Everyone is acquainted with public investments and now, more investors than ever have access and are trading stocks like never before thanks to trillions in stimulus money and free trading platform Robinhood.
Trading stocks on apps like Robinhood is literally child’s play where anyone 18 years or older with a bank account can start trading in a matter of minutes.
Although millions of novice investors have flooded the markets to get in on Wall Street trading action, most have a basic idea behind stock trading. You’re buying and selling shares of public companies in the form of stocks with the hope of the price of the stock rising so you can sell it for a profit down the road.
It’s all about timing. You want to get in when the price is low and get out before the slide. Pick enough winners and you’ll be in the black.
Although most investors know about public investments, only a fraction are familiar with private investments. Access has a lot to do with this where most private investments (as the name implies) are not publicly known. Despite recent changes by the SEC to loosen the advertising restrictions in some circumstances, most private offerings remain hidden from the public.
Awareness is only one of the differences between public and private investments. A handful of other distinctions have to do with access, disclosure, capital requirements, and liquidity.
ACCESS.
Anyone 18 and over can trade stocks. Private investments (i.e., private placements or private equity), on the other hand, are restricted to qualified investors who possess both the financial sophistication and the resources to withstand investment losses. These qualification requirements are meant to deter unsophisticated investors who don’t fully understand the risks involved and cannot afford to bear economic losses.
There are no qualification requirements for investing in public companies because the assumption is that because of the rigorous disclosures involved in going public, there is enough information available to potential investors to make informed decisions.
Private companies are exempt from going through the expense and rigor of going public. Although they are still required to disclose certain material information with potential investors, the disclosure requirements are not as onerous. It’s the qualification and screening of potential investors that take center stage with private offerings.
Private placements are typically reserved for Accredited Investors. Both entities and individuals can qualify as Accredited Investors, but the list of entities that fall within this category is too long for this discussion.
As the term applies to individuals, an Accredited Investor is a person that meets one of the following criteria:
- Have a net worth exceeding $1 million individually or combined with a spouse (excluding the value of the primary residence).
- Have earned income exceeding $200,000 ($300,000 if combined with a spouse) during each of the last two calendar years, with a reasonable expectation of maintaining these income thresholds during the current year.
Private companies are cautious not to violate the exemption regulations, so they’re meticulous in complying with the specific restrictions imposed by the SEC relating to private offerings. This includes pre-qualifying investors to establish Accredited Investor status because offers can even be made.
To ensure compliance, private companies will have every prospective investor complete an Investor Questionnaire to verify Accredited Investor status.
So no instant trading on Robinhood with private investments like you get with public investments. You have to qualify first, and for some private offerings, the qualification requirement goes one step further.
For a specific class of private offerings – ones that allow advertising – it’s not enough to claim accreditation status, but your status must also be verifiable.
This can be accomplished in one of two ways.
- One. Accreditation can be verified by a qualified, independent third party familiar with the investor, including a CPA, attorney, or wealth advisor attached to a registered broker-dealer. These qualified third parties can verify an investor’s accreditation status simply through a one-page letter.
- Two. Verification can also be accomplished through a third-party commercial provider such as VerifyInvestor.com and www.earlyiq.com, who will review personal documentation such as W-2s, tax returns, and account balance statements to ensure satisfaction of the financial criteria for qualifying as an accredited investor.
DISCLOSURES.
Public company disclosures in the form of a prospectus are available to any investor through the SEC’s website, but very few investors read them before investing. With private placements, investors are required to declare that they have received the company disclosures contained in a private placement memorandum (the “PPM”) and they have read and understood the risks involved.
Chronologically, once Accredited Investor status is established, the private company can now formally offer you its securities through the delivery of its disclosure document, the PPM.
The PPM provides comprehensive information about the securities being offered and the company making the offering, including its business strategy, use of funds, financial terms, risks, and management background.
The PPM will include other documents as part of the offering package, including:
- Subscription Agreement.
- The company’s operating agreement or partnership agreement.
- A form of security offered.
Offering documents can be delivered physically, electronically, or through a secure portal. This due diligence phase is the opportunity for a prospective investor to analyze the deal, scrutinize management, and ask any relevant questions. Most managers are accessible and are happy to answer questions about the offering, company, and management during this phase.
CAPITAL.
Capital involved with private offerings is measured in 10’s of thousands of dollars – not dollars as with public offerings. Minimum investments for private placements usually start around $10k and up.
Once an investor is comfortable with the offering and the company’s management, the prospective investor can now take the next step towards becoming a full-fledged investor.
This is done by filling out and signing the Subscription Agreement, including the number of securities to be acquired. In the case of equity, the prospective investor will also be required to sign the Company’s Operating Agreement or Partnership Agreement to become a partner or member of the company formally. The company will then review the Subscription Agreement, countersign it, and provide directions to the investor for paying for the securities.
Once payment is received, the company will transmit either a certificate of ownership (equity) or note/certificate (debt) evidencing the investor’s ownership of the company’s securities.
ILLIQUIDITY.
Private securities are restricted from being transferred while they’re held except in limited circumstances such as death or unless the company goes public. This means you’re locked in until the company accomplishes its exit plan, which typically involves a sale of its assets or going public. That means no panic selling like with public stocks.
Most PPMs will designate a defined exit plan. With debt securities, the notes/certificates will have defined terms. With equity securities, management will project how far into the future (5, 7, 9 years, etc.) it plans to liquidate the company’s assets and return investor capital along with any profits.
Public investors typically don’t receive direct communications from the company or its executives. That’s because public companies must report their earnings every quarter, which is made available to the public.
With private investments, after being accepted into the company, investors will typically be given access to an investor portal where they can receive updates and direct communications from the company – including periodic financial statements and reports – and annual tax forms, including K-1s.
