Securities: Privately Held Firms

Privately Held Firms

Introduction

A privately held company is like a closely-knit group of friends running their own secret club. It is owned by a relatively small number of shareholders who enjoy certain advantages compared to their publicly traded counterparts. Privately held firms have the freedom to operate in a more secretive manner, with fewer obligations to release financial statements and other information to the public. This secrecy saves money and protects the firm's valuable strategies from competitors' prying eyes.

Flexibility and Long-Term Goals

Imagine a marathon runner who decides to train for a race without the pressure of daily progress reports. Similarly, privately held firms believe that by eliminating requirements for quarterly earnings announcements, they gain the flexibility to pursue long-term goals without constant scrutiny from shareholders. This freedom allows them to make strategic decisions that may not pay off immediately but have the potential for long-term success.

Limitations on Capital

However, privately held firms face a significant hurdle when it comes to raising capital. Picture a charity event where only a limited number of donors are allowed entry. Currently, privately held firms are restricted to having a maximum of 499 shareholders. This limitation severely restricts their ability to raise large amounts of capital from a wide base of investors. As a result, the majority of the largest companies in the U.S. are public corporations, which have the advantage of access to a broader pool of investors.

Private Placements

When private firms do need to raise funds, they opt for a more intimate gathering by selling shares directly to a small number of institutional or wealthy investors in what is known as a private placement. This method, governed by Rule 144A of the SEC, allows private firms to avoid the extensive and costly registration statements required of public companies. It's like hosting an exclusive party for a select group of investors. However, a downside to this approach is that shares in privately held firms do not trade in secondary markets like a stock exchange. This lack of trading activity greatly reduces the liquidity of these shares and subsequently lowers the prices investors are willing to pay for them. Liquidity, in financial terms, refers to the ease of buying or selling an asset at a fair price on short notice. Investors generally demand price concessions when dealing with illiquid securities.

Regulatory Changes and Trading Evolution

As privately held firms increasingly feel constrained by the informational requirements of going public, there is mounting pressure on federal regulators to relax the restrictions associated with private ownership. Regulatory bodies are currently considering potential changes that could benefit private companies. They may increase the maximum number of shareholders allowed beyond 499 before requiring financial disclosures, and they may facilitate the publicity of share offerings.

Moreover, trading in private corporations has seen developments in recent years. To work around the 499-investor restriction, middlemen have formed partnerships to collectively buy shares in private companies. By considering the partnership as a single investor, despite multiple participants, they circumvent the limitation.

Furthermore, some firms have set up computer networks resembling private stock trading platforms. These networks allow holders of private company stock to trade among themselves. However, unlike the public stock markets regulated by the SEC, these networks require minimal disclosure of financial information and provide little oversight of market operations. Think of it as a hidden marketplace where potential buyers and sellers interact, but with limited transparency. For example, prior to its initial public offering (IPO) in 2012, Facebook experienced significant valuations within these markets. Nonetheless, skeptics raised concerns about the lack of clear insight into the firm, investor interest, and the execution process of trades involving the company's shares.

This article takes inspiration from a lesson found in FIN 4504 at the University of Florida.