background
Welcome to Wall Street Prep! Use code at checkout for 15% off.
Wharton & Wall Street Prep Certificates
Now Enrolling for September 2024 for September 2024
:
Private EquityReal Estate Investing
Buy-Side InvestingFP&A
Wharton & Wall Street Prep Certificates:
Enrollment for September 2024 is Open
Wall Street Prep

Private Placement

Step-by-Step Guide to Understanding the Private Placement Transaction Structure

Last Updated September 10, 2023

Learn Online Now

Private Placement

What is the Definition of Private Placement?

A private placement, often referred to as a “non-public offering”, describes the sale of securities to a relatively small group of investors.

The participating investors are most often institutional investors such as pension funds, mutual funds and insurance companies.

Unlike an initial public offering (IPO), where the shares offered trade in the secondary markets post-issuance, the securities sold in private placements are purchased by only a select few investors.

So, why would a company do a private placement?

The regulatory rules and disclosure requirements are not as stringent in the case of a private placement because a private offering is registered with the SEC via Regulation D, placing far less compliance and reporting obligations on the underlying issuer.

Since the securities offered are not available to the general public—as with traditional public offerings—the private placement process is not subject to the same regulatory requirements.

Therefore, private placements can be a more convenient, quicker method for companies to raise capital in comparison to public offerings, resulting in less fees.

What is a Private Placement

What is a Private Placement? (Source: SEC Investor Bulletin)

How Does a Private Placement Work?

Private placement transactions vary based on their unique circumstantial specifics, yet the general high-level steps – aside from the Regulation D filing – that most companies undergo are as follows.

  1. Quantify Capital Raise Target → The first step of a private placement is for the company, along with an advisor, to evaluate its capital needs. The process of establishing a target for the capital raise requires understanding the approximate amount of funding the company needs and where the funds will be allocated.
  2. Identify Potential Investors → Once the amount of capital to raise has been determined, the company must identify potential investors, which will consist of primarily institutional investors.
  3. Prepare Offering Memorandum (PPM) → To convince potential investors, the company must put together an offering memorandum, or private placement memorandum (PPM), a document created for marketability purposes. The offering memorandum includes specific details about the company, its business model, financial statements, details regarding the security being offered, the anticipated use of the proceeds, and risk factors associated with the capital raise.
  4. Investor Presentations → The offering is pitched to potential investors, most often in a presentation format, i.e. via “closed door”, group meetings. The objective here is to convince potential investors that the opportunity at hand is a sound investment that can yield a return that is enough for the risk undertaken.
  5. Due Diligence Phase → After each presentation, each investor will conduct its own due diligence on the proposal, which is a process that differs by each firm but revolves around reviewing the offering memorandum, pro forma financial statements, and other relevant financial data to evaluate the risk/return trade-off.
  6. Finalize Capital Raise → Once the list of committed investors is collected, the terms of the investment are finalized. In particular, the terms of most importance are the pricing ascribed to the securities and the total number of securities to be issued.
  7. Funds Transfer → In the final step, funds are formally transferred from the investors to the company (and securities are issued to the investors) once the terms are agreed upon by both sides.

Based on the specific terms and conditions of the arrangement, the company will now have reporting requirements to their new investors, which at a bare minimum, consists of periodic updates on their recent financial performance going forward.

Regulation D Filing

Regulation D Offerings (Source: SEC.gov)

Private Placement vs. IPO: What is the Difference?

Private placements and IPOs are two distinct methods for companies to raise capital from investors.

