The private company marketplace has become increasingly attractive to investors as the number of opportunities for investment has vastly expanded. There are approximately 6 million companies in the US, but less than 1% are publicly traded on a national stock exchange and more than 85% of businesses with more than 500 employees are privately owned. The attraction for investors is that private companies hold the potential to yield robust financial returns due to the fact that many private companies are family-run businesses with stable management and a long-term focus on growth. As a result, McKinsey reports that private companies have outperformed the S&P 500 Index by an average of about 3 percentage points over the past ten years.
The counter argument is that private company investing can be risky. The downsides include the potential for the loss of the investment when start-ups and early stage companies fail as more than 50% do not survive three years. There is also a much greater potential for fraud as private companies are substantially less regulated than public businesses. In addition, as private companies continue to raise capital, the investor’s ownership interest may be diluted unless the investor makes additional capital contributions. Finally, the investment may be “dead money” for an extended period with no dividends being declared, which requires the investor to wait for years to receive any return on the investment.
The opportunity to invest in private companies therefore presents investors with a classic risk/reward scenario. While a private company investment opens the door to the possibility of securing outsize financial returns, this potential can be realized only if the investor is willing to accept a much higher degree of risk. Whether any private company investment is a good bet is beyond the scope of this post and the terms of an investment agreement cannot eliminate this business risk. But an investor who obtains the contract terms that are discussed in this post in the investment agreement will be poised to secure all of the intended benefits of the investment if the company does achieve success in the future.
These investor-friendly provisions can be included in a shareholder agreement, in a LLC company agreement, in a limited partnership agreement or in the company’s original or amended bylaws. The checklist that follows is not intended to be exhaustive of all terms that are included in an investment agreement, but it includes some of the most essential terms designed to protect the rights of investors who make private company investments.
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