Private Securities - Investable Assets Issued by a Privately Owned Company - Key Points to Understand

 

Private securities are investable assets issued by a privately owned company in accordance with exemptions from the Securities and Exchange Commission (SEC) registration requirements. Private securities allow private companies to raise capital from a limited number of accredited investors to start or grow their business. Although private securities are exempt from registration with the SEC, issuers of private securities are still subject to all of the anti-fraud provisions of the Securities Act of 1933.  Private securities encompass various types of securities, such as stocks, bonds, or debt.  Here are some key points to understand.

Exemption from Registration.

Unlike publicly traded securities (which require SEC registration) private securities can be bought and sold between parties without an intermediary or through a broker-dealer. Private securities are not freely available for trading on open markets like stocks listed on major exchanges (e.g., the New York Stock Exchange).

Less Transparency and Reporting.

Publicly offered securities must register with the SEC based on the Securities Act of 1933 and the Securities Exchange Act of 1934. Private securities, however, are exempt from registration as long as they comply with available exemptions. Consequently, private securities generally have less transparency and reporting requirements compared to public securities.

Restrictions exist around buying and selling private securities.

For example, anyone can buy and sell a stock that is publicly traded on a stock exchange, but generally, only accredited investors (usually high-net-worth individuals) can invest in private securities of a company or a private equity or venture capital fund, for example. These private companies or funds may further restrict sales to only certain types of institutional investors or based on criteria like minimum transaction size.  

Who Issues Private Securities?

Private securities are used by private companies in all stages of their development. Any company that is duly incorporated can issue securities to raise capital, whether as seed capital or growth capital. Private securities can range in the amount ranged from several hundred thousand dollars raised by small start-ups to tens of millions of dollars raised by large growing private companies. Over the last decade, many private companies chose to use private securities to raise capital instead of doing an initial public offering (IPO), giving rise to “unicorns” – which are privately held companies with multi-billion-dollar valuation.

The Importance of Private Securities to Secure Funding in the U.S.

The explosive growth of private markets has become a significant development in the U.S. securities landscape. Here are some key points highlighting the importance of private securities for securing funding.

Capital raised in private markets

More capital has been raised in private markets than in public markets each year for over a decade. Since the late 1990s, the number of publicly traded companies has fallen by 35% while the number of private companies has increased by over 40%. In fact, 96% of all U.S. companies are private. Companies are staying private longer for many reasons, including the high tax and regulatory costs of being a public company. Private placements, venture capital and private equity have become crucial sources of funding for companies.

Unicorns and innovations

The term unicorn refers to a privately held startup company with a value of over $1 billion. It is commonly used in the venture capital industry. The term was first popularized by venture capitalist Aileen Lee. Because of their sheer size, unicorn investors tend to be private investors or venture capitalists, which means they are out of the reach of retail investors. Reaching the unicorn status is a title of prestige, which recognizes the ability of startups to offer groundbreaking technologies, have a clear vision, as well as a viable way to get their message to venture capitalists and private investors. Unicorns are crucial for innovations as they disrupt traditional industries and leverage technology to create solutions that go beyond the convention offered by the market.

The number of unicorns has surged drastically in recent years, with an exceptional peak in 2021. Before 2021, on average, about 5 companies per month were crowned with this title. 2021 witnessed a staggering surge with an average of 43 companies each month joining the unicorn club. The post-2021 average, while lower than the peak, is still significantly higher at 17 companies per month. Specific sectors within the Tech industry are emerging as particularly prominent in this unicorn boom. Tech and Software, along with AI and Data Driven startups, are taking center stage.

These companies are not only big but also consequential, making significant contributions to innovation, job creation, and economic growth.

Longer duration of private status

Regulations and market volatility mean that companies are staying private longer -or potentially never list on the public markets at all. Companies can stay private for longer than before, even when they dwarf their public counterparts in size and influence.

There are several reasons why companies are staying private longer. One is that there are significant costs to publicly list a company. These costs can vary widely depending on a number of factors, they can range from $2.6M for smaller deals to upwards of $58M for larger deals. There’s also a requirement for management to file financial statements and other disclosures as per the SEC rules and meet with institutional investors. That burden is particularly heavy on early-stage companies, which may not have the organizational resources to do it all. Being publicly traded also exposes companies to daily market volatility.

