Private Securities

What Are Private Securities?

Private securities refer to securities that private companies issue as opposed to ones. Unlike securities traded on known stock exchanges like the New York Stock Exchange or NASDAQ private securities are not available for trading on these platforms. Private securities enable companies to raise funds by selling ownership shares or issuing debt without having to go through the processes and scrutiny associated with launching an Initial Public Offering (IPO). Usually, these securities are sold directly to investors through brokers, investment banks or other private avenues. The key distinctions between private securities are:

  • Regulatory rules. Private securities have reporting and disclosure guidelines compared to federal securities laws. This gives companies leeway and privacy.
  • Marketability. Public securities are highly tradable making them easy to buy and sell on public stock exchanges. In contrast private securities lack a market making them challenging to sell.
  • Investor qualifications. Public securities are open for purchase by any investor type. Private securities however can only be acquired by accredited investors meeting income and asset criteria.
  • Openness. Public companies offer financial reports, business information, management profiles and other disclosures.Private companies provide less transparency.

Investing in private securities involves more risks than investing in public securities but it also provides investors with access to investment opportunities that are not typically found on public markets. Private securities serve as a source of funding for startups and emerging companies before they reach the stage of going public.

Who Issues Private Securities?

Private securities are often offered by startups and other private firms seeking to secure funding. In contrast to corporations, private entities encounter regulatory obligations and can sidestep the expensive IPO preparation and execution process. By issuing private securities, these companies can attract investments from accredited investors, venture capitalists and private equity firms to support their growth before transitioning to a public company. This approach allows them to maintain confidentiality regarding details and sensitive company information. Other reasons private companies may issue securities:

  • Gain access to sophisticated investors with industry expertise who can provide valuable advice and connections in addition to funding.
  • Avoid disclosures required of public companies which many view as giving too much competitive insight. Private companies can shield their finances and strategy.
  • Experiment with different capital raising options like equity crowdfunding before deciding whether to pursue a larger public offering.
  • Offer employee incentives and ownership opportunities not possible as a public company. Private securities can be used for employee stock options.
  • So that they are able to participate in mergers, acquisitions, or other major transactions easier than public companies due to less scrutiny.

Benefits of Private Securities

Investing in private securities can provide accredited investors with attractive benefits not found in the public markets. Here are some of the key advantages:

Access to Exclusive Investment Opportunities

Investing in securities allows individuals to invest in, up and coming startups and growing companies before they become publicly traded. This provides investors with the opportunity to access investments that are typically not accessible to the general public. It's worth noting that a significant number of established companies we see today initially secured early funding through private securities offerings. Getting in early through private securities allows investors to realize potentially higher returns as the company grows. It provides ownership stakes and investment opportunities not accessible in public markets.

Higher Potential Returns

While previous performance doesn't guarantee outcomes historical data shows that private investments have typically yielded higher average returns than public market options. To illustrate, a study conducted by PitchBook revealed that from 2006 to 2015 private equity buyout funds boasted an internal rate of return (IRR) of 15.3% surpassing the 6.1% returns seen in the public market during the same period. Investing in emerging businesses offers the chance for investors to potentially earn significant returns before valuations peak before an IPO. The premium for holding illiquid securities is balanced by the potential for returns.

Less Volatility

Private securities tend to demonstrate lower volatility and correlation compared to public market investments. This is because their valuations are not subject to daily public price swings and investor sentiment. With private securities, valuations are set periodically during fundraising rounds. As a result, private securities can continue growing steadily even during times of public market turbulence.

Including securities in a portfolio can improve diversification and lower risk because they are less influenced by short-term market fluctuations. Their performance is typically driven more by the fundamentals of the companies than economic factors.

The mix of opportunities increased returns and reduced volatility makes private securities an attractive choice for accredited investors seeking to bolster their investment portfolios. By providing access to investments that are not accessible in markets private securities offer distinct benefits.

Risks of Private Securities

Investing in private securities can provide unique opportunities not available in the public markets, but it also comes with heightened risks that investors need to be aware of. The main risks include:

Limited Information and Transparency

Private companies have disclosure requirements compared to public companies. This results in an availability of information for analyzing investments in firms. Private companies have the freedom to disclose less about their operations, finances, management and other crucial aspects that are vital for evaluating the business. This information discrepancy poses challenges for investors in conducting diligence and creates opportunities, for questionable practices to remain unnoticed. The lack of transparency and availability of verified data puts investors in securities at a disadvantage compared to those investing in the market.

