Maximizing Growth With Private Placement In Startup Fundraising

Private placement in startup fundraising is an excellent strategy for companies looking to expand quickly. They can approach pre-selected and accredited investors and financial institutions to sell their stock shares or bonds. This tactical move works well for companies not ready for an IPO.

Leveraging private placements lets founders raise capital for accelerated expansion and complete the financial transactions. But without the need to file for registration with the SEC. You’ll reach out to pre-qualified investors and delay or forego an Initial Public Offering (IPO).

Know that private placement transactions are relatively unregulated compared to selling stock in the open market. On their part, investors can take advantage of exclusive investment opportunities with the potential of yielding great returns. Essentially, private placements work well for both entities.

Read ahead for detailed information about securing funding and growing the company using this fundraising strategy.

Understanding What is Private Placement in Startup Fundraising

Private placement funding lets you leverage the advantages of an IPO without government and public scrutiny. You won’t need to register the stock sale with the U.S. Securities and Exchange Commission (SEC). Nor will you have to offer a financial prospectus to potential investors.

Most importantly, you can avoid disclosing the company’s financial information to the public. At the same time, know that private placements must comply with minimum regulatory requirements and guidelines. Typically, companies in the Internet and financial tech verticals tend to use this approach.

The SEC has a set of rules governing how companies sell their stock to investors. However, if you opt for private placement, you’ll use one of the two exemptions to complete your registration.

• 4(a)(2) private placement: This exemption permits companies and entities purchasing their stock to complete the transaction without the company filing for SEC registration. Companies can sell a limited number of shares to a specific group of accredited investors.
• Regulation D: Also called Reg D, this exemption allows companies to sell an unlimited number of shares to non-specific groups of accredited investors.

Who are Accredited Investors?

Accredited investors are typically individuals and financial institutions who have substantial capital resources to invest. They also have sophisticated expertise in the securities industry and capital markets and know how to identify viable opportunities.

Such entities include mutual funds, banks, pension fund managers, insurance companies, family offices, and wealthy individual investors or angels. They support startups and small businesses trying to raise capital at affordable rates to fund their operations and rapid growth.

Keep in mind that storytelling is everything in fundraising. In this regard, for a winning pitch deck to help you here, take a look at the template created by Silicon Valley legend, Peter Thiel (see it here), which I recently covered. Thiel was the first angel investor on Facebook, with a $500K check that turned into more than $1 billion in cash.

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Private placements can be of different types:

• Preferential allotment sold privately to investors
• Qualified institutional placement or securities sold to qualified institutional investors
• Corporate bonds sold as private placement even if the company is publicly traded

Why Private Placement is a Better Option

Startups typically rely on equity options like business loans, IPOs, venture capital, private equity firms, and, of course, private placements. Well-established companies can go through the IPO process and raise funding by selling their stock in the open market.

However, this process is restrictive for smaller companies and startups since IPOs are complex and expensive. Private placements enable them to follow a procedure similar to the IPO to sell their shares. The key difference is that they can privately offer shares to a select group of investors.

Private placement in startup fundraising has several advantages over an IPO, and avoiding regulatory procedures is only one of them. Selling shares to private investors takes less time and expense. Further, as the founder, you’ll retain complete control over the company since it remains private.

You’ll sell securities like stocks, bonds, and other financial instruments to raise funding in exchange for an ownership share. Although you must comply with some regulatory requirements and eligibility constraints, you can compile a list of bespoke investors.

For instance, targeted investors invited to participate in the purchase should be able to absorb potential losses. From the investors’ perspective, they have fewer regulations to comply with when buying the stock aside from, say, anti-fraud regulation.

From the founder’s perspective, share prices are not subject to the fluctuations of the open market. They are simply sold to private investors on condition that they cannot distribute the securities or stock to the public. Information about the stock sale is also kept private until after the transaction.

Regulations Governing Private Placements

Although private placement stock sales have fewer regulations, you’ll comply with some basic rules:

• Select the proper SEC exemption when completing transactions, which can be Regulation D or 4(a)(2) private placement.
• You can offer private placement stock only to accredited investors, including high-net-worth individuals or financial institutions. These entities must demonstrate a specific income or net worth to qualify.
• Companies offering private stock sales need not divulge detailed information about their finances to investors, unlike in public IPO.
• Broker-dealers facilitating private placement transactions must file documents as FINRA and SEC rules mandate. For instance, they must file the offer documents with FINRA’s Corporate Financing Department within a deadline of 15 calendar days. This date is calculated from the sale date.
• When selecting your list of investors, you’ll identify entities who have sophisticated knowledge about the financial market. Further, their net worth should be substantial enough to absorb the economic risks of the investment.
• Investors must accept the condition that they cannot resell or distribute the securities to the general public.
• Private placement offerings are subject to minimum investment amounts, and investors must agree to pre-determined lock-in periods. They cannot liquidate their holdings during this time frame.
• SEC regulations require investors to do their due diligence before offering to purchase shares. Since companies may not divulge complete financial information, investors must conduct investigations.

Broker-dealers should act in the best interest of the investors by making informed recommendations and disclosing potential conflicts of interest.

