An organization always remains in need of funds. This funding need is for various purposes, to run day-to-day operations, plan expansion and diversification, new product launch, restructuring of the organization, etc. For raising the funds the organization has various sources that it can tap. Organizations can take loans from banks, raise money through IPO’s, get unsecured loans from shareholders and directors, can seek funds from its vendors, or seek funding from private investors. A private placement is issuing stocks, bonds, preferred shares, convertible bonds, or shares to private investors or institutions. It is a preferred source of funding for start-ups, small companies planning for expansion. Start-ups that have now grown, like Byjus, Nykaa, etc in India secured their initial funding through private placement only.
Who are these Private Investors?
Private investors will include wealthy individuals or high net worth individuals, banks, financial institutions, pension funds, mutual funds, and insurance companies. Basically any firm or individual investor who has extra funds and is looking for investment options. Nowadays, Venture Capitalists, Angel Investors are also available for initial and second-level funding on a private placement basis.
How does it Work?
Unlike IPO, private placement is an unregistered process. And it can vary as per the circumstances, choice of private investors and the size of funding requirements, etc. Therefore, there is nothing fixed or mandatory for raising funds through private placements. Whereas in the case of IPO, the organization has to go through a detailed mandatory process and approvals. And the process would include the appointment of the Lead Manager, Registration and approval from the Securities and Exchange Commission (SEC), issuance of a prospectus, sharing financial and other details, and so on.
All these are not a requirement for a private placement. Of course, there is a separate regulation- Regulation D that governs private placement in the US. However, it is not so stringent nor so lengthy. It classifies private investors broadly into two categories. These are accredited investors and non-accredited investors. The rules and rules and requirements vary for each of them. And the issuer needs to follow only that limited rules relating to the category of investors, it wants to approach for raising funds.
Advantages of Private Placement:
Long Term Focus on Goals:
It takes at least 3-5 years to earn a minimum amount of return, it can be 10 years too, depending on various macroeconomic factors. When a company chooses to go public, it creates the pressure of generating short-term results. To ensure that the company stays in the good books of shareholders, companies constantly have to align the goals of the company with that of shareholders. Apart from the business performance, it also needs to pay regularly some amount of dividends. Good consistent performance and regular dividend payments keep the company in the good books of analysts and investors.
Let us consider an example to make it more clear. X is a public company, that wants to invest in a risky yet fruitful project. Considering the amount of risk and absence of past credentials, it may not be attractive for the investors. Hence, the company has no other option but to approach private investors. And convince them about the project’s feasibility and potential. Thus, with private placements, the company would be able to raise the funds for the investment in that project. Moreover, it would also get the benefit of onboarded investors’ expertise and guidance they bring to the table.
Expertise and Guidance
When companies are seeking funds from angel investors or venture capitals, they are largely also utilizing their expert guidance and expertise in their area or industry. We all know, how Mr. Ratan Tata invests in many start-ups and exciting business ideas. Now imagine the guidance and suggestions coming from a man with such stature. It adds a new perspective to the firm.
A private company goes easy when it comes to disclosure requirements and regulations. For a young company, less red-tapism will smoothen the process of raising funds. Even while raising funds through other securities like bonds, the painful process of getting a credit rating from an agency may not be required.
Sale of Complex Securities
A firm that wants to sell complex securities finds it difficult when it comes to selling the securities to the public at large. While this is not the case with the private placement. Mainly, due to the varying risk appetite of investors, as they may be comfortable with more risk to earn extra returns.
An organization can have multiple sources of capital like loans, private placement, negotiable certificates of deposits, etc. This will provide diversification benefits for the organization. Because this way it will have funds from multiple sources with varying costs and conditions. Rather than the dependency on a single source that will be riskier.
In the Time of Crisis
A public firm has an option of resorting to private placements when in crisis or when the firm wants to expand. By raising a certain portion of its funding requirements through private placements, they save up on the pressure for short-term results and gain better guidance. This will also cut short the process as well as time for the arrangement of funds. Timing of availability becomes crucial in times of crisis or to seize any good opportunity. For example, a public company may choose to go private if it is in distress or planning an expansion.
Disadvantages of Private Placement
- Although, the way we talked about the process of raising private equity seems smooth, the real hustle is in convincing investors to get on board. For convicing and showing the intent and credential these businesses need to make a series of presentations. They need to divulge more about the financial aspects as well as business plans and technologies. They also need to do serious negotiations to bring these investors on the board. To be able to explain the idea and paint the potential of the business to investors is not an easy task.
- With the benefit of expertise also comes the limitation of reduced flexibility. When firms are raising private equity from various private equity firms, few of the investors secures a position on the board of the company. They do this to ensure the company sticks to its stated long term goals and also suggests actions in certain situations. Sometimes there remains a clash of interest between the organization and the private investors. In the bargain sometimes the flexibility of the business decisions gets compromised. Moreover, sometimes it does create a situation of indecision that also affects the performance of the business.
- Selling securities at a discount: As we see, when a company goes public, many potential companies with great prospects trade at a premium as investors are optimistic. In private placements securities are often sold at a discount. Because knowing the dependency of the firm these investors make a very serious bargain on pricing.
Practical Examples of Private Placement
For example, currently, Mr. A has $200,000 and is looking for investment options to deploy these funds. Company X, is a start-up running an internet company that has great potential. The company approaches Mr. A and asks him for an investment of $100,000 in the company. Looking at the business and prospects, Mr. A gets excited and agrees to make an investment of $100000 with Company X. This is the process and arrangement of funds by private placement from investors privately.
Another example can be, funds created by amazon for various climate change-oriented start-ups. Many climate protection-oriented start-ups have received funding from Amazon’s fund to grow and expand their projects.