Private Placements – The Golden Goose of Investing

New York Stock Exchange

The average investor doesn’t know about private placements. Everyone has heard of initial public offerings (IPO’s) and Angel investors but private placements are often overlooked. In the age of digital brokers, online trading software and social media guru’s toting the best stock picks money can’t buy, it’s easy to understand why. Investor’s attention is drawn to volatile penny stocks & high leverage S&P futures and away from where most sophisticated investors, and banks, make their biggest ROI; private placements.

What is a Private Placement?

Private placements are a method of raising capital where the company sells securities to a relatively small number of investors. These investors generally come from investment banks, mutual funds, brokerage firms and insurance companies. One of the key difference is that private placements are generally not available to the public. “Accredited Investor” is the term given by regulators to those who meet certain criteria. Accredited investor status is required to participate in Private placements. The definition of an Accredited Investor varies in different jurisdictions. The simple way of explaining it is an individual or organization with experience in public markets and/or a reasonably high amount of capital or high net worth.

Accredited Investors – The Tick of Approval

The idea of an Accredited Investor was created to protect the general public from being swindled by dubious salesmen and phoney companies. Regulators decided that if an individual or entity met certain criteria, then they were experienced enough to understand the risks associated with any investment. However, there is no formal process or department that curates the accredited investor status. Being an accredited investor does not require registration, application or any certificate issued by an agency or governing body. The responsibility is on the issuer of the securities (ie. the company) to ensure that they follow certain steps to verify individuals or entities meet the required criteria. These steps began as a simple form or questionnaire asking the participant to validate their experience, income and net worth.

Fast forward to 2019 and not much has changed in the verification process. Except information is more transparent and companies can be researched accurately in minutes. The reasons for this barrier to entry aren’t as relevant as they once were. The sophisticated investor can quickly acquire all the information they need on a company and who else is investing. If banks, brokers and high net worth individuals are investing in early stage companies, their experience is signalling an opportunity. That signal can be an opportunity for other investors as well.

Crowdfunding for Companies

There are lots of ways around the Accredited Investor tick of approval. Or lack there of as is the case. In 2012 Barack Obama signed the Jumpstart Our Business Startups Act (JOBS) making it easier for small businesses to raise capital. This was designed to spur economic growth and facilitate accelerated business development in the startup phase. In October 2015 the Securities and Exchange Commission (SEC) made possible for non-accredited investors to participate in crowdfunding.

Startengine.com is the Kickstarter for public companies. Aspiring businesses float their ideas to the public and seek investment from anyone who believes in their vision. Med-X is an agriculture and technology company whose mission is to develop alternatives to harmful chemicals, pesticides and pharmaceuticals. Currently, they have raised over $4 million through the online crowd funding platform.

Digital Documentation

We have previously written about Capiche, a secure web-based platform for public companies to manage their private placements. Capiche.io brings private placements online and simplifies the administration work required by the company. Capiche also enhances accessibility for participants allowing investors to receive and return the subscription documentation digitally. The platform walks the participant through the whole process making the experience seamless and reducing errors or formalities.

At the time of writing, anyone can invest in a securities-based crowdfunded offering. But there are limitations. As far as other types of securities investments, it’s all down to what the investor puts on paper…

Man filling out Private Placements

Private Placement vs Convertible Debentures vs Bonds

Some other terms an investor may hear thrown around are Convertible Debentures and Bonds. Understanding these two terms will help understand the benefits of each and where they sit in the investment risk spectrum. Companies can raise capital in three ways. By issuing debt or equity; Loans or stock, or a hybrid of the two.

Bonds

A Bond is a debt note. Corporate bonds are the same as government Bonds, they’re essentially a loan between the company and a creditor/investor. Bonds have a duration or expiry, where the principal amount is due to be paid to the owner of the bond. They also have an interest rate either variable or fixed and payment terms. Simply put, a Bond is an I.O.U. between a lender and borrower, or a loan. There are two reasons an investor, or sometimes trader, buys a bond. Either they believe that their investment will allow the company or government to grow and increase in value, resulting in higher yield or interest. Or they believe they can sell or trade the bond to someone else for a higher price. Government bonds are traded heavily and are fairly liquid. Corporate bonds are much trickier to transact.