Positive contributions

Private companies shift paradigms that are shaping the future of jobs, such as:

·        Generative AI (GenAI). The emergence of GenAI transforming how work is done, enabling new levels of creativity and efficiency

·        Employee benefits. Getting creative with employees benefits to retain top talents and gain a competitive edge.

·        ESG (Environmental, Social, and Governance). Shifting from Corporate Social Responsibility (CSR) to ESG

·        Sustainability. Moving towards sustainability, responsibility, and competitiveness as core values

Opacity and transparency challenges

Despite their significance, private businesses remain relatively opaque compared to their public counterparts. Opacity and lack of transparency present significant challenges for private companies for several reasons:

Trust

Investors may hesitate to invest in companies that do not disclose enough information, leading to a lack of trust and potentially higher capital costs.

Performance Metrics

Inadequate transparency can obscure the true performance of a company, making it difficult for investors to make informed decisions.

Capital Allocation

Opacity can impede the efficient allocation of capital, as investors may not have enough information to identify the best opportunities.

Valuation Challenges

 Without transparency, it’s difficult to accurately value a company, which can lead to mispricing in the market.

In essence, opacity and lack of transparency can create barriers to trust, investment, and efficient market operations, all of which are crucial for the success and growth of private companies.

Let’s explore various forms of private selling of securities in the United States, each catering to different stages of a company’s growth and specific capital needs.

Private equity transactions

Private equity investing refers to investing in shares of companies not publicly traded or listed on a stock exchange. It is comprised of investment partnerships that buy and manage companies before selling them.  These firms operate investment funds on behalf of institutional and accredited investors. Private equity funds may acquire private companies or public ones in their entirety or invest in buyouts as part of a consortium. Unlike venture capital (which often targets startups), most private equity firms invest in mature companies.

The underlying reason for private equity investing is to achieve returns on investment that may not be achievable in the public market. Partners at PE firms raise and manage funds to yield favorable returns for shareholders, typically with an investment horizon of four to seven years. Their goal is to increase the value of portfolio companies before exiting the investment years later. A significant capital outlay is needed because private equity invests directly-often to gain influence or control over a company’s operations- so deep pocket funds dominate the industry.

The global private equity market has grown to over $10 trillion in assets, driven by strong performance compared to public market, a rising opportunity set in private companies and increased investor demand and the emergence of investment vehicles focused on expanding access to the private equity market.

 

Strategies and actions commonly associated with private equity

Process

-       The private equity firm identifies a target company.

-       The purchase price is negotiated, and the deal is structured.

-       The firm raises capital using a combination of equity (the private equity firm’s own capital) and borrowed funds, usually from banks and other lenders funds (leveraged buyouts or LBOs)

-       The acquired company becomes a portfolio company

Value Creation

-       After acquisition, private equity firms work closely with portfolio company management

-       They appoint board members, provide strategic guidance, and monitor performance.

-       The firm’s success is tied to the portfolio company’s success

-       They implement operational improvements, cost-cutting measures, and strategic changes.

-       The goal is to enhance the company’s value during ownership

Exit Strategy

-       Typically, private equity firms hold the portfolio company for several years (around 5-7 years on average).

-       They aim to sell the company at a higher valuation, realizing a profit for their investors.

-       Common exit routes include initial public offerings (IPOs), selling to strategic buyers, or secondary buyouts.

In essence, private equity firms play a crucial role in reshaping businesses, driving growth, and creating value. Their strategies and actions impact both the companies they invest in and the broader market.

Venture Capital

Venture capital is a form of private equity financing provided by firms or funds to startup, early-stage, and emerging companies that have been deemed to have high growth potential or that have demonstrated high growth in terms of number of employees, annual revenue, scale of operations, and other relevant factors.   VC funds startups and early-stage companies by providing money, technical support, and managerial expertise. Fledgling companies sell ownership stakes to venture capital funds in exchange for financing.  It is an essential source of funding, especially when startups lack access to capital markets or traditional debt instruments.  VC investors often participate in management decisions to drive growth.

Venture capital offers entrepreneurs other advantages. Portfolio companies get access to the VC fund’s network of partners and experts. Moreover, they can depend on the VC firm for assistance when they try to raise more money in the future. Venture capital is an alternative investment that’s typically only available to institutional and accredited investors. Pension funds, big financial institutions, high-net worth investors and wealth managers, typically invest in VC funds.

