Updated July 21, 2023
Introduction to Private Placement
Private Placement is the offering of shares or bonds by companies to accredited investors directly instead of placing them in the market for the public. This is an extremely popular way to generate finance for private companies at the initial growth stage.
It is done by companies who need money to finance their business but are not eligible enough to list their companies in Stock Market. Private companies prepare a presentation for accredited investors who have business knowledge and thoroughly analyze the company before investing. Private Equity funds are the main players in this segment. They have the cash and are ready to invest in companies with high prospects.
Purpose of Private Placement
The primary objective is to generate funding from affluent individuals, institutions, and banks, bypassing the arduous legal and documentation procedures typically involved in raising public funding. This method offers significantly less transparency and lacks the restrictive regulations necessitating disclosure of company operations to the public. Private placements in the US benefit from exemptions in disclosure requirements, enabling companies to raise funds through the issuance of a private placement memorandum without making it accessible to the general public. Consequently, the relaxed nature of private placement renders it an appealing option.
Example of Private Placement
During the 2008 financial crisis, when Investment banks faced the risk of collapse following the Lehman Brothers’ downfall caused by the Sub-Prime Mortgage crisis, Goldman Sachs approached Warren Buffet to offer a 5% stake. Warren Buffet’s investment, made through a private placement, instilled market confidence and attracted additional investors to support Goldman Sachs, ultimately saving the company from potential failure. This demonstrates that private and public companies can also resort to private placements when necessary.
Uses of Private Placement
- Stage 1 investing involves providing funding to companies in their initial stages and have not yet started operations. For instance, a group of individuals planning to work on alternative energy may require funding to establish a company and carry out further research.
- Private placement is the method used to secure investment during this stage of the business cycle. Accredited investors know the business and the company and are approached for funding.
- Private Equity funds comprise highly skilled experts from various fields, making them exceptionally sophisticated. These funds possess the knowledge and connections necessary to facilitate the success of any company they invest in.
- Accepting funding from Private Equity through Private Placement proves advantageous for private companies. The infusion of capital from these funds aids in the company’s growth by leveraging their in-house expertise.
- Private companies must actively cultivate a positive environment and generate innovative ideas to attract funding. This is essential as accredited investors will expect the company to demonstrate its potential and align with their investment goals.
Private Placement vs Private Equity
Private equity firms invest in private placements, which involve companies generating funds with limited legal documentation. They act as investors, providing capital to private businesses with the expectation of generating higher returns by selling the company when it becomes successful. Thus, the relationship between private equity and private placement is that private equity firms actively invest in private placements as lenders.
Advantages and Disadvantages of Private Placement
- Small companies planning to grow and not meeting the requirements for listing on an exchange find it advantageous due to the minimal documentation and disclosure it entails.
- Private equity funds provide small businesses with valuable benefits as they come equipped with expert teams that actively assist in their growth.
- The process of raising money through Private placement is much faster than raising money through a public offering, as lots of legal procedures need to be followed during the public offering.
- During the start-up phase, the Idea is new, so the competition is huge. In a public offering, there is a huge requirement for disclosure to the public regarding the planning and documentation of the company. This may lead to the leakage of ideas. So this kind of guarantees finances without leakage.
- The cost of maintaining a public company is huge as there needs to be a board set up for shareholders and separate teams for audit, capital budgeting, and deciding executive payment structures. The disclosures are done quarterly, which is expensive and acts against confidentiality. It lets the company remain private, so additional costs are saved.
- As the investment in a private company is illiquid, so the investor may ask for greater returns than what is prevailing in the market. So if bonds are issued in a private placement, then investors may ask for greater interest than what is prevailing in the market. In case of equity shares being issued as a private placement, the investor may ask for a higher dividend.
- Investors who participate in this may demand for higher ownership and, in turn, will indulge in the decision-making process. This may be difficult for management to make independent decisions.
It is extremely popular for budding companies that can’t generate capital through public issues. Many companies have flourished from these placement investments, as they are easy to avail of and don’t force new companies to disclose plans for the future. As the company lies with the management, so the management doesn’t have to bother about the share price all the time. He can make decisions for the long-term good of the company.
This is a guide to Private Placement. Here we also discuss the introduction to private placement, its purpose, uses, advantages, and disadvantages. You may also have a look at the following articles to learn more –