What Is IPO Private Placement and How Does It Work?

By Rebecca Lake · January 11, 2022 · 6 minute read

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What Is IPO Private Placement and How Does It Work?

Companies use private placements to raise capital by selling securities without having to first register them with the Securities and Exchange Commission (SEC). Private companies can pursue private placements independent of an Initial Public Offering (IPO) or as part of a pre-IPO arrangement.

Also known as unregistered offerings, private placements follow the SEC’s Regulation D rules. These rules, included as part of the 1933 Securities Act, specify the number of unregistered shares that a company can sell to accredited and/or non-accredited investors without having to complete the full registration process.

What Is Private Placement?

According to the SEC’s definition , a private placement is “a securities offering exempt from registration.”

Private placements allow private companies to raise capital through the sale of stocks or bonds without having to go public or meet the lengthy registration requirements associated with an Initial Public Offering (IPO). Rather than making its shares available to the public for trading on a stock exchange, the company can privately offer shares, warrants, or bonds to a select group of including institutional or sophisticated investors only. A sophisticated investor is someone who meets the definition of an accredited investor, as set forth by the SEC, and also sufficient financial knowledge to weigh the risks and rewards associated with a prospective investment.

Private companies may offer private placement stocks as a shortcut to raising capital if they wish to remain private or need to raise funds ahead of a full IPO launch. Hedge funds and other private funds also use private placements to raise capital from investors.

Recommended: Investing in Private Companies

Common Types of Private Placement

Companies interested in private placement can offer them under one of three rules established by the SEC as part of Regulation D. The type of private placement will determine how many investors the company can include in the offering and whether those investors must be accredited.

Rule 504

Under Rule 504, private companies are allowed can sell up to $1 million in securities in any 12-month period. These securities can be sold to any number of investors and any type of investor (i.e. accredited vs. non-accredited, institutional vs. individual). The issuer isn’t subject to any specific disclosure requirements.

Unregistered offers made under Rule 504 are generally restricted securities. This means that investors who hold them can’t resell them in the public market unless they’re registered with the SEC first or the sale is exempt from SEC registration rules.

Rule 506(b)

Rule 506(b) of Regulation D allows companies to raise an unlimited amount of money through private placement. Companies can sell securities to an unlimited number of accredited investors, as long as:

•   The company doesn’t use general solicitation or advertising to market the securities.

•   The company limits the number of non-accredited investors who can purchase the securities to 35.

To qualify as an accredited investor, individuals must:

•   Have earned income in excess of $200,000 ($300,000 if married) in each of the prior two years and expect to earn the same for the current year, OR

•   Have a net worth of over $1 million, excluding the value of their primary residence, OR

•   Hold a Series 7, 65 or 82 license in good standing from the Financial Industry Regulatory Authority (FINRA).

If a company offers a private placement that includes non-accredited investors, they must give those investors disclosure documents that contain the same kind of information found in a standard Regulation A offering. The company should also be available to answer questions from non-accredited investors.

Investors who purchase shares under Rule 506(b) receive restricted securities.

Rule 506(c)

Rule 506(c) allows issuers to solicit and advertise offerings if:

•   All the investors purchasing the securities are accredited

•   The company has taken reasonable steps to verify investors’ accredited status

Investors who buy shares under Rule 506(c) receive restricted securities. Companies offering private placements under Rule 506(c) must file Form D with the SEC within 15 days of the first sale of securities.

Companies considered “Bad Actors” cannot use rules 504, 506(b) or 506(c). Under SEC rules, this generally means companies that have experienced a disqualifying event, such as a criminal conviction, court injunction, cease-and-desist order, SEC disciplinary order of FINRA suspension action.

Pros of Private Placement

The chief advantage of private placement is that it allows companies to raise capital without having to formally register with the SEC. This is beneficial on several levels, as having to complete an IPO can be time-consuming, which may not appeal to a company with immediate capital needs. It can also be less expensive, as private placements involve less paperwork and allows a company to skip the typical IPO process steps, such as due diligence and SEC review.

