What Is Private Placement?

Private Placement Explained

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Private placement is a way companies can sell securities through a private market rather than going through the traditional IPO process. Companies that raise capital in this manner are required to get an exemption from the Securities and Exchange Commission and aren’t subject to the normal registration and filing requirements.

Private placements, also known as unregistered offerings, are generally available only to certain investors. Depending on the type of private placement, companies may be limited to selling to institutional or sophisticated investors, or in rare cases, to individual investors.

Definition and Examples of Private Placements

A private placement is when a security is offered for sale without being subject to the typical registration process required by the Securities and Exchange Commission (SEC)

Rather than being posted in a public market for anyone to buy, securities offered through private placement are generally available only to certain investors.

Private placements are a fairly common practice. According to the Financial Industry Regulatory Authority (FINRA), nearly 23% of broker-dealers registered with the self-regulator reported revenue from private placements in the past five years. They are especially common for start-ups and smaller companies that don’t want to hold a traditional initial public offering (IPO).

Despite its common use, some private placements draw more attention than traditional IPOs. In a famous example, Goldman Sachs in 2011 announced that it would sell private shares in Facebook, which was still a private company at the time. Goldman Sachs initially planned to sell shares privately to domestic investors but instead decided to limit sales to non-U.S. investors. The sales ultimately helped the company raise $1.5 billion.

  • Alternate name: Unregistered offering

How Private Placement Works

Generally speaking, companies that sell public shares are subject to certain requirements, including registering with the Securities and Exchange Commission and filing regular financial statements. But SEC regulations exempt unregistered offerings. These exemptions fall within the “safe harbor” rules included in Regulation D of  the Securities Act of 1933.’ 

Companies that offer securities under Regulation D don’t have to meet all of the typical SEC requirements. This makes it easier—and possibly cheaper—for them to raise capital, but thereare other requirements they must meet.

First, companies are limited as to the type of investors they can sell to. Depending on the type of private placement, companies may be limited to sell only to sophisticated investors or to those classified as accredited investors. Accredited investors include:

  • Financial institutions.
  • Private business development companies.
  • Directors, executives, or partners of the firm.
  • Individuals with a net worth of more than $1 million.

In cases where companies are permitted to sell to nonaccredited investors, they must provide additional disclosures to those investors. Private placements also require that companies file Form D, which provides basic information about the company, its operations, the offering, and its top executives. 

Companies that sell via private placement are subject to the SEC Rule 506 “Bad Actor Disqualification,” which disqualifies companies from selling via private placement if they have a relevant criminal conviction, court order, or similar event on their record.

For example, let’s say an up-and-coming technology firm wanted to raise capital to grow its business operations, but it wasn’t ready to issue an IPO. The company could instead use a private placement or unregistered offering.

First, the firm would issue a private placement memorandum or offering memorandum that introduces the investment opportunity and shares additional information about the securities for sale. But such a memorandum is not required, and the SEC warns that the absence of one from a private placement could be considered a red flag. The memorandum is also not vetted by a regulator so it may not present a balanced view of the company or the offering.

In certain types of private placements, companies may even be able to solicit investors directly. Then, once the company has made its first sale, it must file Form D with the SEC

Types of Private Placement

Companies are allowed to sell stock and other securities thanks to the safe harbor exemptions provided in the Securities Act of 1933. These safe harbor exemptions are found under Regulation D, but several different rules outline rules for various methods of private placements.

Rule 504

Under Rule 504, companies can sell unregistered securities to both accredited and nonaccredited investors with no disclosure requirement for nonaccredited investors. The company may also solicit investors through advertising under certain circumstances. However, with this type of offering, a company can only raise up to $5 million over 12 months.

Rule 506(b)

Rule 506(b) is the most commonly used exemption under Regulation D. It allows companies to sell via private placement and raise an unlimited amount of capital as long as:

  • There is no general solicitation.
  • There are a maximum of 35 nonaccredited purchases and an unlimited number of accredited purchases.
  • All investors are sophisticated.
  • The company provides disclosures to nonaccredited investors.
  • The company makes itself available to answer questions from prospective investors.

Rule 506(c)

Rule 506(c) allows companies to generally advertise and solicit investors to sell unregistered offerings and raise an unlimited amount of capital if the following conditions are met:

  • All purchasers are accredited investors.
  • The company takes reasonable steps to verify that investors are accredited.

Alternatives to Private Placement

While private placement is one option for companies to raise capital, it’s not the only option available. Here are a few alternatives companies might consider instead of a private placement.

IPO

An initial public offering (IPO) refers to the first time a company sells public shares. An IPO, often known as “going public,” is a significant step for a company. Not only does the firm give up a percentage of ownership to outside investors, but it also subjects the company to SEC registration and filing requirements. Once a company is public, any investors can buy or sell shares on an exchange.

While an IPO may be a more well known way of raising capital, it’s not the right move for all companies. Many firms wait until they’re well established before going public. Private placements can help them to raise capital until that happens.

Direct listing

A direct listing is a method companies can use to bypass the traditional underwriting process involved in an IPO. Companies that sell shares via direct listing are still subject to the same requirements as exist in an IPO. They must still register with the SEC and file financial statements.

The direct-listing process removes underwriters, who often act as an independent form of checks and balances to ensure a company has met all of its requirements. As a result, direct listings may be considered higher-risk investments.

Business loan

Private placements, IPOs, and direct listings are three different methods a company can use to raise capital, but they all have one thing in common: All three generally involve a company giving up a percentage of ownership in exchange for capital.

Companies that wish to raise capital without forfeiting ownership in the firm may instead choose to take out a loan. Companies can opt for a traditional business loan. But they might also consider a 7(a) Small Business Loan, which is guaranteed by the Small Business Administration.

The downside of this funding mechanism is that, unlike in the case of selling equity, businesses will eventually have to pay back what they borrow.

Pros and Cons of Private Placement

Pros
    • Fewer filing requirements for the company.
    • Allows a company to maintain its privately owned status.
    • Opportunity to be an early investor.
Cons
    • Fewer protections for investors.
    • Not available to all investors.
    • A limited number of potential investors.

Pros Explained

  • Fewer filing requirements for the company: Private placements can be extremely beneficial for the company since they don’t come with the same disclosure requirements as IPOs. As a result, the offering process can move more quickly.
  • Allows a company to maintain its privately owned status: When companies sell unregistered offerings, they’re still technically privately owned firms. They don’t give up their private status like they would by going public.
  • Opportunity to be an early investor: Private placements can be excellent opportunities for investors since they give ground-floor access to growing companies.

Cons Explained

  • Fewer protections for investors: The filing requirements in place for publicly traded firms are designed to protect investors. Investors don’t get those same protections when they purchase unregistered offerings.
  • Not available to all investors: Buying an unregistered offering isn’t quite as simple as buying a public share through a stock exchange. The opportunity isn’t available to most investors.
  • A limited number of potential investors: The fact that these opportunities are limited to fewer investors can also be a downside for the company because they have a smaller pool of potential investors through which to raise capital.

What Private Placements Mean for Individual Investors

In most cases, individual investors aren’t able to purchase unregistered offerings. First, some types of private placements — including the most popular types — are available only to accredited investors or sophisticated nonaccredited investors. But in some select cases, individual investors may still be able to participate.

First, according to the SEC, private placement investments come with a substantial amount of risk, which could make them inappropriate for many investors. Before you purchase unregistered shares, it’s important to do significant research into the company and how they plan to use the funds.

Some precautionary steps you should take before investing  include:

  • Analyze the company’s financial statements.
  • Research the company, its business model, and its management.
  • Learn what the company plans to do with the money it raises.
  • Find out if restrictions on the shares will eventually be lifted.

Because private placements involve the sale of unregistered shares, investors can’t simply resell them on a stock exchange or through their brokerage account. Only purchase unregistered shares if you’re comfortable holding them for the long term.

To purchase shares via private placement, you’ll have to work with your broker. Even if your broker recommends the investment to you, it’s still critical that you do a bit of your own research. In many cases, brokers will recommend investments that they think are suitable for you but they may not necessarily be in your best interest.

Key Takeaways

Key Takeaways

  • Private placement is a way for companies to sell securities to investors without being subject to the typical SEC registration and filing requirements.
  • The Securities Act of 1933 allows for private placements, also known as unregistered offerings, through several safe harbor exemptions found in Regulation D.
  • Companies can generally only sell unregistered offerings to accredited and sophisticated investors, which include financial institutions and high-net-worth individuals.
  • Rather than selling securities via private placement, companies can raise capital through an IPO, direct listing, or business loan.
  • The private placement process may be simpler for companies but removes certain protections for individual investors.