If you’re interested in diversifying your portfolio and moving away from basic bonds and stocks, you’re in the right place.
Have you heard of private placement? Put simply, a private placement is the direct sale of company shares (stock) or bonds (loans with interest payouts) to qualified investors. It is a less-common alternative to an initial public offering (IPO), in which a company goes public on a stock exchange to order to sell it shares to the public.
In this article, I will cover the private placement in-depth, to help you determine if its something you’d like to invest in.
I also explain the importance of private placement memorandums. These are the financial documents that are prepared in order to facilitate the financial terms and conditions of a private placement.
What Is a Private Placement?
As mentioned earlier, a private placement is a strategic alternative to the initial public offering (IPO).
When a company decides to do a private placement in order to sell shares of its stock to private investors, it will frequently approach institutional, wealthy, or experienced investors. Examples of institutional investors include but are not limited to:
- mutual funds
- insurance companies
- pension funds
- venture capitalists
In addition to the prior mentioned entities, private placements can be offered to people like you and me, such as:
- family members
- wealthy (accredited) investors
- angel investors (this includes well-known people like Tim Ferriss, Tony Robbins, etc.)
When it comes to the private placement, there are minimal regulatory standards, even though it involves the transaction of securities. Oddly enough, the sale does not even have to be processed by the U.S Securities & Exchange Commission (SEC).
The transaction of stock in public exchange is regulated by the Act of Securities of 1933, which was developed after a market crash to ensure that investors had sufficient disclosure about their purchases. The D regulation of that act supplies an exemption for the private placement memorandum.
The regulation allows the issuer to transact securities to pre-determined groups of investors who meet the requirements set out by them. Instead of the prospectus, private placements are transacted via a memorandum, and cannot be marketed to the broader public.
It only applies to accredited investors (individuals with earned income exceeding $200,000, investors with a net worth of over $1 million; other exceptions apply), which might include but are not limited to individuals or entities who qualify under SEC terms.
When Is the Private Placement memorandum (PPM) Used?
Let’s take real estate, for example. In real estate, a Private Placement Memorandum (PPM) is a legal document that gets provided to prospective investors involved the private placement deal. It explains the terms of the deal, including its risks and projected returns.
A PPM can be used when the business is privately selling securities (financial instruments) related to real estate. Examples of this include:
- Syndication pooling
- Private real estate investment trust
- Real estate investment fund
PPMs are not always required in a private offering. For instance, a crowdfunding deal that is sold via the Rule 506(c) in the Securities Act is not required to provide a PPM or any disclosure for that matter.
However, as an investor, you should be very careful when it comes to purchasing securities without a memorandum. While a memorandum may not be required, any information the issuer chooses to provide must be accurate. Thus, there is reduced risk and greater safety associated with receiving an private placement memorandum.
On the flip side of the coin, for people who are selling securities, it’s important to supply a PPM to potential investors. First, most investors will be distrusting of you if don’t. Not to mention, a PPM can help to clarify and prevent misunderstandings that could later result in a lawsuit.
Within your memorandum, you’ll want to disclose all of the investment details, including risks, costs, and payback structures.
Any surprise, whether pleasant or unpleasant, is still a surprise. Investors don’t like unexpected surprises.
Canadian vs US Private Placement
If you’re trying to get a private placement in the New York Stock Exchange or the one in Toronto, the process is quite similar. If you’re an American looking for a Canadian private placement, or a Canadian looking for an American one, the first thing to do is to determine foreign availability.
However, thanks to the political relationship between the USA and Canada. The placements are most often open to citizens of the other country. This holds true for both Canada & the USA.
Another thing to make sure of is the fact that you match the accredited investor criteria in your own country. When it comes to being qualified in each of the countries, the criteria have very minor differences. At the least, you need to meet the criteria for your country, because the other country has forms for foreign investors.
Pros & Cons of Private Placement
In recent years, private placements have become common among startup companies as a way to raise money, particularly those in the financial tech (“fintech”) or software sectors.
A private placement allows these companies to raise substantial amounts of capital—often millions—all while avoiding the public scrutiny that comes with an IPO.
However, private placement buyers also tend to demand higher returns. This is because shares purchased during a private placement can’t be readily sold to others, as can be done on public stock exchanges.
So, what are the pros and cons of private placements?
1. A Quick, Cheap, and Streamlined Process (Advantage)
As an advantage of the private placement, a new company can retain its private structure, while avoiding the regulations and disclosures that come after an IPO.
The minimal standards of private placements allow companies to avoid the expenses and time-consumption of becoming affiliated with the SEC.
This leads to faster underwriting and quicker funding for the enterprise. (*Note: If the issuer sells bonds, it also avoids the inconveniences of credit rating acquisition from agencies.)
In premise, private placement allows the issuer to sell complicated securities to qualified investors who comprehend the scope of the rewards and risks.
2. Investors Will Demand More (Disadvantage)
As a disadvantage, the investors involved within a private placement (PP) deal will nearly always expects higher returns than those that can be secured through publicly traded instruments (stock or bonds).
Because of the risk of not knowing the credit rating, a buyer might not buy into a private placement unless it has been secured with collateral. Collateral is something of physical value that could sold if the loan were to default.
Not to mention, a PP investor will nearly always ask for a larger percentage ownership in the business (per dollar invested) or a larger dividend payout (per share).
Financial Literacy for You
Now that you know what a private placement is and how valuable it can be, you can decide whether you’re interested in moving into higher risk, higher reward investments.
What questions do you have about private placements? Ask them in the comments below.
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