What Are Private Placements of Shares?
Private placements of a company’s shares are shares of the company’s securities that are not registered with the U.S. Securities and Exchange Commission (SEC). These securities are offered to only a limited group of wealthy investors, and they do not trade freely on any exchange. As a practical matter, this means that you can’t buy and sell private placement shares through your online brokerage account. Because they are high-risk investments, they are often the subject of securities fraud allegations.
Private Placement vs. Public Offering
Typically, companies offer private placements when they need to raise money, but don’t want to engage in an initial public offering (IPO). While these securities are unregistered, it doesn’t mean that they’re unregulated. Private placement offerings are regulated under the SEC’s Regulation D. Regulation D specifies who can invest in unregistered securities like private placements. Regulation D has three specific rules that companies need to meet to sell securities in private placements: Rule 504, Rule 505, and Rule 506. Any one of these rules can apply to the type of private placement investments you’re evaluating. Because the rules vary slightly for each type of private placement, it’s essential to understand what you’re investing in. An experienced financial adviser or securities lawyer can assist you.
Types of Private Placement Offerings and Securities
Types of private placement securities can vary. They can include equity (stocks) and debt (bonds). Public and private companies can raise money through private placements of their securities. Specialty financial vehicles like hedge funds and private equity funds also offer shares to investors through private placements. Under most circumstances, companies and funds offer their private placements under one of three rules or exemptions under Regulation D.
Rule 504 Offerings
Rule 504 allows a company to offer up to one million dollars of securities in any 12-month period to any type of investor. A Rule 504 offering has few restrictions on what type of investor may purchase the privately placed securities. However, these are typically restricted securities, so the rules governing restricted securities will apply.
Rule 505 Offerings
Rule 505 offerings are what investors typically imagine when they think of private placements. Offerings of up to five million dollars in securities can be made under this rule to an unlimited number of accredited investors and up to 35 non-accredited investors. These offerings have more robust disclosure requirements than Rule 504 offerings.
Rule 506 Offerings
Rule 506 is similar to Rule 505 but has to do with how the offering is advertised. Companies can raise an unlimited amount of money relying on one of two Rule 506 exemptions. Through Rule 506(b), a company can sell to an unlimited number of accredited investors but to no more than 35 non-accredited investors. However, in this case, the non-accredited investors in the offering must be financially sophisticated or be represented by a purchaser representative.
Who Can Invest in Private Placements?
As an investor, you may be wondering if you’re eligible to invest in private placements. Because private placements are not subject to the same types of robust disclosure requirements that public offerings must follow, they tend to be riskier investments. As a result, Regulation D limits the types of investors who can invest in private placements.
An “accredited investor” under Regulation D is defined as an investor who meets the following criteria:
- Has a net worth of over one million dollars (either individually or with a spouse); or
- Has earned an income of over $200,000 annually as an individual, or over $300,000 combined with a spouse.
Certain institutions, like trusts, banks, and other private funds, may also qualify as accredited investors under Regulation D. A company has no restrictions on offering private placement shares to accredited investors. Companies can have as many accredited investors as they have shares to sell in a private placement.
A non-accredited investor is anyone who doesn’t meet the criteria for being an accredited investor. Though companies can issue private placement shares to an unlimited number of accredited investors, non-accredited investors are capped at 35. Even as a non-accredited investor, in certain types of private placements, you’ll still need to demonstrate you have enough financial knowledge to participate.
What Are the Pros and Cons of Investing in Private Placements?
As with any risky investment, it’s important to get as much information as possible about a private placement before investing. Unregistered securities can be particularly risky because there may not be a market in which to sell the securities if you need to liquidate them for any reason.
Do Private Placements Have Any Advantages?
Brokers may try to sell you on the advantages of investing in a private placement. Keep in mind that these supposed advantages are usually negated by their inherent risk.
Private placements offer investors:
- The ability to easily invest in different asset classes of quality companies, since even small companies can sell their equity or debt without having to go through a costly IPO or the time-consuming process of getting a bond credit rating;
- Investment in an attractive private company that doesn’t want to go through the hassle of public disclosures or isn’t ready to go through an IPO;
- The ability to purchase a risky investment that is still subject to some regulatory oversight; and
- In some cases, the ability to get to know company management and have hands-on engagement with the company.
These are only some of the advantages of private placements. In your individual case, you may find additional advantages relevant to your personal risk tolerance and circumstances.
Disadvantages of Private Placements
There are also numerous disadvantages to these risky investments. Some disadvantages include:
- The complexity and overwhelming variety of private placement investments—since everything from a small dry-cleaning business to cryptocurrency funds can offer private placements;
- A lack of standardization in disclosures and documentation can leave less experienced investors confused; and
- Scant information offered to investors about the risk of private placement losses.
Even sophisticated, accredited investors can misjudge the risks of private placement losses. Private placements, while regulated, are unregistered, speculative, and often illiquid (meaning you cannot easily sell them).
What Happens for Investors if Private Placements Go Wrong?
While private placements can sometimes make investors a lot of money, they can also potentially rack up serious losses. How can you best protect yourself from private placement losses? Because private placements are unregistered and risky investments, you should be prepared to lose your entire investment if things go wrong. However, being a well-informed potential shareholder can help you understand the risks and responsibilities of investing in private placements.
Understanding the Private Placement Documents
When assessing private placement investments, you should always ask to review the company’s essential documents. Whether you’re considering an investment in a start-up company or an established hedge fund, get as much information as possible. The information in these disclosure documents can protect you from losses and harm. Obtaining and understanding all available disclosures is one of the best ways to help protect yourself in the event something goes wrong with your investment.
Looking at the company’s operating agreement will help you confirm that the company is a legitimate business. You may also want to ask for a certificate of good standing. Both these actions can help protect you from buying shares from a fraudulent business.
Private Placement Memorandum
The private placement memorandum (PPM) is the document that lays out the terms of the private placement offering. This is perhaps the most important disclosure document for you to review when assessing whether a private placement is right for you. The PPM provides specific information about the securities being offered. Additionally, the PPM contains disclosures about investor rights and company responsibilities. An experienced securities lawyer or financial services professional can help you understand the contents of a PPM.
FINRA Suitability Requirements
The Financial Industry Regulatory Authority (FINRA) requires that the broker-dealer investigate a private placement before allowing their brokers to recommend it to investors. According to Regulatory Notice 10-22, their investigation should review:
- the issuer and its management;
- the business prospects of the issuer;
- the assets held by or to be acquired by the issuer;
- the claims being made; and
- the intended use of proceeds of the offering
If you suspect a brokerage firm failed to appropriately investigate a private placement, you may be entitled to recover damages with a suitability dispute.
A subscription agreement is a contract between you and the company for the purchase of shares. Make sure to review this document carefully, as it is a critical document governing your relationship with the company. A securities lawyer who represents investors can help ensure that any subscription agreement you sign is in your best interest.
Accredited Investor Certification
Finally, you should receive an accredited investor form. This form should ask you to certify whether you are an accredited investor or a non-accredited investor. If you don’t receive a form like this, speak with a financial services professional or securities lawyer. Private placements that don’t understand the importance of regulatory requirements may be too risky overall.
Still Trying to Understand a Private Placement? Kurta Law Can Help
With nearly 20 years of experience in securities, Kurta Law advocates on the side of investors. We can work with you to decipher the confusing world of private placements. We can also help if you’re concerned that you’ve been taken advantage of in an unscrupulous private placement scheme. Kurta Law is a nationally recognized team of New York investment fraud lawyers that exclusively represents investors. Please contact Kurta Law if you would like us to evaluate your potential case.