What Is A Private Placement?

Working with investors to generate capital is key to the success of many companies and businesses. When raising capital for your business, you may consider offering private placements to potential investors, but first you must understand what private placements are and how they work. 

A private placement is a sale of securities to a select group of investors in compliance with specific federal securities laws that permit such sales without the registration of the securities offering with the Securities and Exchange Commission (“SEC”). That’s an awful lot of technical language, so let’s break that apart. The word private is used because the offering is not registered with the SEC. In other words, it’s not a public offering (i.e., what’s commonly referred to as “going public”). By default, all securities offerings must be registered, and therefore are considered to be public, unless an exemption from the default registration rule can be met (more on that below in the next section).

Next, the word placement means sale. So, to place a security with an investor is to sell that security to that investor. Either the company issuing the security or a broker acting on behalf of the issuing company can sell that security.

That takes us to the meaning of security, which is a more loaded term. A security is an investment of money where the investor is led to expect profits from the efforts of others. That is a simpler way of stating the more formal legal definition, which, in turn, is replete with additional defined terms. The definition in this paragraph captures the most important elements, at least for the purpose of this article, so as not to make things too unnecessarily confusing.

Having defined all of “private,” “placement,” and “securities,” what’s left is to identify and explain the specific federal securities laws that permit the sales of private placements in the first place.

Regulation D (Reg. D) and Rule 506

Regulation D (“Reg. D”) is a federal regulation that contains rules — Rules 504, 505, and 506 — setting forth specific requirements that an issuer can meet in order to qualify for an exemption under federal securities laws. Of Rules 504, 505, and 506, Rule 506 — in particular Rule 506(b) — is the most relied upon rule under Reg. D for the purpose of qualifying for an exemption. 

Under Rule 506(b), an issuer may raise an unlimited amount of funds from investors if the issuer does not engage in any general solicitation of investors or general advertising, and if the issuer files Form D with the SEC not later than 15 days after the first sale of securities under the offering. The investors can include an unlimited number of accredited investors and up to 35 non-accredited investors, as long as those investors are sophisticated, which means that the investors must have sufficient knowledge and experience in financial and business matters to evaluate the issuer and its business. However, in practice, Rule 506(b) offerings are usually limited to only accredited investors so that issuing companies do not jeopardize the entire capital raise by having a single unqualified investor, since the word sophisticated can be subject to interpretation.

The securities sold under a Rule 506(b) private placement offering are restricted securities, which means that the investor receiving the securities should expect to hold the securities indefinitely. 506(b) private placements often require that investors review and sign a robust private placement memorandum (PPM), which, among other things, sets forth explicit prohibitions on the transfer of the securities.

Typical Documentation

In addition to a PPM, 506(b) private placement offerings also typically require investors to review and sign accredited investor questionnaires and subscription agreements. Issuing companies prepare these documents with the advice and assistance of legal counsel. The PPM is a long document that sets forth in detail ample risk disclosures by the issuing company. It also provides a summary of the company’s products or services, its financials, key officers and their backgrounds, and the intended use of the funds.

The accredited investor questionnaire is a shorter document that requires the investor to identify how the investor qualifies as being accredited, which is another way of saying wealthy enough to make the investment. The subscription agreement is the contract signed by the investor to purchase the securities; it sets forth additional risk disclosures by the company, contains investment representations by the investor, and explains the terms of the investor’s investment — that is, the dollar amount and number of shares.

Other Filings

Apart from Form D, which must be filed with the SEC, state filings also must be made. Each state has its own securities laws. For every state in which an investor is located, the issuing company must ensure to comply with that state’s securities laws. Most states simply require the payment of a fee and the filing of a courtesy copy of the filed Form D. However, some states, such as New York, are notorious in their difficult and cumbersome filing requirements.

Overall, the documentation and filing requirements for conducting a private placement require a great deal of time and money. Companies conduct such offerings because the offerings give the companies access to additional capital from wealthy investors. Investors, on the other hand, make such investments with the expectation of possibly receiving great returns, while agreeing to take on the high risk of, in a worst case scenario, losing the entire investment. For business owners and companies ready to invest sufficient initial resources in the process, private placements can be a smart and effective way of raising capital.