Expanding Solo 401k Investing – Private Equity

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Private equity is at the heart of capitalism. It’s a form of financing that invests money or capital into a company. A limited number of shareholders own these private companies. Open stock exchanges do not trade these shares either. Investing your Solo 401k as private equity can be exciting with handsome returns. 

Government organizations, like the Securities Exchange Commission, heavily regulate publicly traded companies on stock exchanges. Public companies disclose regulated information about their performance, which makes it easy to see their financials, revenue, and much more.

Private companies do not answer to public shareholders, so they have lighter regulation standards. They do not have to disclose earnings reports or submit financial statements for auditing. This makes it hard for outsiders to find reliable and up-to-date information about them. Privately held companies are not required to disclose details about their operations that could potentially benefit competitors.

The Upside of Private Equity

Because there are fewer regulations, private companies have much more flexibility in how they go about business. For instance, the company can be structured as a corporation, limited liability company, or other entity that best serves the interests of the company and shareholders. Many choose an income flow-through tax structure. The business income flows to the shareholders, who are then taxed at lower rates than corporations. This way privately held companies avoid double taxation. Another factor is that public companies are more vulnerable to civil liability lawsuits than privately held companies. Reporting and disclosure requirements make public companies vulnerable to shareholder litigation.

Although a privately owned company can be owned by an individual, a family, or closely held by a few partners, it can also be owned by multiple individuals or sell shares to other companies. But it can be selective about who it accepts as investors and typically has a set number of shareholders. Many Solo 401k account holders can invest in private placements. Unlike a public company, shares in a private company are not available through a brokerage for investors to purchase. To invest in a private company, directly reach out to the company and managing owners.

However, selling shares of a private company can be a little tricky because there needs to be a buyer. Negotiating the price of the shares requires that the two parties agree on the value rather than a price set by the open stock market.

Private Investing: Upside vs Risk

With that said, there is plenty of upside to private equity investing:

  • Potential to go public in the future, generating exceptionally large returns for shareholders.
  • Acquired or merged with another business for healthy returns.
  • Investments can spur rapid expansion or growth to generate high rates of return.
  • Unorthodox growth strategies (without publicly listed company pressure).
  • Less risky than venture capital (more on this below).
  • Fund management fees paid out directly to shareholders.

As with all investments, there are risks when investing in private companies:

  • Finding high-quality investment opportunities due to limited information and lack of public market.
  • Your capital may not be liquid.
  • The investment period can be lengthy.
  • Large minimum investment.

Private Capital -v- Venture Capital

Private equity is a form of venture capital, but it is also much more. The two do have similarities. For instance, investments are made in exchange for partial ownership and future profits. But there are major differences such as private investment and venture capital typically invest in different types of companies with different long-term goals.

The specialty of venture capital is young companies and startups needing help to get off the ground and established. These tend to be early-stage companies.

Private equity prefers established businesses with five or more years of operations under their belt. They are often entering a stage of rapid growth and expansion.

Private Equity Funding Options

Private equity can come from an individual or a Solo 401k. It can also be a private equity firm managing a group of investors. A Solo 401k may buy a minority interest in a small to medium-sized business but a private equity firm is likely to purchase a majority share and take an active role in management. It probably won’t be 100% equity but at least 51%. The majority share enables the private equity firm to take a seat on the board of directors to heavily influence the strategy of the company.

In contrast, venture capital firms typically take minority ownership and allow existing management to maintain control. This has been effective with technology companies when current management has a clear vision for the potential of the new technology. The minority ownership also allows venture capital firms to spread multiple smaller investments around in this high-risk environment.

Examples of Privately-Held Companies

A major difference in the level of ownership is that often private equity deals are far more expensive to gain more control. Since they purchase a majority stake in the company, they have a higher expectation of return.

You may be thinking that privately held companies are limited to small and medium-sized businesses, but many larger private companies are closely held, meaning that only a few individuals hold the shares. Cargill is a global food corporation and the largest privately owned company in America (by revenue). Founded in 1865, it had $134.4 billion of revenue in 2020 and 155,000 employees. Other privately held companies in the U.S. that you might recognize are:

  • Chik-Fil-A
  • Mars Inc. (the candy company)
  • State Farm (and other insurance companies)
  • Dell computers
  • Publix Supermarkets

What it Means to Be an Accredited Investor

One government regulation still limiting some investment opportunities is SEC Rule 144A. The rule prevents some investors from participating in private placements. Individuals allowed to participate in these private placements are known as “accredited investors.”

Until recently, the accredited investor requirement severely limited the people who qualified to invest in private placements. Previously, these two wealth thresholds defined an “accredited investor” –

  1. Earned income of more than $200,000 ($300,000 together with a spouse) in each of the last two years and reasonably expects to earn the same for the current year.

-or-

  1. Has a net worth over $1 million, either individually or together with a spouse (excluding the value of a primary residence).

Changes to “Accredited Investor” Thresholds

The SEC made two significant changes. One change broadened the application of wealth calculation. The wealth calculation now includes the term “spousal equivalent,” which means that if one spouse qualifies as an accredited investor, that person’s spouse does also. The other change provides a path to accreditation that is no longer solely based on already accumulated wealth.

Your Solo 401k can play a key role in this qualification. Generally, if you are the trustee of your Solo 401k and your combined assets (Solo 401k plus personal assets) meet the $1 million threshold, both you and the Solo 401k should qualify as accredited investors.

A non-wealth change is that there are now other ways to become an accredited investor. Individuals can now qualify as accredited investors based on certain professional credentials or certifications. As of now, it includes people who have obtained Series 7, Series 65, or Series 82 investment securities licenses. State or SEC-registered investment advisors also qualify. Expect the list of qualifying licenses to expand sometime in the future.

There is no certified exam or piece of paper issued that states a person is an accredited investor (other than for the securities licenses). The process and duty are for the companies issuing unregistered securities to determine a potential investor’s status by conducting due diligence prior to the sale of shares. Each time an investor purchases unregistered securities, the purchasing company conducts the due diligence at that time. After you go through the process once, you’ll know what will be required in the future.

You can read the Nabers Group blog about the changes at: Significant Changes to SEC Accredited Investor Definition.

How You Can Invest with a Solo 401k

By opening a Solo 401k, you can make private equity investments. Unlike a conventional 401k through an employer, your Solo 401k is 100% self-directed. You will have total control over your retirement funds so you can make private equity and other wealth building investments tax-free.

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