above, the price-to-earnings ratio of companies involved in certain industries allows for valuations of those companies that can seem ridiculous. The essential point to remember, however, is that this extreme value inflation almost always occurs after a company goes public by making an initial public offering (IPO). While a company is still private, the value of shares usually remains much more grounded in reality. This is because the accredited investor requirement has meant that there simply isn’t a huge market with an appetite for speculation which can “bet” on these companies and thus inflate the share price. Where sophisticated investors have found opportunity in this situation is through investment in technology (and sometimes pharmaceutical) companies that have become established enough to almost certainly ensure an eventual IPO, while remaining valued as a private company.  

The company Cloudflare clearly demonstrates how this strategy works in real life. In March of 2019, while still a private company, a group of accredited investors purchased $150 million dollars of Cloudflare’s stock at a company valuation of $3.1 billion dollars. Just six months later, in September of 2019, Cloudflare conducted an IPO which immediately increased the company’s valuation to $5.57 billion dollars. And this dramatic price spike didn’t stop there. By August of 2020, less than 18 months after the accredited investor group purchased their shares, the now publicly traded company had achieved a valuation of $11.7 billion dollars. The accredited investor group had almost quadrupled the initial investment! 

One final fact is perhaps what makes the impact of IPO on valuation, and the advantage this grants accredited investors, most clear. That is, while Cloudflare’s valuation increased approximately 377% during this period, company revenues increased only 26%. This isn’t the case of a company dramatically improving performance, only value. Value directly funneled into the pockets of accredited investors.  

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