What Is the Meaning of Private Placement of Shares?

While splashy public stock offerings seem to get all the attention, thousands of companies sell stock without actually "going public." They do so with private placement -- the sale of shares to a small, select group of investors, free from most government securities regulations. Buying privately placed shares is a strategy that might be best left to sophisticated investors. In fact, "sophisticated" investors may be the only ones who are even allowed to buy them.

Public Offering Versus Private Placement

The defining characteristic of a public stock offering is that it's, well, public. The company lists its stock on an exchange, and once the company goes public, just about anyone can buy and sell its shares. In a private placement, by contrast, the stock doesn't trade on open markets. The company sells shares directly to specifically chosen investors, and those investors can resell their shares only under certain circumstances outlined in federal regulations.

Reasons for Private Placements

The big advantage of private placements is that companies can do them quickly and with a minimum of regulatory paperwork. When a company wants to sell stock to the public, it must register that stock with the U.S. Securities and Exchange Commission. That involves filing stacks of documents, disclosing all kinds of financial information that the company might prefer to keep under its hat, paying hefty underwriting fees and enduring lengthy delays as regulators, underwriters and others sign off on the offering. With a private placement, the company can pretty much sell stock as soon as it's ready, and it doesn't even have to report the sale to the SEC until after the stock has gone out the door.

Regulation D

To privately place its stock, a company must qualify for an exemption to the SEC registration requirement. Criteria for those exemptions are spelled out in an SEC rule that goes by the vaguely pharmaceutical-sounding name of Regulation D. For example, the exemption described in Section 506 of the regulation allows a company to raise an unlimited amount of money through private placement if it meets several criteria. First, it can't advertise the stock or send out a general solicitation for investors. Second, stock can be sold only to investors -- institutions or individuals -- whose experience, wealth or position makes them sophisticated enough to understand the risks. There are federal guidelines for determining who is "accredited" or "sophisticated" and who is not. Third, companies must provide financial information to the investors and be available to answer their questions. Finally, the investors usually can't resell their stock for a year.

What's in It for Investors

If you can get your hands on them -- you are "sophisticated," right? -- privately placed shares offer both benefits and risks. The big benefit is the potential for higher returns than you would get from stock from a public offering. These companies tend to be younger, with higher growth potential. The downside of young companies, of course, is that they have limited track records and may not be able to translate promise into consistent profits. Other risks stem from the fact that these companies aren't subject to the regulatory oversight and public scrutiny that accompany public offerings. Major problems with the company may remain hidden. Also, investors who want to "get out" may not be permitted to sell their shares -- and even if they are, there might not be a market for the shares, as they don't trade on an exchange.

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