Private placements are non-public offerings in which unregistered equity securities are sold to an exclusive group of specific investors.
Private placements are a common pathway to raising capital for public and private entities, including junior resource companies, as well as tech and life science startups. Not all market players can participate in private placements; this investment product is typically reserved for high-net-worth accredited investors, along with institutional investors like banks, brokerage firms and fund managers.
As a capital-raising strategy, private placements have advantages over more open-market routes such as initial public offerings (IPOs). For investors, private placements offer an excellent wealth-building opportunity — but not without a high level of risk.
Why private placements?
The sale of equity securities is most often associated with a public offering, particularly an IPO. IPOs involve the sale of equity securities to investors on the open market for the first time.
A company looking to complete an IPO must register with a regulatory authority such as the US Securities and Exchange Commission (SEC); once public, disclosure of the company’s financial statements and information relating to its performance is required on a routine basis.
Making a public offering opens the door to increased influence from outside shareholders, allowing them to vote on the ultimate direction of the company.
In contrast, a private placement is exempt from oversight and doesn’t have to be registered with securities regulators. What’s more, a private placement allows companies to minimize the number of outside shareholders who will then be able to influence the direction of the organization.
Who can participate in private placements?
As mentioned, both public and private entities can execute private placements, and there are a variety of motivators for going the private route. But companies must meet certain conditions in order to do so.
For example, according to Section 4(a)(2) of the US Securities Act, in America companies can qualify for an exemption from having to register a placement with the SEC if the purchasers of their securities are:
- Considered “sophisticated investors” — as in knowledgeable and experienced in finance and business and able to evaluate the pros and cons of an investment.
- Able to access the data normally provided in a prospectus for a registered securities offering.
- In agreement not to resell or distribute the securities to the public.
“The precise limits of the non-public offering exemption are not defined by rule,” the SEC states. “As the number of purchasers increases and their relationship to the company and its management becomes more remote, it is more difficult to show that the offering qualifies for this exemption. If your company offers securities to even one person who does not meet the necessary conditions, the entire offering may be in violation of the Securities Act.”
The US is far from the only nation that features a private placement workaround for companies. For example, in Canada, organizations are typically required to provide buyers with a prospectus approved by the securities regulatory authorities in each of the provinces where the offer is made. However, a private placement makes companies exempt from this rule if buyers are accredited investors.
Similar to the SEC’s accredited investor definition, Canada describes buyers with accredited investor status as those whose financial and business knowledge minimizes their need for the additional information normally provided by a prospectus for a public offering.
According to the Ontario Securities Commission (OSC), to qualify for accredited investor status, the applicant must be one of the following:
- A company with net assets of at least $5 million.
- An individual or company already recognized by the OSC as an accredited investor.
- An individual who alone or with a spouse owns financial assets worth more than $1 million before taxes or has net assets of at least $5 million.
- An individual who is or once was a registered advisor or dealer, other than a limited market dealer.
- A financial institution, government agency, insurance company, pension fund, registered charity or a certain mutual fund, pooled fund or managed account.
What are the risks?
For investors, the greatest private placement risk is generally a lack of information and the potential to lose their entire investment. Unlike with public offerings, investors will be contending with limited details regarding a company’s financial standing and internal operations. In some cases, that has opened the door to fraud and sales abuse.
In the case of a private placement investment, investors would be well served by finding out as much as they can about a company before investing capital.
This is an updated version of an article first published by the Investing News Network in 2016.
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Securities Disclosure: I, Melissa Pistilli, hold no direct investment interest in any company mentioned in this article.
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