Convertible Debentures

A Convertible Debenture is essentially a loan that can be converted into stock. It is a hybrid financial product with the advantages of both of debt and equity. For the issuing company, convertible debentures are cheaper than equity but slightly more expensive than debt. This is due to the tax benefits of interest payments. A company usually issues convertible debentures with lower interest rates because of the embedded option allowing conversion into stock. This means that the lenders principle amount is protected with the added bonus of participating in any share price upside should it occur during the time frame.

In the event that a company goes bankrupt, debentures are paid out after other fixed-income holders. This increases the risk slightly but the reward is higher because of the option to convert. If a public company receives $1,ooo,ooo through issuing bonds and turns that into $10,000,000, the share price will likely increase. The investor’s only receive their principle plus interest. If that same $1,000,000 is raised through convertible debentures, the investor’s may choose to convert into shares giving them much higher returns than simple interest payments.

Just like warrants and options, convertible debentures are factored into the diluted per-share metics. These are visible in a companies financial statements.

Wall Street Sign

So Why Invest in Private Placements?

The major advantage to private placements is that it is generally the cheapest stock an investor can buy in a company. The only way to get in earlier is to be a founder or an angel investor, both of these being far riskier. Private placements will also generally occur before but fairly close to an IPO. Meaning that investing in Private placements provides the best way to get in before the public. Once an IPO is complete company shares are tradable on secondary markets, providing liquidity for anyone who holds the stock.

Another consideration is the other investors who have already committed capital. Often a company may perform several rounds of capital raising and if the previous rounds were successful or even over subscribed it’s a good indicator. Angel investors are also a good sign as they often spend a lot of time curating potential investment opportunities, and if they liked a company enough to invest early, that’s a good sign.

Shares purchased through private placements are often accompanied by “sweeteners”. Warrants and options can be attached to the shares allowing investors to buy more shares at an agreed upon price before a set date in the future. If the companies stock moves significantly to the upside, investors have guaranteed returns if they exercise the warrant and immediately sell the shares. Perks like this are another reason why private placements are such a great opportunity for investors.

The Downside

Despite all the pro’s to private placements, there are a few con’s to consider. Private placements which occur before a company is publicly traded result in stock which is illiquid. It is important to know that the company has plans in its near future to list on a secondary market or exchange. This can usually be found out fairly easily by contacting the company’s representative. The other option is a merger or acquisition by a publicly traded company. These are far less easy to plan for.

Private placements which occur after a company is already publicly traded are referred to as secondary offerings. Secondary offerings dilute the existing share pool meaning investors who already own stock now have a smaller percentage of the company’s equity. While this can result in the share price to fall short term, it gives the company extra capital to deploy. If done correctly this can catalyze the company’s growth long term. Shareholder’s who are patient benefit from these types of successful private placements.

So Where are the Golden Eggs?

tgod-logo

An example of the prestigious goose in recent times is The Green Organic Dutchman (TSX: TGOD). In February of 2017 TGOD announced a $10 Million Private placement. The company had already raised $13,200,000 in a previous round and was heavily over subscribed. TGOD did this by diversifying its’ investor pool rather than just using a few banks and brokerage houses. The details were as follows;

  • Private placement aimed to raise gross proceeds of $10,000,000
  • At a share price of $1.15 per unit
  • Each unit contained 1 common share and one warrant
  • Each warrant was convertible to a common share at the price of $2.15 and valid for 24 months
  • The common shares came with a 6 month hold and the warrants with a 12 month hold (meaning they were not tradable for that period of time)

There were a few other small details but that is the bulk of it. One year later, in March 2018, TGOD ran an IPO raising over $115,000,000 at $3.65 for 1 common share and one half-share purchase warrant. The company listed in May and was publicly traded on the Toronto Stock Exchange. By June, The Green Organic Dutchman was trading for over $8.00 per share.

That’s almost a 700% return in less than 18 months!

Let the Egg Hunt Begin!

Participating in private placements is getting easier with new technologies, like Capiche, coming to market every day. Investment banks and stock brokers are also a good way to get exposure to private placements. Some investment news sites, like HighEnergyTrading, will report on companies holding capital raising events. If they stack up. As far as eligibility, well that’s entirely up to the investor and their paper work.

 

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