In recent years, the predictable phases of company development - and the accompanying stages of financing - have changed dramatically. During the "bull market years" of the late 1990s, many small private companies began to grow at accelerated rates and, with a strong IPO market as a driving force, entered the public arena rapidly to continue to further their growth. However, as the IPO market began to lose steam, companies looked for alternative sources of financing.
While an initial public offering is a suitable option for many private companies ready to make that significant jump, going public is not always the logical next step for others. Depending on the nature of a company's business, along with its unique financial needs and goals, a private placement may make more sense.
A private placement is the sale of securities to a limited number of qualified private investors. While an IPO is the initial sale of shares to the general public, a typical private placement is offered only to institutional investors and accredited individuals and entities that meet certain eligibility requirements.
For companies, private placements can provide an infusion of cash more quickly and less expensively than a public offering. Private placements are also generally not subject to public disclosure obligations. They typically allow companies to have a great deal of control over the process - the company can decide how much to sell, at what price, and to whom. However, those decisions do require a tremendous amount of due diligence and careful deliberation.
For investors, securities purchased through a private placement typically fall into the realm of alternative assets - investments that often have a low correlation to public markets and offer essential diversification to portfolios dominated by traditional stocks and bonds. Private placements also may give investors more control of their private equity allocations. Unlike venture capital - which usually takes the form of funds raised by venture capital firms and invested in portfolios of private companies - investments through private placements are made on an individual basis.
What are private placements?
Private placements are exempt from the registration requirements of the federal Securities Act of 1933 and public disclosure requirements as long as certain requirements are met. The sale of securities through private placements cannot involve any public offering, public solicitation, or advertising. In addition, private placements must comply with state laws and anti-fraud provisions of securities laws. Companies must disclose to potential investors all of the pertinent information needed to make a fully informed decision.
Securities sold through private placement securities can take different forms. Typically, they involve the sale of either debt or equity.
Why opt for a private placement?
Private placements are good options for companies that need to generate capital but, for whatever reasons, aren't suitable for venture capital or a public offering. As noted previously, private placements can enable companies to raise capital more quickly and in a less costly manner than a public offering. A company may also wish to avoid the consuming task of meeting public disclosure obligations required when making a public offering.
While public offerings also impose minimum issue sizes, private placements generally involve smaller transactions than IPOs. The typical candidate for a private placement has established a proven track record of success and shown readiness to advance to the next stage of growth. The company should be a compelling investment opportunity.
Private companies considering private placements need to assess whether they possess certain crucial elements. The company should have several key positions filled with top-notch managers, particularly in sales. It should anticipate a strong future growth rate and potential exit strategy for investors.
Who invests in private placements?
Investments in private placements carry a high degree of risk for various reasons. Securities sold through private placements are not publicly traded and, therefore, are less liquid. Additionally, investors may receive restricted stock that may be subject to holding period requirements. Companies seeking private placement investments tend to be in earlier stages of development and have not yet been fully tested in the public marketplace.
Investing in private placements requires high risk tolerance, low liquidity concerns, and long-term commitments. Investors must be able to afford to lose their entire investment. For those reasons, these offerings may be made available only to certain institutional investors and high net worth individuals and entities. As with all alternative investments, investors must meet certain eligibility tests to qualify as purchasers. Currently, entities must have assets of at least $5 million (or all individual owners meet accredited investor tests). Individuals must have a net worth of more than $1 million or gross income for each of the last two years of at least $200,000 ($300,000 with spouse) with the expectation of the same income in the current year.
Investors should also be mindful that the company may require more capital in the future to continue growing, with no guarantee that it will be successful in securing it. But investors may reap huge rewards for the risks - most importantly, the potential for high returns. Also, because of the long timeframe, investments made now won't be affected by current market volatility.
How do private placements work?
A company seeking a private placement issues a Private Placement Memorandum, or PPM. The PPM details the company's financial situation and business plan, as well as any other pertinent information about the company and the offering. However, a great deal of preparation is required before the PPM is issued. The first step is to consult attorneys who specialize in private placements. They should oversee all of the paperwork included in the PPM to help to ensure that the company is meeting SEC and state requirements during the process.
Although potential investors will typically conduct independent research, companies should be careful about how they promote themselves in the PPM. Investors may try to bring suit against the issuer if they feel that the company failed to live up to representations made in the PPM.
An investment bank typically acts as an intermediary between the company issuing the PPM and potential investors. Once investors decide to invest, they complete a subscription agreement.
In today's increasingly varied business landscape, different company circumstances require different financing solutions. Private placements are opportunities for companies to generate capital and grow their businesses without going public, while offering investors early access to promising companies.
Both company owners and potential investors must devote a great deal of time and effort to successfully complete a private placement, but both also stand to gain considerably from this type of investment vehicle.
This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or as a determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on their objectives, financial situations, and particular needs. This article is not designed or intended to provide financial, tax, legal, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought.