What Is a Private Placement?
A private placement is a sale of stock shares or bonds to pre-selected investors and institutions rather than publicly on the open market.It is an alternative to an initial public offering (IPO) for a company seeking to raise capital for expansion. Private placements are regulated by the U.S. Securities and Exchange Commission under Regulation D.
Investors invited to participate in private placement programs include wealthy individual investors, banks and other financial institutions,mutual funds, insurance companies, andpension funds.
One advantage of a private placement is its relatively few regulatory requirements.
Key Takeaways
- A private placement is a sale of securities to a pre-selected number of individuals and institutions.
- Private placements are relatively unregulated compared to sales of securities on the open market.
- Private sales are now common for startups as they allow the company to obtain the money they need to grow while delaying or forgoing an IPO.
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Understanding Private Placements
Private placements have become a common way for startups to raise financing, particularly those in the Internet and financial technology sectors. They allow these companies to grow and develop while avoiding the full glare of public scrutiny that accompanies an 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 even have to be registered with the U.S. Securities and Exchange Commission(SEC). Thecompany is not required to provide aprospectusto potential investors and detailed financial information may not be disclosed.
The sale of stock on public exchanges is regulated by theSecurities Act of 1933, among other laws. 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 a registration exemption for private placement offerings.
The same regulation allows an issuer to sell securities to a pre-selected group ofinvestors that meet specified requirements. Instead of a prospectus, private placements are sold using a private placement memorandum (PPM) and cannot be broadly marketed to the general public.
It specifies that only accredited investors may participate. These may include individuals or entities such as venture capital firms that qualify under the SEC’s terms.
Advantages and Disadvantages of Private Placements
Advantage: A Speedier Process
Above all, a young company can remain aprivate entity, avoiding the many regulations and annual disclosure requirements that follow an IPO. The light regulation of private placements allows the company to avoid the time and expense of registering with the SEC.
That means the process ofunderwritingis 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 ratingfrom 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 of not obtaining a credit rating, 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 dividendpayment 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. Additionally, there could be a loss of control if private placements result in increased ownership from investors.
How Does a Private Placement Work?
Private placements are the sale of a company's shares to a number of pre-selected investors. The process takes place privately, hence the name, meaning that a company does not have to go through the regulatory hurdles of an IPO and being a public company but is still able to raise external funds to expand the business.
What Is the Difference Between a PO and an IPO?
An IPO is an initial public offering; when a company sells shares publicly for the first time. A PO is a public offering; when a company sells shares publicly again after its IPO. A company can only have one IPO but many POs.
Why Do Companies Go for Private Placements?
There are many benefits that would make a company choose a private placement. These include a faster process to selling shares than an IPO, having to meet fewer regulatory requirements than an IPO would require, having to meet fewer regulatory obligations on an ongoing basis than being public would require, and the ability to retain more control of the company.
The Bottom Line
Private placements allow business owners to raise capital by foregoing the IPO process, which is often 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. Though it comes with benefits, there are downsides, with demanding investors seeking high returns for the increased risk they take on through private placements.
