A private placement is a sale of stock shares or bonds to pre-selected investors and institutions rather than on the open market. It is an alternative to an initial public offering (IPO) for a company seeking to raise capital for expansion. Investors invited to participate in private placement programs include wealthy individual investors, banks and other financial institutions, mutual funds, insurance companies, and pension funds. One advantage of a private placement is its relatively few regulatory requirements. There are minimal regulatory requirements and standards for a private placement even though, like an IPO, it involves the sale of securities. The sale does not even have to be registered with the U.S. Securities and Exchange Commission (SEC). The company is not required to provide a prospectus to potential investors and detailed financial information may not be disclosed. The sale of stock on the public exchanges is regulated by the Securities Act of 1933, which was enacted after the market crash of 1929 to ensure that investors receive sufficient disclosure when they purchase securities. Regulation D of that act provides a registration exemption for private placement offerings. The same regulation allows an issuer to sell securities to a pre-selected group of investors that meet specified requirements. Instead of a prospectus, private placements are sold using a private placement memorandum (PPM) and cannot be broadly marketed to the general public. It specifies that only accredited investors may participate. These may include individuals or entities such as venture capital firms that qualify under the SEC’s terms.
Advantages and Disadvantages of Private Placement
Private placements have become a common way for startups to raise financing, particularly those in the internet and financial technology sectors. They allow these companies to grow and develop while avoiding the full glare of public scrutiny that accompanies an IPO. Buyers of private placements demand higher returns than they can get on the open markets. Above all, a young company can remain a private entity, avoiding the many regulations and annual disclosure requirements that follow an IPO. The light regulation of private placements allows the company to avoid the time and expense of registering with the SEC. That means the process of underwriting is faster, and the company gets its funding sooner. If the issuer is selling a bond, it also avoids the time and expense of obtaining a credit rating from a bond agency. A private placement allows the issuer to sell a more complex security to accredited investors who understand the potential risks and rewards. The buyer of a private placement bond issue expects a higher rate of interest than can be earned on a publicly-traded security. Because of the additional risk of not obtaining a credit rating, a private placement buyer may not buy a bond unless it is secured by specific collateral. A private placement stock investor may also demand a higher percentage of ownership in the business or a fixed dividend payment per share of stock.
Small businesses face the constant challenge of raising affordable capital to fund business operations. Equity financing comes in a wide range of forms, including venture capital, an initial public offering, business loans, and private placement. Established companies may choose the route of an initial public offering to raise capital through selling shares of company stock. However, this strategy can be complex and costly, and it may not be suitable for smaller, less-established businesses. As an alternative to an initial public offering, businesses that want to offer shares to investors can complete a private placement investment. This strategy allows a company to sell shares of company stock to a select group of investors privately instead of the public. Private placement has advantages over other equity financing methods, including less burdensome regulatory requirements, reduced cost and time, and the ability to remain a private company.
Regulatory Requirements for Private Placement
When a company decides to issue shares of an initial public offering, the U.S. Securities and Exchange Commission requires the company to meet a lengthy list of requirements. Detailed financial reporting is necessary once an initial public offering is issued, and any shareholder must be able to access the company’s financial statements at any time. This information should provide enough disclosure to investors so they can make informed investment decisions. Private placements are offered to a small group of select investors instead of the public. So, companies employing this type of financing do not need to comply with the same reporting and disclosure regulations. Instead, private placement financing deals are exempt from SEC regulations under Regulation D. There is less concern from the SEC regarding participating investors’ level of investment knowledge because more sophisticated investors (such as pension funds, mutual fund companies, and insurance companies) purchase the majority of private placement shares.
Saved Cost and Time
Equity financing deals such as initial public offerings and venture capital often take time to configure and finalize. There are extensive vetting processes in place from the SEC and venture capitalist firms with which companies seeking this type of capital must comply before receiving funds. Completing all the necessary requirements can take up to a year, and the costs associated with doing so can be a burden to the business. The nature of a private placement makes the funding process much less time-consuming and far less costly for the receiving company. Because no securities registration is necessary, fewer legal fees are associated with this strategy compared to other financing options. Additionally, the smaller number of investors in the deal results in less negotiation before the company receives funding. The greatest benefit to a private placement is the company’s ability to remain a private company. The exemption under Regulation D allows companies to raise capital while keeping financial records private instead of disclosing information each quarter to the buying public. A business obtaining investment through private placement is also not required to give up a seat on the board of directors or a management position to the group of investors. Instead, control over business operations and financial management remains with the owner, unlike a venture capital deal. A company can be more selective about who buys its shares if it sells them in a private placement. Shares sold in an initial public offering or IPO, are offered to the general public and tend to attract more attention. However, private placement allows a company to raise money without going public and having to disclose financial information. A company can remain private while still gathering shareholder investments. A private placement might take place when a company needs to raise money from investors. Yet it is different from taking money from other private investors, like venture capitalists. It’s still regulated by the Securities and Exchange Commission (SEC), but under different rules, collectively known as Regulation D. Reg D allows companies to issue securities based on the investors buying them. It distinguishes between accredited and non-accredited investors, as defined by the SEC. Any number of accredited investors can take part in private placements. Though private placements can issue securities to non-accredited investors, only 35 such investors can be included. If you’re looking to invest in a private placement as an accredited investor, you’ll need to meet some requirements, including:
• A net worth of over $1 million (either independently or with a spouse).
