Private placement refers to a method of raising capital where select investors are invited through the offer of equity shares.
Unlike an IPO where shares are made available on the open market, a private placement involves select investors like large banks, mutual funds, insurance companies and pension funds. Furthermore, the capital raising event does not have to be registered with the SEC.
This type of event can either be carried out by a private company or a public traded company. Private companies can initiate a private placement event with the aim of acquiring more investors while public companies can do so as a secondary stock offering.
In order for a private investor to participate in a private placement event, one must be an accredited investor and must meet all requirements set by the SEC. For example one must have a net worth of $1 million or have an annual income in excess of $200,000.
When it comes to a publicly traded company, equity ownership held by existing shareholders is diluted during the secondary provision of additional stock thus increasing the total number of shares. What you need to know is that the dilution should be proportional to the private placement size.
Private Placement Requirements
The following requirements must be met by a company before a private placement event is held:
i. The company must have a sound business plan.
ii. It should have a private placement memorandum. This document discloses full facts about their investments and the company.
iii. Representation by a law firm or an attorney is a must. They should be experienced in matters of private placement.
How It Works
Public traded companies must register their offerings with the SEC if they are planning to host a private placement event. For private companies, they don’t have to register their offerings.
Through the laid down regulations, private and public traded companies can approach investors – individuals and institutional – for additional funding.
Public traded companies usually initiate a secondary offering of additional stock which lowers the percentage held by the existing shareholders.
When private and public traded companies choose a private offering, the event is governed by the Securities ACT of 1933 which was enacted after the stock market crash of 1929.
The act was established with the purpose of ensuring that investors are able to receive sufficient disclosure before purchasing securities. As a result, any company in need of issuing stocks and bonds to the public must register the offering with the SEC and sell the offering using a prospectus.
A private placement is documented in a memorandum (private placement memorandum) that helps to disclose a company’s characteristics, its business plan and terms of the securities on offer.
Pros
i. The security offering provides a high degree of flexibility in terms of financing options. Companies can benefit from financial options ranging from $100,000 to $ 20 million.
ii. Private placement investors are more patient compared to angel investors. This is because they only seek 10% to 20% ROI over a period of 5 to 10 years.
iii. Costs lower than hosting an IPO or approaching venture capitalists
iv. It’s a quicker method of raising additional capital
v. Private companies can avoid filing annual disclosures with the SEC
Cons
i. Investors expect a higher interest rate
ii. Investors may shy away from private placement offering since the company has not secured a credit rating
iii. Investors may demand fixed dividend payment per share
Final Thoughts
A private placement is a great option for businesses to raise additional financing without experiencing the regulations set aside by the SEC. Furthermore, the option is much cheaper compared to an IPO or venture capitalists.
Before undertaking in one of these types of offerings, it’s wise to consult with experts. This will ensure that your company and the investors have a clear picture of the rewards and risks.