Private Placements - Risk vs. Reward

Private Placement Fraud and Misrepresentation FINRA Arbitration and Litigation Attorney, Russell L. Forkey, Esq.

Should the average person consider investing in a private placement?

At the end of the day, this is a personal decision that must be made by an investor. Importantly, there are a number of important factors that should be considered before you make a final decision. This post is designed to generally point out a few of these items for your attention and consideration. Please keep in mind that this post is being provided for informational purposed only and is not designed to be complete in all material respects. Thus, it should not be relied upon as legal or investment advice. If you have any questions, you should contact qualified professional assistance.

What is a private placement?

A private placement is the non-public sale of illiquid securities to individuals or entities that meet certain predefined criteria. Generally, private placements offer for sale equity shares (common or preferred stocks) or debt instruments such as debentures or notes that are not publicly tradable. However, there are any number of combinations of securities that can be offered through a private placement.

How does a private placement operate?

Securities offered through a private placement are not registered with the Securities and Exchange Commission. They are offered through an exemption from registration called Regulation D. Regulation D provides a "safe-harbor" exemption from registration. Sections 504, 505, and 506 of Regulation D contain the descriptions of these exemptions. These exemptions detail the rules for privately offering securities without registration via a Form D filing with the SEC.

General Summary of Regulation D Exemptions:

  • Section 504: Known as the Small Corporate Offering Registration, or SCOR. SCOR offers an exemption to private firms that receive no more than $1 million of funding in any one year via the sale of securities. There are no restrictions as to the number or types of investors. Under this exemption, privately placed securities can trade publicly.
  • Section 505: Allows a small firm to offer up to $5 million in securities during a twelve-month period to an unlimited number of investors, with the restriction that no more than 35 of the investors are non-accredited. By definition, an accredited investor must possess enough assets or income to make such an investment. The SEC states that accredited individual investors must have either $1 million in assets or $200,000 in net annual income, while institutions must have assets of no less than $5 million. The securities exempted under Section 505 are not allowed to be publicly traded.
  • Section 506: Provides for a company to offer unlimited securities to any number of investors, as long as no more than 35 are non-accredited investors. Section 506 investors are required to be sophisticated market participants. Securities exempted under Section 506 may not be freely traded. Typically, real estate private placement deals are filed under Section 506.

What Type of Information Should be Contained in a Private Placement Memorandum?

The specific information contained in a private placement memorandum (PPM) is dependent upon the requirements of the specific of Regulation D used by the issuer. A PPM is designed to provide all necessary information that an investor needs to make an intelligent investment decision. Generally, a PPM has sections detailing:

  • Suitability Standards for Investors
  • Summary of the Securities Offering
  • Capitalization of the Company
  • Risk Factors
  • Use of Proceeds from the Securities Offering
  • Dilution
  • Plan of Distribution of the Securities
  • Analysis of Financial Condition and Results of Operation
  • Selected Financial Data
  • The Business of the Company
  • Management and Compensation
  • Certain Transactions                     (transactions between the Company and its shareholders, officers, directors or affiliates)
  • Principal Shareholders
  • Terms of the Securities Offered
  • Description of Capital Stock of the Company
  • Tax Matters
  • Experts
  • Legal Matters
  • Documents Available for Inspection
  • Financial Statements
  • Projections
  • Exhibits

When reviewing the sections of a PPM all of the sections are equally important. However, particular attention should be paid to the sections describing risk factors, capitalization and stock ownership.  For example, many PPMs alert the investor that he or she should not invest unless the investor is willing to loose all of the money invested.  If you are an average investor, the risk factors should be enough to dissuade you from investing.

If you feel that the information contained in the PPM through which you invested was false, misleading or omitted to provide relevant material information, you do have recourse. Don't wait to take action.