• Earned income more than $200,000 a year (or $300,000 with a spouse).
Private Placements: Pros and Cons
Since private placements fall under different regulations compared to IPOs, they operate differently.
Pros
• Faster turnaround time: The security underwriting process is faster, which means investors can get proceeds from the sale in less time.
• Different assets: Since sellers aren’t registering with the SEC, even bonds can be sold more quickly. A company doesn’t have to get a credit rating from a bond agency and can sell to accredited investors who understand more complex bond offerings.
• Privately owned status: A company can file a private placement and remain privately owned, avoiding the regulations and information disclosures of publicly owned companies.
Cons
• Higher interest rates: Compared to bonds issued by publicly traded companies, private placement bonds earn a higher rate of interest. That leaves a company on the hook for larger payouts.
• Increased collateral: Without a credit rating, a private placement bond offers little assurance to a buyer. A company may have to offer some form of collateral to entice buyers.
• More ownership: An investor of a private placement company may want a larger percentage of ownership in the business or a guaranteed fixed dividend payment for each share of stock they own.
Restrictions of Private Placements
There are some limitations of private placements, especially when it comes to what types of investors are allowed to participate. A number of rules within the SEC’s regulation D cover those restrictions.
Rule 504: Issuers can offer and sell up to $1 million of securities a year to as many of any type of investor as you want. They aren’t subjected to disclosure requirements.
Rule 505: This rule says issuers can offer and sell up to $5 million of securities a year to unlimited accredited investors and 35 non-accredited investors. If you’re selling to a non-accredited investor, you’ll need to disclose financial documents and other information. With accredited investors, the issuer can choose whether or not to disclose information to investors. But if you provide that information to accredited investors, you must also share that information with their non-accredited ones.
Rule 506: An unlimited amount of money can be raised if the issuer doesn’t participate in solicitation or advertising. While an unlimited amount of accredited investors can be brought in, 35 non-accredited can take part if they meet specific criteria. They need to have enough financial knowledge or have a purchaser representative present to understand and evaluate the investment.
Investment Tips
• Investing in securities that don’t disclose their financial information can be confusing. A financial advisor can help investors get a clearer picture. Finding the right financial advisor that fits your needs doesn’t have to be hard.
The Problem with Private Placements
One of the biggest problems I am seeing these days is private placements (also called alternatives or non-registered investments) that are sold to accredited investors through a private placement memorandum or PPM. Because these investments are not registered with the SEC the information that you can get about them is far more limited, and can even be fraudulent. Private placements can be great opportunities, but they nearly always carry significant risk and in some cases they can be Ponzi schemes. Aside from the risk, one of the biggest concerns regulators have is how the products are sold. FINRA has warned in the past about “fraud and sales practice abuses” by firms and brokers in the market. In some cases this may be due to the fact that these smaller, less known firms tend to hire troubled brokers for their track record in aggressively selling high-commission deals, sometimes using questionable tactics. Most of these firms are small to midsize brokerages, with fewer than 500 brokers, and are spread throughout the country. According to the WSJ, more than 1,200 brokerage firms sold around $710 billion of private placements last year, and sales for the first five months of this year will be even higher. To make matters worse, securities firms with an unusually high number of “bad brokers” are selling tens of billions of dollars a year of private stakes in companies. The WSJ reviewed records of who was pushing these investments and identified over a hundred firms where 10% to 60% of the in-house brokers had three or more investor complaints, regulatory actions, criminal charges or other red flags on their records.
Securities Law
A private placement memorandum is meant for an issuing company to be compliant with both state and federal laws, no matter where the PPM is issued. A company selling securities wants to ensure they do not break any laws when approaching investors and are exempt for registration requirements. For an investor to make an educated decision the PPM should contain all the noted data above, including financial projections and past financial performance and of course the risk factors of the business and industry. Risk factor information will not scare away experienced investors who are most likely well aware of such language being placed in a private placement memorandum. The important thing is make sure your company is compliant with securities laws and regulations when raising capital. While a business plan is not always included in the private placement memorandum, many companies do create a section for some information related to the business. Others will create a full exhibit and put the entire business plan in that section, while others will just put an executive summary in the PPM. The business plan is normally the first document a company would create when starting a business and most likely prior to raising capital. The business plan and the private placement memorandum are in many ways two sides of the coin. The business plan details the company’s plan of action, the market, strategies to engage clients and more. The private placement memorandum details what the investor will receive in return for their money, i.e. what kind of stocks or bonds, and what terms are attached to them and much more.
Securities Lawyer
When you need legal help to do a private placement memorandum, please call Ascent Law LLC for your free consultation (801) 676-5506. We want to help you.
8833 S. Redwood Road, Suite C
West Jordan, Utah
84088 United States
Telephone: (801) 676-5506
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