Liquidity Risk and Lack of Active Trading Market

Private securities are illiquid assets with a limited secondary market. These securities cannot be easily resold or exited at an investor's discretion. There are restrictions on the transfer and resale of private securities that vary based on the offering terms and securities regulations. Investors should expect to hold onto these assets for long time periods and have no guarantee they can divest when desired. The lack of an active trading market also makes it very difficult to value private securities. Their fair market value is highly subjective compared to publicly traded stocks and bonds. This uncertainty makes it harder to quantify investment performance and risks.

Higher Risk of Fraud

With regulations and supervision in place, private securities offerings pose a risk of fraudulent activities. Private companies and issuers tend to overstate information misrepresent management capabilities, conceal problems or resort to fraudulent practices. Due to the lack of transparency and reliable data, investors need to be especially vigilant in assessing the accuracy of the issuers assertions and conducting diligence. Investigating the issuers history its leadership team, transaction terms audited records and other specifics is crucial, for identifying any warning signs.

Accredited Investor Requirements

To invest in securities, individuals looking to become an "accredited investor" must meet certain qualifications. The Securities and Exchange Commission (SEC) has established criteria based on income and net worth to determine accredited investor eligibility. The general requirements to qualify as an investor include;

  • Maintaining an income of $200,000 individually or $300,000 together with a spouse, for the past two years with the anticipation that this income will persist in the current year.
  • Possessing a worth exceeding $1 million whether jointly with a spouse (excluding the primary residence).
  • Holding positions such as partner, executive officer, director or a combination of these roles, for the issuer of the securities.

These requirements restrict securities to investors who are assumed to comprehend and handle the risks linked with more intricate investments that may not be suitable for the general public.

The SEC views this as an added layer of safeguard for investors. By meeting the criteria as an investor, you unlock access to a selection of private investments that are typically unavailable to other regular investors.

This encompasses investing in early-stage startups and private companies that have not yet gone public through an IPO. Private investments can offer opportunities not commonly found in markets, particularly for qualified investors.

Performing Due Diligence

Private securities come with less regulation compared to public offerings so investors bear more responsibility in investigating their potential investments. Here are some key steps for conducting diligence on securities:

  • Carefully examine the private placement memorandum, financial statements, business plans and other relevant documents to gain a clear understanding of the company its financial standing and the terms of the deal.
  • Dive into the company's background as that of its founders and management team. Keep an eye out for any warning signs such as bankruptcies, unsuccessful ventures or allegations of fraud. Use resources like LinkedIn, court records, and news archives.
  • Verifying credentials and experience of the management team. Call references if possible. Look for deep industry expertise.
  • Consulting lawyers, accountants, or investment advisors to review private placement documents and provide guidance. Their outside perspective is invaluable.
  • Analyzing the company's operations, products, services, market, competition, and growth potential. Conduct market research to assess assumptions and projections made by the company.
  • Visiting the company in person. Observe operations first-hand and meet management if possible.
  • Getting third-party due diligence reports from known companies for an unbiased assessment.

Completing thorough diligence demands a lot of time and energy. It's essential to prevent expensive errors when investing in riskier private securities. Depending on professionals' details, delve into research and pose challenging inquiries to guarantee well-informed investment choices.

Regulation A+

Regulation A+ is a rule that allows private businesses to raise up to $50 million per year from both nonaccredited investors. This rule was established under the JOBS Act. Offers a route to going public through a full initial public offering (IPO) for companies seeking access to public funding on a smaller scale. Through Reg A+ companies can gauge interest in their offering before committing resources to the SEC registration process essentially allowing them to dip their toes in the water. To comply they must submit an "Offering Circular" to the SEC for review and approval by SEC experts. This circular contains details about the company risks involved and the offering itself. With less complexity than a comprehensive IPO prospectus.

Companies utilizing Reg A+ have ongoing SEC reporting requirements after the offering, but not to the same extent as publicly listed companies. The securities can be traded on secondary market exchanges providing some liquidity for investors. Reg A+ provides more access and participation to non-accredited investors compared to private placements under Reg D.

However, companies are limited to raising a maximum of $50 million within any 12 month period. Overall, Regulation A+ bridges the gap between private placements and IPOs. It allows companies to access public capital in a more streamlined process than a full public listing. For investors, it provides exposure to growth companies and private deals they may not have access to otherwise.

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