What are Private Placements?

Private Placements 101: A Guide to Offerings, Rules, and Private Placement Memorandums

Private placements are securities offerings exempt from full SEC registration requirements. Placements are often made by the company issuing stock or by an underwriter. The offering may be debt or equity.

How Private Placements are Governed

Private placements are not an asset class. They are a non-public capital-raising technique. With them, non-institutional private capital sources — mainly individuals — raise capital. You see private placements in private equity, venture capital, and some tangible assets. 

A multitude of state and federal laws and regulations govern private placements, including:

• The Securities Act of 1933, which governs the issuance of securities by companies
• The Securities Exchange Act of 1934, which governs trading, buying, and selling those securities.
• Regulations derived from the 1933 and 1934 Securities Acts, promulgated by the Securities and Exchange Commission — especially Regulation D (see below)
• Regulations promulgated by the Financial Industry Regulatory Authority and the various stock exchanges
• State securities laws and regulations, known as blue sky laws, administered by the various state securities commissions
• The JOBS Act of 2012

There are placements of tens or hundreds of millions of dollars. But this article focuses on placement alternatives that can raise $5 million or less in a single year.

[Editors’ Note: As of January 2019, bipartisan support continues for the JOBS Act 3.0. The House of Representatives passed the act, but it failed in the Senate. The deregulatory act aimed to ease the way for small businesses to raise capital from ordinary investors. The legislation included private offering reforms, including redefining accredited investors. There has not been further progress.]

What Are Private Placement Securities

In a private placement, both federal and state securities law consider shares of stock or debt instruments to be securities. Transactions involving shares or debt must be registered or be exempt from registration.

The offeror is often an emerging growth company that has few capital alternatives. More mature companies tend to be more successful in this process. Securities laws generally require that offers are made mainly to accredited investors.

There are 2 types of private placement offerings:

• Private Placement Equity Offering — The company sells partial ownership via stock or a membership unit. Generally, early-stage companies prefer equity offerings because there is no set repayment schedule.

• Private Placement Debt Offering — The company sells a note instrument to investors. It has a set annual rate of return and a maturity date when the funds will be paid back in full. A debt offering is like a business loan, but investors, not institutions, provide the financing.

Private placements are exempt from full SEC registration, but they must comply with federal and state regulations. The most important private placement rules fall under Regulation D.

Regulation D: Private Placement Rules and Exemptions

Reg D is a series of six rules. Rules 501-506 establish 3 exemptions from the registration requirements of the 1933 Act. Rules 501-503 describe general definitions, terms, and conditions. Specific exemptions are set out in Rules 504-506.

Rule 504

Rule 504 is the most popular of the Reg D rules. Raising capital for a small business can be expensive and time consuming. Private placement under Rule 504 can minimize costs and delays while giving the issuer access to debt or equity capital.

In a Rule 504 offering, a business can raise a maximum of $1 million in any year. Rule 504 has

• No prescribed disclosure requirements
• No limit on the number of purchasers
• No investor sophistication standards

Offerings exempt under Rule 504 are simpler to prepare. Therefore, they can be undertaken by the offeror without substantial outside professional expenses. The JOBS Act of 2012 allows offerings to be made through general solicitation or advertising.

Rule 504 does not mandate the offeror to provide specified disclosure to purchasers. However, the offeror must provide enough information to meet the full disclosure obligations under the anti-fraud provisions of the securities laws.

Rule 505

A Rule 505 offering may not exceed $5 million in any given 12-month period. This exemption limits the number of non-accredited investors to 35 with no investor sophistication standards and no limit on accredited investors. The SEC adopted Rule 505 to give small businesses more flexibility in raising capital.

If only accredited investors are involved in the offering, there is no specific information the issuer must furnish. If the offering involves non-accredited persons, the issuer must furnish all purchasers with the information specified by Regulation D. As with a 504 offering prior to the JOBS Act of 2012, this offering could not be made by means of general solicitation or advertising.

For Rule 505 offerings over $2 million, financial statement conditions include the following:

• Only financial statements for the most recent fiscal year need be certified by an independent public accountant.
• If an issuer other than a limited partnership cannot obtain audited financial statements without unreasonable effort or expense, only the issuer’s balance sheet must be audited. That balance sheet must be dated within 120 days of the start of the offering.
• Limited partnerships unable to obtain required financial statements without unreasonable effort or expense may furnish financial statements prepared on the basis of federal income tax requirements. They must be examined and reported on by an independent public or certified accountant in accordance with generally accepted auditing standards.
• The issuer must also be available to answer questions by prospective purchasers about the issuer or the offering.