Advantages of Private Placement for Companies

Private placement for startup fundraising has several advantages over other funding options, such as:

• Registering the company as a public entity means complying with a complex and expensive registration process that you can avoid. Further, you’ll have to complete mandatory quarterly and annual filings, which can be a burden. Remaining a private company has its advantages.
• When reaching out to investors, you don’t need to use a public prospectus and advertise it publicly. Instead, you’ll use a private placement memorandum without releasing sensitive data to the public.
• You’ll complete the stock purchase quickly and get money in the bank within a short time. Even if you’re issuing bonds, you’ll avoid the time and costs of getting a credit rating from an authorized bond agency.
• You can issue complex bonds and securities since your targeted investors have the expertise to understand how they work. They are well aware of the potential risks and returns.
• Avoiding the extensive and time-consuming processes the SEC or venture capitalists undergo is a huge advantage.
• You’ll incur fewer legal costs since no registration is involved, and there’s much less documentation.
• You’ll target a smaller number of pre-vetted potential investors, which makes the negotiation less complex. Such transactions conclude quickly.
• Private placement in startup fundraising is completely customized with terms and conditions that work well for both parties. You can structure the deal to meet your funding objectives.
• Such transactions ensure complete confidentiality since information is shared on a need-to-know basis.
• Private placement funding gives you complete flexibility to offer stock or securities according to the company’s cap table. You can also choose specific investors with the potential to be strategic partners for long-term growth.

Disadvantages of Private Placement

Although private placement funding has advantages, you should also be prepared to deal with a few downsides. Here are some key points to consider.

• Investors offering to purchase private placement bonds may levy a higher interest rate than a publicly traded security. That’s because the risk factor is much higher, particularly since they get only a limited amount of financial information. Further, these bonds are not given credit ratings.
• Aside from higher interest, investors may also require some collateral to secure the money.
• Even if the interest rate is not higher than the market interest rate, investors may require a higher ownership percentage in the company. This factor can raise the dilution risk.
• Investors may also demand a fixed dividend payment per share to hedge their risks. This factor can pressure the company to perform at an accelerated rate, which is detrimental to controlled, healthy growth.
• You’ll structure the stock sale carefully while keeping a close watch on possible dilution and ownership transfer to investors.
• Private placement stock sale is restricted to a specific group of investors, which limits the pool you can target. If you need to raise substantial capital, the funding round may not yield the desired results.
• Even though private placements don’t need to comply with extensive regulations, they must follow certain SEC rules. If you’re unfamiliar with them, you’ll need expert legal support.
• From the investors’ perspective, they must accept restrictions around liquidating their holdings. And maintain the holding for a fixed time. You may have to agree to additional terms to offset these limitations.

The success of private placement strategies hinges primarily on approaching the right investors. If you’re looking for information on compiling a list of investors, check out this video I have created.

How Private Placement Procedures Work

To raise capital successfully using the private placement approach, you’ll follow these steps:

1. The first step in the process involves retaining the services of expert financial analysts. These professionals will help you determine the exact amount of capital you need to meet your immediate growth objectives. You’ll also work with the team to formulate a game plan for allocating the funds.
2. Create a list of potential investors you can approach, ensuring they meet the guidelines of accredited financial entities.
3. Design a private placement memorandum demonstrating the company as a viable investment opportunity. You’ll include details like the business model, financial statements, collateral, use of funds, and possible risks. Adding financial projections and competitor performance can also help.
4. Once investors receive the memorandum, the next step involves in-person or virtual meetings. Such meetings are typically closed-door and confidential, and parties can discuss possible terms and conditions.
5. Investors conduct detailed due diligence as with any other capital raising or M&A transaction. Their objective is to study all the relevant information to assess the risks and rewards of the investment before moving forward. Accordingly, they will review the memorandum, financials, and other data.
6. Once the due diligence is complete, both parties proceed with negotiating the terms, such as interest rates and dilution. Depending on the risk propensity, they may require collateral or fixed dividends. They’ll also iron out the holding period and liquidity conditions. Most importantly, they’ll finalize the number of shares, bonds, and securities investors will receive.
7. After completing the documentation, the broker-dealer files the paperwork with the relevant regulatory authorities.
8. The funds are transferred to the company account after the regulations and procedures are complete. The capital raise is now concluded.

The Takeaway!

You can use private placement in startup fundraising to raise additional capital beyond the company’s capacity. Early-stage and seed-stage companies needing capital to kickstart their growth can use this strategy. Particularly when approaching existing lenders is not an option.

Leveraging private placement gives you much flexibility regarding your target investors, stocks, and securities. You can structure the capital raise according to the company’s cap table, funding needs, and growth you hope to achieve.

Although the lack of regulations, cost efficiency, and short time frames are distinct advantages, you’ll consider the downsides carefully. Investors want to offset their risks with terms and conditions to protect the investment.

Weighing the pros and cons and making informed decisions is crucial. This is why working with professional advisors who can guide you in the right direction is always advisable. They will ensure the private placement structure aligns with your business goals and long-term needs. You’ll also explore other funding options and their pros and cons.

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