How Does Private Company Stock Work?

Private company stock represents ownership in a business not publicly traded on a stock exchange. Unlike shares of publicly listed companies, private stock is held by a smaller group of individuals or entities, often including founders, employees, and early investors. This form of ownership provides a direct stake in the company’s performance and potential growth.

Characteristics of Private Company Stock

Private company stock signifies equity in a privately held entity. A key difference is its limited liquidity; private shares are not easily bought or sold on an open market. This makes converting private shares into cash a more involved process.

Companies that issue private stock are not subject to the same rigorous public financial reporting requirements as public companies. They do not file extensive financial disclosures with regulatory bodies, resulting in less public information about their financial health and operations. This reduced transparency can complicate the assessment of a private company’s financial standing for external parties.

Valuing private company stock is more complex than valuing public stock due to the absence of a market-driven price. The worth of private shares must be determined through various analytical methods, often relying on internal financial data and projections. Private companies also face less regulatory oversight compared to their publicly traded counterparts, which operate under strict rules from bodies like the Securities and Exchange Commission (SEC).

Shareholders in private companies possess voting rights that correspond to their ownership stake, allowing them to influence company decisions. These rights often afford a direct say in significant corporate matters, such as board elections or major strategic shifts.

Acquiring Private Company Stock

Individuals can acquire private company stock through several channels, often linked to their relationship with the business. Founders typically receive common stock when the company is first established, usually paying a nominal amount for these shares. These founder shares commonly come with vesting requirements, meaning full ownership is earned over a period, often four years with a one-year cliff.

Early-stage companies frequently raise capital through equity financing rounds, which allow outside investors to acquire shares. Angel investors, often high-net-worth individuals, provide initial capital in pre-seed or seed rounds in exchange for an ownership stake. As companies mature, venture capital firms invest in subsequent funding rounds, such as Series A, B, or C, providing significant capital for growth in exchange for equity. Each funding round involves issuing new shares to investors and setting a valuation for the company.

Many private companies use equity compensation to attract and retain talent, particularly in the startup environment where cash compensation may be limited. Stock options grant employees the right, but not the obligation, to purchase company shares at a predetermined price, known as the strike price, at a future date. Restricted Stock Units (RSUs) represent a promise to deliver company shares upon the satisfaction of certain conditions, typically vesting over time. Some employees may also receive direct stock grants, where shares are issued outright, often subject to vesting schedules.

Occasionally, shares in private companies are acquired through private secondary transactions from existing shareholders. Such sales are less common and often face restrictions imposed by the company or existing shareholder agreements.

Valuing Private Company Stock

Valuing private company stock presents unique challenges because it lacks a public market price. There is limited comparable transaction data and financial information, as private companies are not required to disclose their financials publicly. This necessitates a reliance on internal financial records and projections, which can be less standardized or comprehensive.

Valuation professionals commonly employ several methods to estimate the worth of private stock. The Discounted Cash Flow (DCF) method projects a company’s future cash flows and then discounts them back to a present value. This approach provides an intrinsic valuation based on the company’s expected future financial performance.

Another prevalent method is Comparable Company Analysis (CCA), which involves comparing the private company to similar businesses that are publicly traded or have recently been acquired. This method uses valuation multiples, such as price-to-earnings or enterprise value-to-revenue ratios, derived from comparable companies to estimate the private company’s value. For companies with substantial tangible assets, an asset-based valuation approach may be used, which determines value based on the fair market value of its assets minus liabilities.

For employee equity, a specific type of valuation called a 409A valuation is frequently required. This is an independent appraisal of a private company’s common stock, crucial for setting the strike price of stock options and ensuring compliance with U.S. tax regulations. These valuations are performed annually or when a significant event, such as a new funding round, materially impacts the company’s value. Obtaining a 409A valuation through a qualified third-party appraiser provides a “safe harbor” status with the IRS, presuming the valuation’s reasonableness.

Selling and Transferring Private Company Stock

Selling or transferring private company stock involves navigating various mechanisms and common restrictions. Shareholder agreements or company bylaws often contain provisions that limit a shareholder’s ability to freely sell their shares. A common restriction is the Right of First Refusal (ROFR), which grants the company or existing shareholders the primary option to purchase shares before they can be offered to an external buyer.

Vesting schedules also affect when an employee can sell their acquired shares, as they dictate the period over which ownership is earned. Shares become fully transferable only after they have vested. Lock-up periods may restrict the sale of shares for a specified duration, particularly after a liquidity event like an Initial Public Offering (IPO).

While private shares lack a public trading market, limited private secondary markets have emerged, such as platforms like Forge Global or EquityZen, where private company shares can be traded. These platforms offer some liquidity but are not as robust or accessible as public stock exchanges. Sales through these avenues are still subject to company approval and existing transfer restrictions.

Shareholders realize value from their private stock through “liquidity events.” An Initial Public Offering (IPO) is a process where a private company sells its shares to the general public for the first time, listing them on a stock exchange. This transition allows existing shareholders to sell their private shares on a public market. Another common liquidity event is an acquisition or merger, where a larger company purchases the private company, often resulting in private shareholders exchanging their stock for cash or shares in the acquiring entity. Direct sales to other private investors can also occur but require company consent and adherence to specific legal and contractual terms.