Rule 506

Rule 506 provides an exemption for limited offers and sales. There is no ceiling on the amount of money which may be raised. The JOBS Act of 2012 permits general solicitation and advertising. There is no limit to the number of accredited investors, but the number of non-accredited investors may not exceed 35.  However, the issuer must furnish information specified by Regulation D unless all investors are accredited.

Rule 506 requires detailed disclosure of information to potential investors; the extent of disclosure depends on the dollar size of the offering. For offerings over $2 million, the issuer must provide audited financial statements. Offerings under $2 million follow Reg A as a guide, with an additional requirement for a certified balance sheet.

The securities sold are restricted under the same stipulations in Rules 504 and 505. A company is required to file a notice of the offering on Form D at SEC headquarters within 15 days of the first sale in the offering. There is no requirement to file the offering memorandum with the SEC.

Here are some important compliance features of Regulation D:

• No offerings are exempt from the anti-fraud and civil liability provisions of the various federal securities laws.
• Issuers are obligated to provide information needed to avoid making disclosures misleading.
• Regulation D provides transactional exemptions to issuers only. An investor whose purchase was exempt from registration cannot resell their interest without establishing an independent basis of exemption.

Table 1: Summary of Private Placements Characteristics, Per Reg D

Documents to Support a Private Placement

The following documents are needed to raise private financing from investors.

Private Placement Memorandum

A private placement memorandum (PPM) provides critical details about the offering. Note that this differs from a business plan, which does not provide information about the technical structure of an offering. A PPM is used to raise capital from a number of investors instead of trying to find one with the entire amount of required capital.

The PPM outlines information such as:

• Purchase price per note
• Number of shares or notes being sold
• Maturity date
• Rate of return
• Risk factors

Additional Private Placement Documents

• Subscription agreement sets forth terms and conditions of the investment. The investor executes this document and attaches a check.
• Promissory note agreement (for debt only) is the actual loan agreement between the investor and the company.
• Form D SEC Filing is the notification sent to the SEC in Washington, DC. It notifies the SEC that the issuer is using the Regulation D program and provides basic information on the company and the offering. It is not an approval document.

Types of Private Placement Offerings

Regulation D Equity Offering

An equity offering lists the securities authorized and offered by the issuer. Also, it describes the use of proceeds. Purchasers of these securities are almost always minority investors; this creates a liquidity risk and minority rights issues that should be strongly considered. Offerees should seek legal assistance before making such an investment.

Regulation D Debt Offering

A debt offering involves the sale of a promissory note to investors. The note sets forth terms and conditions of the loan arrangement between the company and the investor. It describes the interest rate, payment periods, and maturity date.

Notes are sold in fractional amounts providing investor flexibility. For example, in a debt offering, a company raises $1,000,000 which might involve the sale of 20 notes at $50,000 per note.

Red Flags and Expectations for Investors

When private placements fail, it is usually because the offeror does not present the market with a security that promises enough return for the risk, or the investors cannot ascertain the risk of the investment.

Most of these offerors are small companies with unproven business models. It is reasonable for investors to expect 25% to 35% effective returns on their investments. Individual investors cannot measure the risk of most private placements. Blue-sky laws protect individual investors from themselves.

Here are some questions to ask offerors before you consider investing in a private placement:

• What problem or need does the product or service address?
• How many competitors are already in the marketplace?
• Who are potential customers and how will they be reached?
• How will management deliver the business plan?
• What does the investor get for his or her investment?

Final Caution for Investors

Offerors should treat all investors at arm’s length, even if the offering is targeted mainly at family and friends. There should be no special deal offered to some investors that isn’t offered to all.

[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can listen to at your leisure and each includes a comprehensive customer PowerPoint about the topic):

• Private Offering Exemptions and Private Placements, 
• Private Offering Exemptions and Private Placements 2
• Securities Law,  An Overview

This is an updated version of an article originally published in February 2013 and was previously updated on June 21, 2019. It has been updated by Maryan Pelland.]

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