What Is Private Placement?
A Private Placement is a process whereby stocks are sold privately to investors selected beforehand. In the process, the respective stocks are not put for sale in an open market and are only accessible to those who have already been chosen based on certain criteria.
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This group of accredited investorsAccredited InvestorsAccredited investor refers to a person who has been granted special status under financial regulation laws, allowing him to trade in securities that have not been registered with the regulatory authorities, and it usually involves high-net-worth individuals, brokers, trusts, banks, and insurance companies.read more includes wealthy individuals, financial institutions, insurance firms, etc. Though the private placement program, like the Initial Public Offering (IPO), involves the purchase and sale of securities, it does not have stricter rules and regulations related to stock transactions.
Table of contents
- What Is Private Placement?
- Private Placement Explained
- Types
- Features
- Rules & Requirements
- Example
- Advantages & Disadvantages
- Private Placement vs Preferential Allotments vs Public Offering vs Rights Issue
- Frequently Asked Questions (FAQs)
- Recommended Articles
Key Takeaways
- Private placement of shares refers to the sale of company shares to the investors and institutions selected by the company, also called accredited investors.
- The company calls for such investors, which they choose based on certain metrics. They can be wealthy individuals, financial institutions, etc.
- It is not issued in the open market for the public. Hence, it has fewer regulatory requirements.
- It helps diversify fundraising, but finding a suitable investor is difficult. Investors often exhibit higher demands and charge higher interest rates too.
Private Placement Explained
The private placement of shares is a stock or securities distribution strategy in which the companies sell assets to pre-decided investors. Also known as a non-public offering, these are an effective alternative to IPOs that help companies raise funds in exchange for the share in profits they earn. The investors invited for this privately-held sale are wealthy individuals and entities, mutual fund providers, insurance companies, and banking and financial institutions.
The privately sold assets offered to accredited investors fulfill the required eligibility criteria and meet a certain threshold of financial net worthNet WorthThe company's net worth can be calculated using two methods: the first is to subtract total liabilities from total assets, and the second is to add the company's share capital (both equity and preference) as well as reserves and surplus.read more. They have more experience in making investments and prudent financial decisions. The companies invite only those investors for such schemes who could afford to take risks and bear losses that may arise from such an investment.
One of the major reasons that make investors accept this invitation is the lenient rules and regulations. Unlike IPO, privately sold securities have fewer regulatory requirements to fulfill, making it an easier investment option. In addition, such placement of shares, if done by a private company, does not affect the share price as they are not listed publicly. However, for a publicly listed company, such securities distribution leads to a share price decline, at least in the near term.
Types
The meaning of private placement could be better understood by exploring the types of such distributions found in the market. Preferential allotment and qualified institutional placement are the two significant types of it.
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Preferential allotment allows the distribution of stocks and bonds to a preferred group of investors. These accredited individuals and entities include mutual fund companies, financial institutions, etc. On the contrary, qualified institutional placement includes institutional investors that meet the eligibility criteria per the US regulations.
Features
The distribution of shares done privately has many features, which are the reason investors await such invitations. These options are specifically kept aside for the chosen investors and hence offer the company the entire control to deal with them. The maturity periods of the securities are extended to a significant period, and the fluctuation in the market conditions does not affect the interest rate applicable for these non-public offerings.
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As discussed above, the regulatory requirement to meet is lenient, and the cost involves a one-time cost for the investors to pay. Overall, the process of distribution is faster than IPO. Hence, investors are always willing to invest in these deals.
Rules & Requirements
Regulation D of the US Securities and Exchange Commission (SEC) rules and guides the private placement of shares. This regulation allows firms to sell the assets to accredited or selected investors only. Once the investors are in, the companies issue them the private placement memorandum.
The commission has recently changed the definition of accredited investors who are offered a chance to buy stocks and securities privately. In August 2020, SEC added the following points to the existing definition of such investors:
- Any individual or a married couple or anyone equivalent to a spouse possessing a net worth of at least $1 million with the cost of their primary residence remaining excluded while calculating could be an accredited investor, or
- An individual with a minimum income of $200,000, or
- A married couple with a minimum combined income of $300,000 per record of the last two years as well as for the current year, and
- An individual with specific professional certifications or credentials or designations obtained from an accredited education or professional institution as recognized per SEC’s order from time to time, along with individuals holding a significant position in accordance with Series 7, Series 65, and Series 82 licenses.
Example
Let us consider the following example to understand how issuing private placement memorandum works:
Company A has been suffering from a financial crisis for a few months. However, it plans to sell some of its shares to raise funds quickly to pay its debts. It decides not to invite all investors as it will likely consume more time. Thus, it selects trustworthy investors and sends them invitations to buy its shares. Most of them agree to purchase its shares, given the company’s past performances. This helps Company A pay off all its debts without consuming much time.
Advantages & Disadvantages
Private distribution of shares has its own set of advantages and disadvantages, given the opportunity to raise funds that organizations receive and the difficulty that companies face in finding a suitable investor. Let us have a look at the pros and cons of the concept:
| Pros | Cons |
|---|---|
| Maturities extend for longer, hence returns are long-term | Finding suitable investors is difficult |
| The process of investing and raising funds is faster. | The buyers are more demanding as they expect higher rates of returns. |
| Fewer regulatory requirements | |
| Investors are pre-decided | |
| An easier way of raising funds than an IPO |
Private Placement vs Preferential Allotments vs Public Offering vs Rights Issue
Private placement and preferential allotments sound similar, with the latter being part of the former. However, these two differ in certain terms. In addition, the private selling of securities is also different from a public offering and rights issue, which are also major types of distribution of shares amongst investors. Let us find out how private placements differ from preferential allotments, public offerings, and rights issues.
- A preferential allotment is a scenario in which private placement acts as a mode of share distribution.
- While the latter finds significance with respect to all kinds of securities, the former only deals with equity shares and convertible securities.
- Public offering refers to the sale of shares in an open market where the securities are accessible to all interested investors. On the contrary, the private or non-public offering is the distribution strategy in which companies sell shares to invited investors privately.
- While in the case of rights issues, firms send invitations to a large group of investors, the private placement of shares involves inviting only a selected group of investors for the private selling of securities.
Frequently Asked Questions (FAQs)
This distribution strategy is considered good, given the faster raising of funds, it ensures to a company. In addition, the maturities extend to a longer period, guaranteeing long-term returns. However, finding suitable investors to invite for the purpose could be tough as they might not meet the requirement per SEC or might possess a higher rate of return demands.
Yes, private and public firms can adopt this distribution strategy. However, the companies require approval from their shareholders before extending invitations to suitable investors. However, the stocks decided for private sale cannot be publicly issued.
Once the companies know whom to sell the stocks privately, and the accredited investors are ready to buy those shares, the former issues this memorandum to confirm the deal and take the transaction forward.
Recommended Articles
This has been a guide to what is Private Placement & its meaning. Here, we explain the types, features, rules and requirements, and pros & cons along with an example. You may also have a look at the following articles on Corporate Finance –
- Pledged Shares
- Public-Private Partnership
- Reverse Stock Split
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