Closely held companies

What Are Closely Held Companies?

Closely held companies are private businesses where ownership is concentrated among a small group of individuals, often family members, founders, or a tight-knit group of investors. These companies form a significant part of the broader corporate finance landscape, differing fundamentally from publicly traded entities. In a closely held company, the shareholders maintain substantial control over decision-making and operations, as their shares are not typically traded on public stock exchanges. The Internal Revenue Service (IRS) generally defines a closely held corporation as one where 50% or more of the equity is owned by five or fewer individuals during the latter half of the tax year, excluding personal service corporations²¹. This concentrated ownership structure distinguishes closely held companies from corporations with widespread public ownership.

History and Origin

The concept of closely held companies, particularly those with a strong family influence, predates modern corporate structures. Early forms of business organizations, such as partnerships and sole proprietorships, were inherently "closely held" as ownership and management were typically vested in a few individuals. As formal corporate law evolved, notably in England with acts like the Joint Stock Companies Registration and Regulation Act of 1844 and the introduction of limited liability in 1855 and 1856, the distinction between entities with dispersed public ownership and those with concentrated private ownership began to sharpen²⁰.

In the United States, the federal government's involvement in regulating business, while initially focused on industries like railroads in the late 19th century, gradually expanded to address public interest concerns and prevent monopolies¹⁹. However, closely held companies, due to their private nature and limited shareholder base, have historically been subject to fewer regulatory disclosure requirements compared to their public counterparts. Key legislation, such as the Securities Act of 1933 and the Securities Exchange Act of 1934, primarily targeted publicly traded securities, with specific exemptions often granted to private offerings¹⁸. This legislative framework reinforced the distinct operational and disclosure environment for closely held entities.

Key Takeaways

• Closely held companies are characterized by concentrated ownership, often among a small group of individuals or family members.
• Their shares are typically not traded on public stock exchanges, limiting public accessibility to their financial information.
• Owners of closely held companies often enjoy greater control and operational flexibility compared to publicly traded corporations.
• These companies face unique challenges in areas such as valuation, raising capital, and succession planning.
• Despite their private nature, closely held businesses are a significant part of the economy, employing a large percentage of the workforce.

Interpreting the Closely Held Company

Interpreting a closely held company involves understanding its unique operational dynamics and financial characteristics. Unlike public companies, whose performance is routinely scrutinized through public market data and extensive financial reports, closely held companies operate with a high degree of privacy¹⁷. This means that traditional financial metrics might be less accessible, and their performance is often measured internally against strategic goals rather than short-term market pressures¹⁶.

For stakeholders, understanding a closely held company requires looking beyond typical market indicators. Emphasis is often placed on the relationships among owners, their long-term vision for the business, and the specific terms of any shareholder agreements that might govern ownership, control, and future transactions. The success of a closely held company is frequently tied to the continued commitment and alignment of its core owners.

Hypothetical Example

Imagine "Maplewood Organics," a company founded by two siblings, Sarah and David, that produces organic food products. They initially funded the business themselves, then brought in two close family friends as minority investors. Each of the five individuals holds a significant percentage of the company's equity, with Sarah and David collectively holding over 60%. Maplewood Organics does not trade its shares on any stock exchange, and all major decisions, such as expanding product lines or seeking debt financing for a new facility, are made directly by the five owners. This structure allows for quick decision-making and a shared vision, reflecting the defining characteristics of a closely held company.

Practical Applications

Closely held companies appear across various sectors of the economy, from small local businesses to large, multi-billion dollar enterprises like Cargill, which remains family-owned¹⁵. Their practical applications vary depending on their size and industry, but common themes include a focus on long-term growth over short-term financial reporting, and the ability to reinvest earnings without immediate pressure to distribute dividends¹⁴.

In terms of analysis, valuing a closely held company presents unique challenges because there is no readily available public market for its shares¹³. Professional valuation methods are employed, often involving discounted cash flow (DCF) models or comparable company analysis, which require adjusting for inherent differences between private and public firms,¹². For instance, when a private company like Figma recently prepared for its initial public offering, its pre-IPO valuation reflected these considerations, leading to a significant market assessment for what was previously a closely held entity¹¹. Furthermore, these companies often play a crucial role in local economies, contributing significantly to employment¹⁰.

Limitations and Criticisms

While offering benefits such as control and privacy, closely held companies face several limitations and criticisms. A primary concern is the limited liquidity of their shares, as there is no active public market for selling ownership stakes⁹. This can make it challenging for existing shareholders to exit their investment or for the company to raise large amounts of external capital⁸.

Another significant criticism revolves around potential governance issues, particularly the risk of majority shareholders expropriating minority shareholders⁷. Because control is concentrated, minority investors may have limited recourse if decisions made by the controlling group are perceived as detrimental to their interests. Legal frameworks in some jurisdictions, however, impose heightened fiduciary duties on shareholders in closely held corporations, akin to those among partners in a partnership, to mitigate such risks⁶. Additionally, closely held businesses must often navigate economic uncertainty, regulatory shifts, and challenges in attracting and retaining talent without the broader market access available to public companies⁵.

Closely Held Companies vs. Publicly Traded Companies

The core distinction between closely held companies and publicly traded companies lies in their ownership structure and access to public capital markets.

This fundamental difference impacts everything from corporate governance and financial statements to strategic decision-making and investor relations.

FAQs

What is the main characteristic of a closely held company?

The main characteristic is concentrated ownership, where a small group of individuals, often family members or founders, owns the majority of the company's shares. This means their shares are not publicly traded.

Why do closely held companies often have more privacy?

Closely held companies typically have more privacy because they are not subject to the extensive public reporting and disclosure requirements mandated by regulatory bodies like the Securities and Exchange Commission (SEC) for publicly traded entities. This allows them to keep internal strategies and financial statements confidential⁴.

How do closely held companies raise capital?

Closely held companies primarily raise capital through personal investments from existing owners, debt financing from banks, or by attracting private investors. Unlike public companies, they cannot raise funds by issuing shares on a public stock exchange³.

Are all private companies closely held?

No, not all private companies are closely held. While all closely held companies are private, a private company can have a more dispersed ownership structure, even if its shares aren't publicly traded. The defining feature of a closely held company is the concentration of ownership among a very small number of individuals.

What is a key challenge for closely held companies?

A key challenge for closely held companies is valuation and the limited liquidity of their shares². Without a public market, determining a fair price for shares can be complex, and selling shares often requires finding a private buyer, which can be time-consuming. Additionally, succession planning and ensuring smooth transitions of leadership are critical challenges for these businesses¹.