Private Placements: Definition, Example, Pros and Cons

What Is a Private Placement?

A private placement is a sale of stock shares or bonds to pre-selected investors and institutions rather than on a public exchange. It is an alternative to an initial public offering (IPO) for a young company seeking to raise money to expand.

The process is sometimes referred to as a 4(a)(2) private placement. The main process that enables such a sale is the 4(a)(2) exemption to Securities and Exchange Commission (SEC) rules regarding registration of public companies. The 4(a)(2) exemption permits companies and buyers of their securities to conduct such transactions without the company first filing for registration with the SEC.

Understanding Private Placements

Private placements have become a popular way for startups to raise money, particularly in the Internet and financial technology sectors. They allow these companies to grow and develop while avoiding the full glare of government and public scrutiny that accompanies an initial public offering (IPO).

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 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.

Companies that sell shares privately can do so under either of two exemptions to the usual SEC rules requiring full registration:

• A 4(a)(2) exemption permits a company to sell a limited number of shares to a limited number of accredited investors.
• A Regulation D or Reg D sale permits the sale of an unlimited number of shares to an unlimited number of accredited investors.

In any case, accredited investors are defined as individuals and institutions that have a sophisticated knowledge of the securities industry and considerable financial resources.

That restricts access to private placements to wealthy individual investors, financial institutions like banks, mutual funds, insurance companies, and pension fund managers.

Private vs. Public Stock Sales

The sale of stock on public exchanges is regulated primarily by the Securities Act of 1933. The law 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 an 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). They cannot be broadly marketed to the general public.

Advantages and Disadvantages of Private Placements

Advantage: A Speedier Process

A private placement allows a young company to put off the onerous process of registering for a public stock offering. Moreover, going public involves a considerable burden of quarterly and annual financial filings that many new companies can ill afford to undertake.

A private company is relatively lightly regulated, as are private placements of stock shares.

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.

Disadvantage: 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, 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. This puts pressure on the company to perform at a higher level, which could lead it to ignore the careful process of healthy growth.

There also is a risk of a loss of control if private placements result in increased ownership by investors rather than founders.

The Bottom Line

Private placements allow business owners to raise capital while foregoing the IPO process, which can be long, difficult, and burdensome. By opening their doors to pre-selected investors through private placements, businesses can raise funds for expansion while not having to abide by the many regulatory requirements that an IPO and being public demand.

There is a downside, given the demands of private investors seeking high returns for the increased risk they are taking on.