Private placements also allow companies that want to remain private to do so. While they can raise money from investors, they can decide to which investors they want to make an unregistered offering available. Once a company goes public, anyone with a brokerage account can generally buy and sell shares. So, private placement offers more control for the company.

Private placement investing can also benefit investors. With an IPO private placement, for example, investors may be able to purchase shares in a company before it goes public. The company may offer those shares at a discount to the IPO price. This could give early investors an edge once the company goes public if its shares trade at a price above the IPO price.

Investors who hold private placement shares can also realize returns in the form of dividend payments. Or if the company offers bonds in place of shares, they can earn interest on those bonds.

Cons of Private Placement

From the perspective of the company, the biggest disadvantage of private placement is that it means giving up some ownership in the company. By issuing shares to investors, you’re allowing them to become shareholders. A demanding investor may be difficult if they insist on having a say in company decision-making or they expect a higher rate of return on their investment than you can provide.

For investors, private placement investing has risks, since these are unregulated offerings. The securities haven’t been fully vetted the way they would be if the company was underwriting an IPO. For example, the company has not undergone due diligence or a pricing process.

There may also be less information readily available with which to make an investment decision. In addition private placement shares have much lower levels of liquidity, and in some cases may have none at all.

If the company is using a pre-IPO placement to raise capital, however, then the standard IPO process applies. It’s important to keep in mind that pre-IPO placements can still be risky, however. Valuations of IPO stock aren’t always 100% accurate and you can purchase a private placement IPO at a discount, only to have it fall short of expectations once the company launches.

Private Placement Pros & Cons

Pros Cons

•   Allows companies to raise capital from pre-selected investors without meeting SEC registration requirements

•   Companies can choose to remain private or complete a full IPO later

•   Open to both accredited and non-accredited investors whom the SEC considers “sophisticated”

•   Investors can earn dividends or interest income from private placements

•   IPO private placements can be profitable for investors if the company’s launch is successful

•   Less regulation can mean less transparency and more risk for investors

•   Companies are still giving up an ownership stake to investors, which could prove problematic

•   There may be limits on the number of non-accredited investors allowed

•   Dividends or interest payments may fall short of investor expectations

•   An IPO private placement doesn’t necessarily guarantee the company will go public or that the IPO will be a success

Private Placement Investing

If you’re interested in private placement investing, you’ll need to do at least the same level of research and preparation as you would if you were to start investing in stocks, bonds or other securities.

Connecting with a broker is a good place to start. Your brokerage can tell you if private placement stocks or pre-IPO private placements are an option and if so, the requirements for purchasing them. This can include requirements for accredited investor or sophisticated investor status, as well as minimum investment limits.

Once you purchase private placement stocks, you can’t turn around and sell them on an exchange as they’re restricted securities. You could take steps to have the securities exempted from the SEC rules, so you can trade them like any other stock but that can be difficult to do.

For that reason, private placements are typically a long-term investment. So consider what portion of your portfolio you’re willing to dedicate to what may be a buy-and-hold investment for several years or even decades to decide if private placements belong in your portfolio.

Invest in IPOs With SoFi

Investing in IPOs could offer more liquidity and potentially less risk than private placements. And they may be more accessible for the everyday investor, in terms of how much you need to get started.

SoFi members, for example, can invest in IPOs before they’re offered to the public with as little as $3,000. If you’re interested in diversifying with IPOs, get started with SoFi Invest today.

Photo credit: iStock/mdphoto16

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Investing in an Initial Public Offering (IPO) involves substantial risk, including the risk of loss. Further, there are a variety of risk factors to consider when investing in an IPO, including but not limited to, unproven management, significant debt, and lack of operating history. For a comprehensive discussion of these risks please refer to SoFi Securities’ IPO Risk Disclosure Statement. IPOs offered through SoFi Securities are not a recommendation and investors should carefully read the offering prospectus to determine whether an offering is consistent with their investment objectives, risk tolerance, and financial situation.

New offerings generally have high demand and there are a limited number of shares available for distribution to participants. Many customers may not be allocated shares and share allocations may be significantly smaller than the shares requested in the customer’s initial offer (Indication of Interest). For SoFi’s allocation procedures please refer to IPO Allocation Procedures.

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