Startups often approach VC firms to secure the funding they need to launch or continue their operations.  After performing due diligence, the firms will then loan money to the companies they choose. In return for funding, a VC firm takes an ownership stake that’s typically less than 50% in the startup company. Many of the larger VC firms will then take an active interest in ensuring that the companies they’ve invested in succeed and become profitable. They’ll do this in many ways, including taking an active interest in marketing, distribution, sales and even more aspects of the company’s daily operations.

A VC firm’s goal is to increase the value of the startup, then profitably exit the investment by either selling the fund’s stake or via an initial public offering (IPO).

Stages of Venture Capital Investing

As portfolio companies grow and evolve, they pass through different stages in the VC process. Some venture capital funds specialize in particular stages, where others may consider investing at any time.

Seed round funding

This is the first round of VC funding, in which venture capitalists offer a small amount of capital to help a new company develop its business plan and create a minimum viable product (MVP).

Early-stage funding.

Typically designated as series A, Series B, and series C rounds, early-stage capital helps startups get through their first stage of growth. The funding amounts are greater than the seed round, as startup founders are ramping up their businesses.

Late-stage funding

Series D, series E and series F rounds are late-stage VC funding. At this point, startup companies should be generating revenue and demonstrating robust growth, while the company may not yet be profitable, the outlook is promising.

The VC firm’s objective is to grow their portfolio companies to the point where they become attractive targets for acquisitions or IPOs. The venture capital firm aims to sell off its stakes at a profit and distribute the returns to its investors.

High Failure Rates

Venture capital investments come with a risk of high failure rates, ranging from 25% to 40%. Factors that can lead to unsuccessful outcomes include insufficient demand for the product or service, inadequate funds for operations and development, poor management decisions as well as an ineffective business model. Despite these risks, venture capitalists often find investing in startups appealing because it offers them the possibility of helping innovative projects grow.

Regulatory Environment

Venture capitalist and private equity firms are monitored by the U.S. Securities and Exchange Commission (SEC) to ensure they abide by federal securities laws. These rules safeguard investors as well as venture capital fund managers well as the businesses that venture capitalists invest in, providing legal assurance for all parties involved.

The Securities Act of 1933, The Securities Exchanges Act 1934, among other pertinent regulations, must be strictly adhered to, which will help maintain investor confidence. To reduce any potential risk incurred from failing adherence to such statutory policies on behalf of portfolio companies or those raising capital through venture capital plays of capitalism.

 

Regulation D and its Implications for Private Securities

Regulation D (Reg D) is a Securities and Exchange Commission (SEC) regulation that governs private placement exemptions. It allows companies to raise capital through the sale of equity or debt securities without the need for full SEC registration. Here are key points:

Private Placement and Exemptions.

Reg D lets companies engage in specific types of private placements without requiring full registration of the securities with the SEC. These offerings are often referred to as private placements or exempt offerings.  Unlike publicly traded securities, which must be registered, private securities under Reg D can be sold directly to investors without the same level of disclosure and reporting requirements.  This type of offering cannot be advertised or marketed to the general public.  It is mainly for companies issuing a private placement to accredited investors. Reg D can also be for only 35 non-accredited investors.

Advantages of Reg D

-       Faster Capital Raising. Companies can raise funds more quickly through Reg D offerings compared to a public offering.

-       Lower costs. The cost of compliance is generally lower for Reg D offerings.

-       Smaller Companies. Reg D is commonly used by smaller companies and entrepreneurs.

Form D Disclosure Document

After the first securities are sold, the company or entrepreneur must file a Form D disclosure document with the SEC. Form D contains essential information about the offering but is less exhaustive than the documentation required for a public offering. It includes details about the company’s executives, directors, and the offering itself.

What Industries Raise Capital with Reg D?

While the most common industry for a Reg D offering is real estate and real estate development funds, syndicators also use it to raise money for new and established businesses that are looking for cheaper capital, crypto-mining, blockchain businesses, private equity funds, and hedge funds.

Risk consideration

Investors should recognize that while Reg D makes raising funds easier, they still enjoy the same legal protections as other investors.  Reg D transactions are not secret, they are private offerings but not necessarily confidential.  Buyers of these securities should consider the ability to weather a total loss and the illiquidity associated with private placements.

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