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Capital plenishment: private placements are a time-honored way to raise both small and large amounts of capital. At best, they can offer quicker access to capital and far less red tape than alternative forms of financing.

Michael Zuppone, a partner and chair of the Securities Practice Group at law firm Paul Hastings, Janofsky & Walker LLP in New York, recalls doing a private placement a few years ago for a fulfillment company in the e-commerce sector. Four employees who were working together at a company came to him with a business plan, he says, which became the germ for a private placement.

The first round of financing, Zuppone says, raised $6 million, and two subsequent rounds raised the capital base to $14 million. The company "rode out the storm in the tech sector bubble," he says; it's now doing $10 million in sales a year with "a blue chip clientele" and is heavily involved in technology like radio frequency identification (RFID) for inventory control.

Compare that to what OneAmerica, a private mutual insurance holding company, did in October 2003. Using an investment banker, the Indianapolis-based firm lined up a $200 million offering of 30-year bonds; the offering ended up attracting 31 institutional investors, many of them other insurers, and was significantly oversubscribed, says Constance E. Lund, the firm's senior vice president, corporate finance.

A pair of very different transactions--but the private placement story is a tale of two markets, both well-established. Small private placements, some under $1 million, are common in start-up or early financing rounds for companies that might have otherwise considered venture capital investments. On the other hand, many public and larger private companies turn to big investment banks for placement of non-public issues with institutional investors; these can be done without the cumbersome registration and disclosure procedures common to public securities.

The first type, and still probably the most common, involves the sale of securities (most often preferred stock) to a small group of investors, usually institutions or well-heeled individuals. Because the offering is generally small and has limited circulation, it can be structured to be exempt from registration with the Securities and Exchange Commission (SEC) or other regulatory bodies.

Small private placements can be done simply with the help of an attorney, with the senior managers of the firm seeking the capital being responsible for selling and recordkeeping. Or the company can enlist the help of an investment bank or private equity firm to help it navigate and locate the necessary investors.

There are specific rules governing these transactions, particularly with respect to their exemption from the Securities Act of 1933. Under Regulation D, common exceptions exist under Rules 504, 505 and 506. (Without getting into lengthy detail, 504 is the most basic, allowing sales up to $1 million; 505 permits sales to more individuals, and up to $5 million; and 506 has no dollar exemption. There are other conditions and caveats that are spelled out in the specific rules.)

When major banks or investment banks are involved, fixed-income transactions in the hundreds of millions of dollars are common, and companies are frequently public. Such offerings are often divided into two or three tranches, or tiered offerings, of varying maturities and price; the vast majority are for senior debt, often in maturities from 4 to 10 years.

Most of these larger bond offerings are rated A or lower by Standard & Poor's, based on data in Private Placement Letter, an industry newsletter. Pricing is generally pegged to Treasury securities of comparable maturity, or less often to LIBOR, the London Interbank Offered Rate. Some even carry an insurance "wrapper," or backing from an insurance firm, that improves their potential rating and would lower the interest rate.

OneAmerica's Lund says the insurance company didn't issue price guidance on its offering, but it settled at 7 percent on a day when comparable Treasuries were selling at 4.973 percent. The company was highly pleased with the placement, she says, adding that "as a private company, we don't have ready access to capital. We were in an acquisition mode, and rates were good. It was an attractive time" to tap the market.

Complexity Isn't Just About Size

Complexity comes not with the number of investors or the size of the placement, says Paul Hastings' Zuppone, but with the complexity of the enterprise. "A small offering could have complex disclosure issues. If you're working with an experienced securities lawyer, it's a relatively smooth process. It's not about reinventing the wheel."

Indeed, he adds that the process can be completed in a matter of weeks if there is a simple subscription agreement involving sophisticated investors. But deals involving "non-accredited" investors--those who don't meet stated income or asset tests--require more disclosure, and as a rule, private placements require adherence to federal securities laws, as well as state "blue sky" laws governing investment disclosure.

In the recently published second edition of Raising Capital: Get the Money You Need to Grow Your Business, author Andrew J. Sherman notes that private placement teams need to consider the requirements and subsequent expenses of filing in both state and federal jurisdictions. While some states have tough "merit reviews," others have only very lenient "notice filings."

While filing requirements are generally quite minimal for small placements, "a lot of companies get it wrong," says Tom Taulli, an investor, investment advisor and author in southern California who runs a Web site devoted to IPOs, An offering statement should provide information about the company's financials and risk factors, or it risks raising issues of securities fraud.

"You need to be mindful of blue sky laws," he says, adding that "this can be a hassle if you have investors in different states." Still, "at the seed [funding] level, you may not get much documentation." Adds Bryan Finkel, an investment manager with Advanta Bank Corp. in Spring House, Pa.: "In a lot of private equity, you don't need to take a sophisticated look at the balance sheets."

