Varieties of Private Company Stock

Qualified investors looking to invest in private company stock before the company conducts an initial public offering (IPO) may be able to trade such shares on a specialized private market. But what sort of shares might be available there?

In general, the market for private company stock comprises three different types of securities: common shares, preferred shares, special purpose vehicle (SPV) units. Each type affords different rights, privileges, and potential return opportunities. (Note that private company employees may also have access to stock options and restricted stock, which we'll discuss below.)

Typically, private markets are accessible only to accredited investors who meet certain financial or professional requirements, and private company stock can come with unique risks, including restricted liquidity, complex valuations, and limited transparency on issues such as financial disclosures and strategic plans.

Here's what to know.

Common shares are typically the basic form of equity issued by private companies, with each share representing a proportional ownership stake in the business. Company founders, employees, and company advisors typically hold or acquire common shares.

Owners of common shares usually have voting rights, giving them a say in corporate decisions such as the election of board members or approval rights over mergers and acquisitions. While one vote per share is standard, some classes of common shares carry multiple votes per share.

Common shareholders may receive dividends, but they aren't guaranteed. Should the company falter and be forced to liquidate or sell itself, common shareholders usually have the lowest priority in terms of payouts. Once creditors (lenders, bondholders, etc.) and holders of more senior preferred shares have been paid, common shareholders get a proportional share of what's left.

Preferred shares (also known as preferred stock) are a more senior form of equity and generally come with more rights and advantages. (Though, preferred shareholders rank below creditors when it comes to payouts.) Private companies typically issue preferred shares to venture capitalists, institutional investors, and early-stage investors.

These shareholders are typically paid dividends or liquidation proceeds before common shareholders. Their dividend rights may consist of fixed or cumulative dividends (i.e., a guarantee that they'll be paid any missed dividends), giving these shares characteristics of both common stocks and bonds. Like bonds, they generally provide income and are sensitive to changes in interest rates. Like stocks, their prices can be more volatile.

Preferred stock may also be broken into two additional classes—non-participating and participating—which determine how holders are paid in a sale or liquidation. With non-participating preferred stock, holders generally have two options: They can receive their original investment back, plus a fixed dividend, and forego a slice of any leftover proceeds. Or they can convert their preferred stock to common stock and receive a proportional share of what's left after creditors and preferred shareholders are paid. (Generally, the larger payout is preferrable.)

In contrast, participating preferred shareholders get their money back, plus a share of the remaining proceeds based on their ownership stake.

Preferred shareholders generally have the right to convert to common stock when they wish, though some may require conversions under specific conditions, such as an IPO.

Preferred stock may also offer stronger voting rights, such as the ability to elect one or more members of a company's board of directors and the power to veto certain significant corporate actions, such as incurring significant debt, entering into material commercial contracts, or changing the company's line of business.

Holders of preferred stock may also have rights of first refusal, which give them the right to purchase any shares other shareholders (including employees) might want to sell before a public listing. In other words, preferred shareholders might have the right to approve or deny any sale of common stock on the secondary market.

A special purpose vehicle (SPV) is a legal entity created for a specific purpose, such as holding private company shares. These vehicles might then go on to issue units representing a stake in the SPV to investors. (To be clear: SPVs can be used for a variety of purposes and financial objectives, but for this article we'll just focus on their role in private stock markets.)

In short, an SPV can offer investors access to private company stock, much like a fund that invests in only one asset. When a group of investors wants to invest in a private company, they can create, or invest in, an SPV that will hold the investment on behalf of the investors. The investors will then own a portion of the SPV, which will, in turn, own a portion of the private company. There may also be cases where an SPV owns units of other SPVs.

SPVs are typically managed by a general partner (GP), while investment decisions are generally handled by an investment manager (sometimes an affiliate of the GP). The investment manager is often a venture capital firm or another professional investment manager, although in some cases, it may be an individual investor who has experience in the relevant industry or sector.

Note that SPVs are lightly regulated and have recently drawn increased regulatory scrutiny as several SPVs have been involved in bankruptcies or been the subject of investor complaints.

Again, investing in private company stock isn't for everyone. But for qualified investors looking to complement their main portfolio with private equity holdings, this rarefied asset class may be worth a closer look.