What is a Private Placement under Regulation D or Regulation A of the Securities Act, and how does it work?

The rise of Alternative Investing has attracted investors looking for investment opportunities that are not publicly traded, meaning they sit outside of the traditional markets of stocks, bonds, and cash. One of these alternative opportunities is to invest in startup companies under a private placement offering.

You can find out more about investing in alternatives in our article What are Alternative Investments, and should I have some in my portfolio?

What is a Private Placement?

In the context of startup investing, a private placement means selling shares to specific investors under a private placement memorandum that is not available to the general public on the open market. It is important to note that private placements have fewer regulatory requirements compared to shares sold to the general public on a stock exchange such as the New York Stock Exchange. Private placements are common for startups seeking to raise capital in the early stages of their funding cycles. Startups will target accredited investors, investment banks, financial institutions, or other business groups looking to get in on the ground floor.

The U.S. Securities and Exchange Commission (SEC) in their Regulation D Investor Bulletin notes the following:

A securities offering exempt from registration with the SEC is sometimes referred to as a private placement or an unregistered offering. Under the federal securities laws, a company may not offer or sell securities unless the offering has been registered with the SEC or an exemption from registration is available. Generally speaking, private placements are not subject to some of the laws and regulations that are designed to protect investors, such as the comprehensive disclosure requirements that apply to registered offerings. Private and public companies engage in private placements to raise funds from investors. Hedge funds and other private funds also engage in private placements. As an individual investor, you may be offered an opportunity to invest in an unregistered offering. You may be told that you are being given an exclusive opportunity. The opportunity may come from a broker, acquaintance, friend or relative. You may have seen an advertisement regarding the opportunity. The securities involved may be, among other things, common or preferred stock, limited partnership interests, a membership interest in a limited liability company, or an investment product such as a note or bond. Keep in mind that private placements can be very risky and any investment may be difficult, if not virtually impossible to sell.

The SEC in their Regulation A Investor Bulletin notes the following:

Regulation A allows companies to offer and sell securities to the public, but with more limited disclosure requirements than what is required for publicly reporting companies. In comparison to registered offerings, smaller companies in earlier stages of development may be able to use this rule to more cost-effectively raise money.

Exemptions under Regulation D and Regulation A of the Securities Act

There are a number of exemptions available for private placements as detailed by the SEC. A summary table of all the exemptions has been prepared by the SEC in their Overview of Capital-Raising Exemptions . For the purposes of this article and in the context of private placements for investments in startups, the following table has been extracted from information provided by the SEC. Note there are some other exemptions available which have not been included in this extract, such as crowdfunding, intrastate exemptions, small capital raises, and re-selling of private securities — the details of those can be found in the SEC source table at the link above.

How Does a Private Placement Work?

A Private Placement for a startup is a capital raise that involves selling stock to selected private investors under a private offering that satisfies an exemption under SEC Regulation D or Regulation A. The company issuing the stock must identify the relevant exemption and ensure that it satisfies the relevant conditions such as investor requirements.

The two exemptions under SEC’s Rule 506 of Regulation D allow companies to sell shares without registering the offering with the SEC, as follows:

• Rule 506(b) allows a “safe harbor” under Section 4(a)(2) of the Securities Act, provided a company satisfies certain requirements, including no solicitation (advertising) to market the stock, and selling only to an unlimited number of “ “ and up to 35 sophisticated but non-accredited investors.
• Rule 506(c) allows a company to solicit and advertise the offering to pre-selected investors, provided they comply with certain requirements, including all investors in the offering being accredited investors.

The two exemptions under Regulation A allows companies to sell shares to non-accredited investors without registering the offering with the SEC, as described below:

• Tier 1, for offerings of up to $20 million in a 12-month period
• Tier 2, for offerings of up to $75 million in a 12-month period

Certain basic requirements apply to both the Tier 1 and Tier 2 offerings. These include requirements for disclosure, company eligibility, bad actor disqualification provisions, and more. Tier 2 offerings have additional requirements, such as limitations on how much a non-accredited investor can invest, the need for audited financial statements, and filing reports on an ongoing basis. Regulation A offerings are available to a wider audience than Regulation D offerings because they are accessible by non-accredited investors. However, because of this accessibility, Regulation A offerings are more restrictive and more onerous in terms of compliance than Regulation D offerings. A Regulation A offering can be considered as somewhere between an Initial Public Offering (IPO) and a crowdfunding offering. It is available to the general public but there is more documentation required than a crowdfunding offering, although less documentation than required for an IPO.

Private placements are often used by startups because they provide access to capital from selected investors without the onerous disclosure and registration requirements associated with the sale of stock to general investors under an IPO.

Even though private placements are less regulated than an IPO, anti-fraud rules always apply to protect investors. However, the offering documents can vary a great deal, so it is important to understand the terms of the investment. Some information on terms can be found in our articles What is a Term Sheet and how is it used in startup investing? and What is a Private Placement Memorandum and how does it work?

Conclusion

Startups seeking to raise capital can do so by selling stock to private investors under a private placement offering that complies with relevant exemption requirements under SEC Regulation D or Regulation A of the Securities Act. Private placements provide suitable investors with an opportunity to access alternative investments such as shares in emerging startups before they reach the initial public offering (IPO) stage.

If you are interested in building your portfolio by adding investments in startups, you can find more information here on how to start angel investing and how to find opportunities for angel investing on the platform.

This article is for informational purposes only. We do not provide legal, financial, or tax advice and investors should consult their advisors prior to making any investment. As with any investment, past performance is no guarantee of future performance, and any investment decision must balance the risk against the potential return. Private investments are highly illiquid and risky and are not suitable for all investors. There is no guarantee that a liquidity event will ever take place.

Originally published at https://www.propelx.com on May 19, 2022.