But with a far larger offering, that relaxed approach changes. Lund recalls that OneAmerica executives went through an intense period--including working through a Labor Day weekend--in developing an offering circular. They then went through an editing process and a review, then had a series of investor conference calls.

Looking to the Angels

While some issuers have learned how to tap an "informal angel network," says Zuppone, "not everyone has Rolodexes with those kinds of contacts." Taulli says that, at their most basic level, private placements are really designed to be generated by an individual or group's personal network, from pre-existing relationships.

Typically Zuppone says, a small placement would involve a half-dozen to a dozen investors. "The key thing is in the nature of the investors--Reg D allows for up to 35 non-accredited investors. On the other hand, you can have an unlimited number of accredited investors."

Investors generally are "looking for a preferred position over common equity," Zuppone says. "The preferred stock will have a stated dividend, though it may not be paid," commonly in a range of 7 to 9 percent. Investors ordinarily get some form of "liquidation preference," he adds, or the ability to convert that preferred into common stock in the event the company goes public.

Advanta's Finkel says that at an early stage of financing, the choice is almost always preferred stock, though investors often try to get different preferences. "In the last couple of years, there have been different ways to create control preferences. You can say that you are preferred ahead of other classes [of stock]; you can also create a participating preferred stock."

One company Taulli is working with doesn't need a lot of money, he says, but has developed an offering document that structures the investments as convertible notes that can convert at a discount to stock if the company does an IPO.

With the globalization of capital markets, it's hardly surprising that private placements pop up around the globe. That's true not just for the public companies that list in Europe or Asia, but startup companies in countries like China. Nils Ollquist, managing director of Orient Financial, a Hong Kong-based investment banking firm, was in New York recently to line up a private placement for China Evergreen Environmental Corp., a small Chinese water treatment firm that Orient took public in the U.S. through a reverse merger last fall.

China Evergreen, listed on the OTC Bulletin Board, has traded at under $1 since its public offering. Ollquist attributes that in part to the reverse merger, which he believes "causes existing shareholders to sell out." So it clearly needs capital, and Orient has been actively working to bring in U.S. investors for this and other Chinese companies, noting that "U.S. investors don't always look outside the U.S."

Market experts say that private placement activity generally tracks with the private equity and venture capital markets. Activity "is nowhere near where it was at the height of the bubble" a few years ago, says Zuppone. But it's still a key financing tactic for small, unsophisticated companies that don't want to load up on debt or hand the keys to the business (figuratively, of course) to venture capitalists.

One fast-growing firm Taulli is working with "has been courted a great deal by Sand Hill Road," referring to a mecca of venture capital in Menlo Park, Calif. The principals have been discouraged by the venture capital process, however, and are turning to a group of high-net worth individuals to raise money in a placement.

Advanta's Finkel sees a shift of power going back toward the companies, which could mean more financings of all kinds. "With a company that is more mature, that is either profitable or is increasing revenues, there are other options that just private placement. A company can raise money by selling equity or priority terms, or it can raise debt. Five years ago, [it] might have had to go a bank or a factor;" now, he says, the pot of gold may come from a hedge fund. Hedge funds have oodles of money and see a lack of attractive traditional investments that may steer them toward smaller transactions.

Private placements will never replace venture capital, nor create the rock-star acclaim given to some VC giants. But for the right company at the right time, they may be just the ticket.


Investment Bank Term Sheet

Commentary on the terms and why an investment bank would consider taking you on as a client.

Engagement Letter

Typically sent by the investment bank to the entrepreneur, it contains much of the same material as in the term sheet, usually offering an even higher-level overview of the proposed terms. Before a term sheet is kicked out by the investment bank, an engagement letter will often be sent as a show of commitment and as initial introduction to the general terms that the investment banker is considering.

Private Placement Memorandum (PPM)

A document setting forth the terms and scope of the financing, and not meant to be negotiated. PPM forms are commonly available on Web sites. Circulation of a PPM does not constitute an offer.

Due Diligence Checklist

A document the investment banker will give to the management team during the preparation of the PPM.

Subscription Agreement

Accompanies the private placement and offers commentary on what constitutes an "accredited investor."

RELATED ARTICLE: Benefits of Private Placement

* A high degree of flexibility in amount of financing, ranging from $100 thousand to $10 million-$20 million (or much more for fixed-income securities).

* Investors are more patient than venture capitalists, often seeking 10 percent to 20 percent return on investments over five to 10 years.

* Considerably lower costs than approaching venture capitalists or selling the stock to the public as an IPO.

* Quicker form of raising money than usual venture capital approaches.

Source:, Small Business Information
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Title Annotation:financing
Author:Marshall, Jeffrey
Publication:Financial Executive
Geographic Code:1USA
Date:Apr 1, 2005
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