Investor Awareness - Private Placements

A private placement is the sale of securities to a limited number of qualified private investors. While an IPO is the initial sale of shares to the general public, a typical private placement is offered only to certain investors and accredited individuals and entities that meet specific eligibility requirements. 

For companies, private placements can provide an infusion of cash more quickly and less expensively than a public offering. Private placements are also generally not subject to public disclosure obligations. They typically allow companies to have a great deal of control over the process – the company can decide how much to sell, at what price, and to whom. However, those decisions do require a tremendous amount of due diligence and careful deliberation. 

Private placements are exempt from the registration requirements of the federal Securities Act of 1933 and public disclosure requirements if certain requirements are met. The sale of securities through private placements cannot involve any public offering, public solicitation, or advertising. In addition, private placements must comply with state laws and anti-fraud provisions of securities laws. Companies must disclose all the pertinent information needed to potential investors, so that they can make a fully informed decision about the investment.  

Securities sold through private placement securities can take different forms. Typically, they involve the sale of either debt or equity. Securities sold through private placements are not publicly traded and, therefore, are less liquid. It’s important to understand that investments in private placements carry a high degree of risk for various reasons. Investing in private placements requires high risk tolerance, low liquidity concerns, and long-term commitments. Investors must be able to afford to lose their entire investment. Additionally, investors may receive stock that may be subject to holding period requirements.  

Something else you will want to make sure you understand before entering into a certain private entity investment is that, in some cases, you may incur UBIT (unrelated business income tax). If an IRA buys into certain investments, these investments may become taxable – not to you, the individual, but rather to your IRA. This means that the IRA itself will have to fill out tax form 990T, allowing it to receive its own tax return to pay tax on it. This means you may need to apply for your own EIN. UBIT can be triggered when the investment is viewed as “running a business”. You may think, “well, I am not running a business; I am simply buying real estate.” You are correct and therefore it is exempt under unrelated business income tax, so you are not taxed under those rules, but there's a side set of rules that deal with debt leveraged, or debt financing income. In other words, when we buy certain types of assets and there is a loan on the investment, there is debt on it. To the extent the investment is debt-leveraged, the profit is subject to this tax. Sometimes this can be taxed very high, and this is something you will want to understand before beginning your investment. 

Your due diligence begins with a background inquiry on the company and its management and an analysis of all the information presented by the company and its offer. This part of due diligence focuses on compensation, self-dealing, background of insiders, litigation history or potential risks, and accurate discussion of the nature of the business. A company seeking a private placement issues a Private Placement Memorandum or PPM. The PPM details the company’s financial situation and business plan, as well as any other pertinent information about the company and the offering.  

An internet search can also provide essential information. Do not solely depend on the accuracy of information supplied by the company or its agent, but engage in an independent investigation that is customized for each offering. Most offerings may have certain unique features that require additional due diligence. Ask for clarification on any information provided that you do not understand and request back up documents to support their claims. If you take these steps and understand what you may encounter along the way, you can better protect yourself from a bad deal.