What Is Private Placement?

Private placement is a common method of raising business capital by offering equity shares. Private placements can be done by either private companies wishing to acquire a few select investors or by publicly traded companies as a secondary stock offering.

When a publicly-traded company issues 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.

Understanding Private Placement

Private placement is an issue of stock either to an individual person 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.

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.

For an individual investor to participate in a private placement offering, he 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.

Private Placement and Share Price

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.

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, since this increases 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.

Motivation for Private Placement

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.

The long-term effect on share price is much less certain and depends on how effectively the company employs the additional capital raised from the private placement. An important factor in determining the long-term share price is the company's reason for the private placement. If the company was 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, if the motivation for the private placement was a circumstance in which the company saw an outstanding opportunity for rapid growth that simply required additional financing, then 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.