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.
A More Demanding Buyer
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.
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. Private placement occurs when a company makes an offering of securities to an individual or a small group of investors. Since such an offering does not qualify as a public sale of securities, it does not need to be registered with the Securities and Exchange Commission (SEC) and is exempt from the usual reporting requirements.
Private placements are generally considered a cost-effective way for small businesses to raise capital without “going public” through an initial public offering (IPO).
Restrictions Affecting Private Placement
The SEC formerly placed many restrictions on private placement transactions. For example, such offerings could only be made to a limited number of investors, and the company was required to establish strict criteria for each investor to meet. Furthermore, the SEC required private placement of securities to be made only to “sophisticated” investors—those capable of evaluating the merits and understanding the risks associated with the investment. Finally, stock sold through private offerings could not be advertised to the public and could only be resold under certain circumstances. In 1992, however, the SEC eliminated many of these restrictions in order to make it easier for small companies to raise capital through private placements of securities. The rules now allow companies to promote their private placement offerings more broadly and to sell the stock to a greater number of buyers.
It is also easier for investors to resell such securities. Although the SEC restrictions on private placements were relaxed, it is nonetheless important for small business owners to understand the various federal and state laws affecting such transactions and to take the appropriate procedural steps. It may be helpful to assemble a team of qualified legal and accounting professionals before attempting to undertake a private placement. Many of the rules affecting private placements are covered under Section 4(2) of the federal securities law. This section provides an exemption for companies wishing to sell up to $5 million in securities to a small number of accredited investors.
Companies conducting an offering under Section 4(2) cannot solicit investors publicly, and the majority of investors are expected to be either insiders (company management) or sophisticated outsiders with a preexisting relationship with the company (professionals, suppliers, customers, etc.). At a minimum, the companies are expected to provide potential investors with recent financial statements, a list of risk factors associated with the investment, and an invitation to inspect their facilities. In most respects, the preparation and disclosure requirements for offerings under Section 4(2) are similar to Regulation D filings.
Regulation D—which was adopted in 1982 and has been revised several times since—consists of a set of rules numbered 501 through 508. Rules 504, 505, and 506 describe three different types of exempt offerings and set forth guidelines covering the amount of stock that can be sold and the number and type of investors that are allowed under each one.
Rule 504 covers the Small Corporate Offering Registration, or SCOR. SCOR gives an exemption to private companies that raise no more than $1 million in any 12-month period through the sale of stock. There are no restrictions on the number or types of investors and the stock may be freely traded. The SCOR process is easy enough for a small business owner to complete with the assistance of a knowledgeable accountant and attorney. It is available in all states except Delaware, Florida, Hawaii, and Nebraska. Rule 505 enables a small business to sell up to $5 million in stock during a 12-month period to an unlimited number of investors, provided that no more than 35 of them are non-accredited. To be accredited, an investor must have sufficient assets or income to make such an investment. According to the SEC rules, individual investors must have either $1 million in assets (other than their home and car) or $200,000 in net annual personal income, while institutions must hold $5 million in assets. Finally, Rule 506 allows a company to sell unlimited securities to an unlimited number of investors, provided that no more than 35 of them are non-accredited. Under Rule 506, investors must be sophisticated. In both of these options, the securities cannot be freely traded.
Advantages to the Company
• Going for an FPO involves a plethora of compliances, disclosures and is altogether a time-consuming procedure.
• Speculations in the market can result in low valuation in the capital market when the market is bleak. In such a situation private placement provides the best solutions to raise capital with good valuation.
• The investors investing through private placements are well educated and informed investors who look forward to long term holdings are ready to invest in the company with higher valuation if they see the significant future value.
• It is surreal for a company to go for an FPO after its valuation is eroded pursuant to an IPO.
Advantages to the Investors
• Investors are able to capture a good stake in the companies at attractive prices when the company raises capital during bleak markets.
• There is a lesser regulatory framework compared to the traditional routes
• There are easy exit opportunities in the listed companies.
