How Private Placement Affects Share Price

What Is a Private Placement?

A private placement is a common method of raising business capital. It involves offering equity shares or bonds privately, and not to the public-at-large. Private placements can be done by either private companies wishing to acquire a few select investors or by publicly-traded companies, for example as a secondary stock offering.

When a publicly-traded company issues equity through a private placement, existing shareholders often sustain at least a short-term loss from the resulting dilution of their shares.

However, stockholders may see long-term gains if the company can effectively invest the extra capital obtained and ultimately increase its revenues and profitability.

What You Need to Know

• A private placement is a private offering of a security for sale to specific investors.
• Private placements of equity or debt can be done by a private or public company.
• Existing shareholders can experience dilution of their percentage of equity ownership due to the additional shares.
• Their loss of value is usually short term; long-term value depends on how well the company invests its added capital and the subsequent demand for shares.
• Investors who participate in a private placement must be accredited.

Understanding a Private Placement

Private placement is an issue of stock or debt either to an individual or corporate entity, or to a small group of investors. Investors typically involved in private placement issues are either institutional investors, such as banks and pension funds, or high-net-worth individuals.

The individual investor who wishes to participate in a private placement offering must be an accredited investor, as defined under regulations of the Securities and Exchange Commission (SEC).

This requirement is usually met by having a net worth in excess of $1 million or an annual income in excess of $200,000.

A private placement has minimal regulatory requirements and standards that it must abide by. The investment does not require a prospectus and, quite often, detailed financial information is not disclosed.

Note

Private placements can be an important funding method by which companies can raise, relatively quickly and easily, the capital needed to grow and advance their businesses.

Private Placement and Shareholder Equity

If the entity conducting a private placement is a private company, the private placement offering has no effect on share price because there are no pre-existing shares.

Dilution

With a publicly-traded company, the percentage of equity ownership that existing shareholders have prior to the private placement is diluted by the secondary issuance of additional stock.

This happens because the extra shares in circulation increase the total number of shares outstanding. The extent of the dilution is proportionate to the size of the private placement offering.

For example, if there were 1 million shares of a company’s stock outstanding prior to a private placement offering of 100,000 shares, then the private placement would result in existing shareholders having 10 percent less of an equity interest in the company.

However, if the company offered an additional 1 million shares through the private placement, that would reduce the ownership percentage of existing shareholders by 50 percent.

The Effect on Share Price

Short Term

The dilution of shares commonly leads to a corresponding decline in share price—at least in the near-term. The effect of a private placement offering on share price is similar to the effect of a company doing a stock split.

Longer Term

The long-term effect on share price is much less certain and depends on how effectively the company utilizes the additional capital raised from the private placement.

Why does the company need the funds? If the company were on the verge of insolvency and did the private placement as a means of avoiding bankruptcy, it would not bode well for the company’s shareholders.

However, the motivation for raising additional funds may be an outstanding opportunity for rapid growth. The private placement can help the company make the most of it. As a result, the eventual extra profits realized from the company’s expansion may push its stock price substantially higher.

Another possible motivation for doing a private placement could be that the company cannot attract large numbers of institutional or retail investors. This might be the case if the company’s market sector is currently considered unattractive, or there are only a few analysts covering the company.

What’s the Difference Between a Private Placement and an IPO?

The difference is that with an initial public offering, or IPO, shares are listed on a public exchange and trade on the open market where anyone can buy them. There are strict SEC regulations for IPOs. These include the required public disclosure of a great deal of financial and perhaps confidential information about a company. Compared to an IPO, a private placement of shares is non-public, less regulated, typically easier and faster, and involves just a few investors.

What Is an Accredited Investor?

According to the SEC, an accredited investor is a person with an earned income of more than $200,000, or a net worth of over $1 million, or who is a broker or other financial professional with relevant certifications in good standing. Other standards apply, such as spousal contributions to those figures.

Are Private Placements Exempt From SEC Registration?

Yes, and that’s because they are limited to a very small number (sometimes even just one) of accredited investors. If they were issued to the general public, SEC registration would be required.

The Bottom Line

A private placement is a non-public issuance of a security to a specific group of accredited investors. It can be undertaken by either a private or public company.

Public company private placements can dilute the ownership percentage for existing shareholders and cause a loss of value in their holdings in the short term. The long-term effect of a private placement on share price depends on the reason for the private placement and how well the funds that are raised are used.

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