By Austin Maness
In many cases, privately-owned companies want to increase their level of growth without taking on debt or going public. If, for example, a company decides to scale up its operations, it can look to bring in private investors as a way to finance the expansion. When this happens, the business first decides how much capital it needs to raise and at what entry price. The company begins by working with a securities attorney to structure the offering. This is very different from an initial public offering (IPO), where anyone in the public can purchase equity (stock) in the company. A securities offering exempt from registration with the Securities and Exchange commission (SEC) is sometimes referred to as a private placement.
A private placement is a capital raising event that involves the sale of securities to a relatively small number of select investors. Investors involved in private placements range from large intuitional investors such as insurance companies, hedge funds, or pension funds down to smaller individual investors or family offices. A private placement is different from a public offering in which securities are made available for sale on the open market to any type of investor. Under the federal securities laws, a company may not offer or sell securities unless the offering has been registered with the SEC or an exemption from registration is available. After compliance is met, the offering is circulated among a specific number of interested parties, sometimes chosen by the company itself.
Generally speaking, private placements are not subject to some of the laws and regulations that are designed to protect investors, such as the comprehensive disclosure requirements that apply to registered offerings. When reviewing private placement documents, you may see a reference to Regulation D. Regulation D includes three SEC rules—Rules 504, 505 and 506—that issuers often rely on to sell securities in unregistered offerings. The entity selling the securities is commonly referred to as the issuer. Each rule has specific requirements that the issuer must meet.
Private Placement Memorandum
A private placement memorandum (PPM) is a legal document that states the objectives, risks, and terms of an investment involved with a private placement. This document includes items such as a company's financial statements, management biographies, a detailed description of the business operations, eligible investor criteria and more. A PPM serves to provide buyers with essential information on the offering and to protect the sellers from the liability associated with selling unregistered securities. PPMs are similar to prospectuses but are for private placements, while prospectuses are for publicly traded issues. The document almost always includes or is accompanied by a subscription agreement, which constitutes a legal contract between the issuing company and the investor.
Business plans and a PPM serve different functions. A business plan is primarily a marketing document created to promote the company. It purposely contains forward-looking information, such as market demand, customer profiles, growth opportunities, competitive landscape, revenue channels, and potential strategic partners. A PPM is primarily a disclosure document that is descriptive but not persuasive in style and allows the investor to decide on the merits of the investment. The presentation of the PPM is more factual and concrete and must address external and internal risks facing the company. A well drafted PPM will balance disclosure requirements with marketing elements designed to sell the deal.
Conducting Due Diligence
Due diligence is an investigation or audit of a potential investment to confirm all facts, such as reviewing all financial records, plus anything else deemed material to the offering. It refers to the care a reasonable person should take before entering into an agreement or a financial transaction with another party. In regards to investments, due diligence is performed by companies seeking to make acquisitions, by equity research analysts, by fund managers, broker-dealers, and of course by investors. Broker-dealers are legally obligated to conduct due diligence on a security before selling it. This prevents them from being held liable for non-disclosure of pertinent information.
As an individual investor, you may be offered an opportunity to invest in an unregistered offering. You’ve possibly been told by a broker, friend or relative that you are being given an exclusive opportunity, or may have seen a website or online advertisement regarding the opportunity. The securities involved could be, among other things, common or preferred stock, limited partnerships interests, a membership interest in a limited liability company, or an investment product such as a note or bond. Keep in mind that private placements can be very risky and any investment may be difficult, if not virtually impossible to sell. A private placement has minimal regulatory requirements and standards that it must abide by. While it is a capital raising event involving the sale of securities, it is a method of capital raising that does not have to be registered with the SEC. Unlike registered offerings in which certain information is required to be disclosed, investors in private placements are generally on their own in obtaining the information they need to make an informed investment decision. Investors need to fully understand what they are investing in and fully appreciate what risks are involved.