Initial Public Offering (IPO):

  1. Participation of General Public → In an IPO, the issued shares are listed on a stock exchange and can be traded openly in the secondary markets among the general public.
  2. SEC Regulations → IPOs are highly regulated transactions that require a formal registration with the Securities and Exchange Commission (SEC). Often, undergoing an IPO—i.e. “going public”—is a time-consuming process, in which the company must submit a detailed prospectus (S-1) detailing the company’s business, financial situation and rationale for the capital raise.
  3. Costly, Time Consuming Process → Given the regulatory requirements and more active involvement of third party advisors, such as investment banks and lawyers, IPOs can be time-consuming to complete (and are thus known for being quite costly at times).
  4. Transparency → As part of going public through an IPO, the company must disclose material information to the public, making its confidential details surrounding its business model, financials and strategy far more transparent to the general public, including to competitors.
  5. Liquidity → Once a company’s shares are publicly listed post-IPO, those securities possess more liquidity as they can be easily bought and sold, assuming the initial lock-up period has passed.

Private Placement (Non-Public Offering):

  1. Limited Participation → In a private placement, the securities are sold to a select group of investors rather than to the general public.
  2. Less Regulation → Private placement offerings are less regulated than IPOs with fewer SEC registration requirements, i.e. less strict criteria.
  3. Convenient Process → Private placements can be completed quicker and are less costly to execute relative to IPOs, which is attributable to the lower burden from regulatory filing requirements.
  4. More Privacy → Contrary to a public offering, the issuer is under no obligation to disclose its confidential information to the general public in a private placement.
  5. Less Liquidity → Because the securities bought in a private placement are typically not publicly traded, such investments are not as liquid as those offered in an IPO. The difference in liquidity between IPOs and private placements is a critical factor that determines the types of investors that decide to participate.

What are the Pros and Cons of Private Placements?

Private Placement Pros:

  1. Quicker Process → Generally, the necessary time until completion for private placements is less relative to other methods to raise capital, namely because the registration process comes with fewer regulatory requirements.
  2. Cost Savings → Since the process is less time-consuming, a private placement can be a less costly option.
  3. Investor Base Flexibility → Companies have more flexibility in choosing their investors, which can be better suited for their long-term strategic business plans.
  4. Maintenance of Control → By deciding who invests based on the alignment of interests, companies can often maintain more control over their shareholder base.
  5. Less Regulatory Oversight → The requirements for regulatory compliance are less strict for private placements compared to public offerings, providing the issuer with more optionality around their long-term strategic initiatives and operating decisions.

Private Placement Cons:

  1. Limited Investor Base → Private placements are only offered to a select group of investors, limiting the potential pool of capital.
  2. Missed Upside → Because private placements are negotiated sales, the risk of raising less capital per security is greater, i.e. more competition tends to drive the price upward (and vice versa).
  3. Ownership Dilution → The existing shareholders on the company’s capitalization table (or “cap table”) are prone to facing dilution in ownership if new shares are issued in the private placement. But the risk of dilution to existing owners can be mitigated more in a private placement, assuming the issuer is private, compared to in public offerings.
  4. Greater Concentration → Since the securities are sold to fewer investors, there is usually more concentration risk from private placements, i.e. more risk of a single investor who ends up with a disproportionate percentage of ownership (and thus, greater say in business matters).
  5. Lack of Liquidity → Securities sold through private placements generally cannot be sold easily on the secondary market, so such issuances are less liquid than publicly listed securities.

In closing, the decision as to whether a private placement is the right choice for a given company is contingent on the specific situation of the issuer, such as its capital need requirements and current state of liquidity.

Step-by-Step Online Course

Everything You Need To Master Financial Modeling

Enroll in The Premium Package: Learn Financial Statement Modeling, DCF, M&A, LBO and Comps. The same training program used at top investment banks.

Enroll Today
Comments
1 Comment
most voted
newest oldest
Inline Feedbacks
View all comments
Private Placement Memorandum
August 22, 2023 9:17 am

Understanding the various aspects of the legal industry can be challenging. This article talks about what a Private Placement is in the legal field. Thanks for sharing!

Learn Financial Modeling Online

Everything you need to master financial and valuation modeling: 3-Statement Modeling, DCF, Comps, M&A and LBO.

Learn More

The Wall Street Prep Quicklesson Series

7 Free Financial Modeling Lessons

Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts.