How To Make Money With a Private Placement (1 of 2 articles )

by Michael Davis

Chances are if you are reading this article you are familiar with the concept of a private placement. If you are not familiar with the terminology an explanation of what it is would be in order.

What is a Private Placement?

A private placement is where a company sells a portion of its assets to an individual or investment entity usually in exchange for operating capital. The private placement may be issued by a publicly traded company that sells restricted shares which may be sold after a specific period of time, usually 12-18 months. However a private placement is usually done by a privately held company to individuals that purchase a piece of a startup. Unfortunately for investors, these oftentimes don't work out and the investors lose a portion if not all their money. It has been estimated that 80-90% of all private placement investments result in losses for the investors.

Why Invest in a Private Placement?

So why would someone choose to invest in a private placement? The answer is to make money. With the odds against the investor how can they get a return from this investment. That answer is also simple. Diversification and due diligence.

Forms of Private Placements

First of all let's examine the form of a private placement and the underlying company. Most private placements are LLCs (Limited Liability Companies) or LLPs (Limited Liability Partnerships). Both of these entities are very similar in that the liability a member of the LLC or LLP has is limited to their original investment. In other words their personal assets beyond their original investment are safe.

An LLC is a hybrid between a corporation in which the shareholders are only subject to loss of their investment and a partnership in which the availability of write off loss or income gain is passed-through to the members of the LLC. That advantage of tax write-offs is a major reason for the popularity of this type of investment particularly in the Oil & Gas Exploration business and Equipment Leasing Partnerships.

There is a distinct difference in the management of an LLP and an LLC. In an LLP the partners have the right to manage the business directly. In an LLC the members elect a Manager that runs the day to day operations of the company. Usually in both of these entities the management control is directly related to the percentage ownership.

The LLPs and LLCs will typically pay a disbursement to their partners or members on a quarterly basis sometimes monthly. These disbursements can be sizeable particularly in successful operations in which a member or partner can recoup their total original investment within the first few months of operation and anything after that is pure profit. Unfortunately, many of these companies never produce a penny in profits and the investors don't see any return. We will address that in our next article.

Another form of a private placement would be that of common or preferred stock in a private or public corporation. This stock is thus ownership in the company itself. The positives of this type of investment would be if the company becomes very successful the value of the investment multiplies tremendously.

Imagine if you were able to buy stock in Google or Microsoft when they were fledgling startups. A $10,000 investment then would be worth tens of millions today if not more. It is difficult to find another Google or Microsoft and most startup companies end up failing. However, there is a company out there right now that may surpass these two in growth over the next 20 years, finding it is the key to success. We will also address this in the next article.

A third type of investment maybe that of a direct loan or some form of a Debenture or Convertible Debenture. In a Convertible Debenture it usually takes the form of a loan or note for some period of time to be paid upon maturity with interest. The interest rate can be very good - sometimes in double digits.

At maturity the note maybe convertible into common or preferred stock or simply result in return of the original investment. The terms would be laid out with the original investment. This is a subject that can also be very influential as to whether the investment becomes a success or failure.

If the investor makes 24% on their money plus can convert the original investment into buying $5 stock for $1 a share in two years that was a good investment. However, if the company results in failure or collapse in those two years, cannot pay the interest and the $1 stock is now worth a penny or nothing, that investment was not so good.

There are other forms of investment into a company but these three are the major ones in play now. There are advantages and disadvantages in each one. In our next article we'll address exit strategies and I'll give you my preferences and recommendations. Again, the key to success in investing in a private placement is Diversification and Due Diligence.

Michael Davis is a former Series 7 and 24 NASD broker, finishing certification for CFP and the president of AAAInvestors.com, a private, third party consulting company dedicated to helping investors with due diligence and discovery of investments.