• Investors can invest in the bearish market in attractive prices and later sell the stake at high prices during the bull cycle.
Private Placements
• Regulation 14(2)(a) of Companies (Prospectus and Allotment of Securities) Rules, 2014 states that a special resolution by the shareholders of the company is necessary in order to initiate the process of private placement.
• For the purpose of invitation for non-convertible debentures, a special resolution one a year for all the offers during the year is sufficient.
• The offer for Private Placement is made only to selected people who are recognized by SEBI.
• Not more than 50 of these people can participate in the procedure. These number does not include QIB.
• Any company who intends to make an offer to subscribe to securities needs to send placement offer form along with Form PAS-4 to the identified persons either in electronic mode or writing.
• No person other than the addressee can fill up the application.
• The company has to maintain a record of the private placement offer in form PAS-5
• A company cannot advertise publicly or through agents or distribution channels about an issue.
Registrar
• A copy of the complete record of private placement along with placement offer form is to be filed with Registrar and stock exchange in case the company is listed and along with requisite fee.
• Pursuant to the allotment of the securities, a return of allotment has to be filed within fifteen days which includes the details of the allotters.
• A company can only utilize money raised through private placement when allotment is made and the return of allotment is filed with the Registrar.
Applicants
• Persons willing to subscribe have to apply in the private placement along with subscription money; the mode of payment cannot be in cash.
• If the private placement is not in accordance with the SEBI regulations then it will be considered as on public offer and Securities Contracts (Regulation) Act, 1956 will be applicable.
• In case of any default in contravention, the promoters of the company are subjected to a fine of 2 cores or the money raised through the placement whichever is lower. Moreover, the company has to refund all the money with interest to the subscribers. The company has to allot securities within a period of sixty days from the date of receipt of application money. In case the company is not able to do so then it is liable to repay the money with interest of twelve percent per annum.
• A fresh offer cannot be initiated unless allotment to the prior issue has been given or the offer is abandoned.
Institutional Private Placement
Rationale
• Minimum Public Holding was introduced through the Securities Contract Act which mandated the listed companies to maintain a minimum public holding of 25%.
• Companies are fined or even delisted if they do not comply with this norm and moreover is not an uncommon affair. Institutional Placement is an efficacious way to increase public holding.
• Institutional Placement is an exclusive placement for the Qualified Institutional Buyers in off-market mechanism.
• Institutional Placements can be either through the new issue of shares or Offer for Sale.
• Firstly, the placements offer the shares only to a fixed number of investors which would otherwise be floated in the secondary market. In such an instance there is a high possibility of erosion of the share value. Secondly, the shares are offered to the group of people who have an appetite for large holdings.
• Institutional Placements are useful during divestments of Public Sector Undertaking shares by the government and for the dilution of the promoters stake.
Statutory Framework
• A special resolution by the shareholders is mandatory for carrying out institutional placement program.
• The offer document has to be registered with the Registrar of Companies and file a company with a stock market. A soft copy of the offer document has to be filed with SEBI.
• The merchant banker has to submit a due diligence certificate Form A schedule VI
• The allocation of the securities in an IPP is made through; proportionate basis, price priority basis, any other criteria mentioned in the offer document.
Allotment
• Minimum 25% of the securities have to be allotted to the Mutual Funds & Insurance companies.
• The bids have to be accepted using ASABA facility only.
• The minimum number of allottee for each offer of eligible securities made under the institutional placement programme shall not be less than ten: Provided that no single allottee shall be allotted more than twenty-five percent.
• The aggregate of all the tranches of institutional placement programme made by the eligible seller shall not result in an increase in public shareholding by more than ten percent. or such lesser percent. as is required to reach minimum public shareholding.
• The issue shall be kept open for a minimum of one day or the maximum of two days.
• The allotted securities are locked in for the period of one year from the date of allocation and can only be sold on the recognized stock exchange.
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