Private placements are discussed all the time in the resource space, but they have many ins and outs. Here’s what you need to know.
Private placements, also known as non-public offerings, are offerings in which securities are sold to a small number of exclusive investors.
Unlike public offerings, private placements do not have to be registered with regulatory authorities such as the US Securities and Exchange Commission (SEC).
The sale of securities is most often associated with public offerings, particularly initial public offerings (IPOs). An IPO happens when equity shares are sold to public investors for the first time. Once a company is considered public, it is regulated by the SEC and disclosure of financial statements and information relating to its performance is required on a routine basis.
Public vs. private
A private placement allows companies to raise capital through the sale of securities while minimizing the number of outside shareholders who will then be able to influence the direction of the organization.
According to Section 4(a)(2) of the US Securities Act, 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 bear the investment’s economic risk
- Capable of accessing the information 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.”
Why go private?
Making a public offering can be an effective way to raise money and expand a company, but it also opens the door to increased influence from outside shareholders, allowing them to vote on the ultimate direction of the company.
Private placements allow companies to avoid that, as well as minimize reporting obligations. Whereas public companies must register with the SEC and receive ratings from credit agencies, private companies can skip these constraints while still receiving the influx of money they need.
Who can participate?
The knowledge, experience and economic security that investors must have means that typically buyers are financial institutions, mutual funds, insurance companies, pension funds and similar entities. As stated above, in order for a company to be exempt due to a private placement with the SEC, the purchasers of its securities must meet certain criteria.
However, as long as prospective investors meet the SEC’s definition of a sophisticated investor who is able to bear the risk of the purchase, they can qualify to participate in private placement transactions.
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.
Similar to the SEC’s sophisticated 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 adviser 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 risk of private placements is generally a lack of information. 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.
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Securities Disclosure: I, Priscila Barrera, hold no direct investment interest in any company mentioned in this article.