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

by Michael Davis

In the previous article we addressed what the different nuances that make up the entity known as a private placement. In this article we will address the pitfalls of a private placement and the all important means of making a sizable return with this investment vehicle.

Due Diligence

As mentioned previously, the way to make money with a private placement investment is with proper due diligence and diversification. Due diligence means the performance of an investigation of a business and its operations. It is the investigation into whether on one's personal inquiry into that company it is expected to be a success or failure.

The problem with personal due diligence is that one may not really have the expertise to do an adequate investigation into the company. The converse may also be true in that the individual doing the due diligence may pass on a favorable investment because they have not been able to evaluate the merits of the company due to a lack of knowledge in that particular business.

If you're used to running a car dealership you probably don't know much about geological reports or online businesses. However, if the investment makes sense and the numbers are sound an investment into a private placement is an appropriate speculative endeavor to round out one's portfolio. If the investment contemplated is of a sizable amount then an independent advisor with experience in due diligence evaluations should be brought into the picture.

When doing your due diligence what makes sense? First and foremost look at the use of proceeds and the cost of raising the money by the company doing the offering. I've seen private placements done with a load factor up to 80 or 85% of the money raised. If the promoters are doing a drilling program drilling 1 well to a depth of 800 feet and their money raise is for $2 million or more chances are it's not going to work out for the investors. It's like the movie "The Producers" where Max Bialystock raised $2 million for a flop and expected to pocket 95% of that. If most of the money for the venture is going into someone's pocket and not the operation it's probably a scam and should be avoided.

Legal Aspects of Private Placements

Most private placements are exempt from registration with the SEC by means of what is called a Regulation D filing. These are broken down into Rule 504 offerings (limited to $1 million raised in a 12 month time frame) Rule 505 offerings (limited to $5 million raised in a 12 month time frame and only 35 non-accredited investors) along with a Rule 506 offering (again limited to 35 non-accredited investors, a $7.5 million cap for 12 months but with additional disclosure of the company's finances required). The complete details of the criteria for exemptions may be seen on the SEC website at www.sec.gov

Even though the offering maybe exempt from registration with the SEC proper forms must be filed with State Security Boards and the SEC to maintain that exemption. Many companies fail to file these documents with the intention of raising the money fast and closing up shop before they are investigated. The quickest way to find out if an investment is legitimate is to see if they have filed their Form D with the SEC. To do this simply do a search of that company with the SEC on their website. This from http://www.sec.gov/edgar/searchedgar/companysearch.html If nothing shows up they probably haven't filed the necessary paperwork and should probably be passed on also. However, the SEC does not comment on the merits of the investment but rather simply reports if the company has filed the necessary documents.

You should look at what is the nature of the people selling the investment. For a company to maintain its exemption from registration the security can only be sold by registered broker dealers or bona fide officers of the company. This eliminates and forbids the use of an independent sales office (ISOs) or other boiler room tactics to fall in the legal guidelines to sell the investment. If the offering is being sold this way it is also something to be avoided. If you're talking with the President of the company or other officer about the investment don't think "why is he wasting his time raising money" but rather think that they are selling the investment legitimately.

Management Team

Of particular importance is the management team of the startup you're investing in or contemplating investing in. Do they have a positive track record with other startups? Are they competent in their field. Are they in their field? It doesn't make sense to expect someone that has worked all their life in retail sales to be successful in a new bio-medical company nor for a physician to be successful in something outside their expertise.

This is extremely critical if the startup only has 1 or 2 people. Hopefully the company can make up for limitations of the key people with the knowledge and expertise of others involved. Management and a sound business plan are usually the cornerstones to success of the startup company. These are probably the 2 most important concerns in evaluating the merits of the investment. It is what the venture capital companies look at first and foremost in their due diligence.

So all that said why would anyone want to invest in a private placement. With proper due diligence and knowledge these can be great investments. Imagine buying into a company when it is a startup for $1 a share. The company goes public five years later at $18 and immediately jumps to $32 a share. Imagine also if you had done that with EBay, your return would have been about 250 times your original investment.

Diversification

However I have always told my clients the key to success in the financial arena is with diversification. "Don't put all your eggs in one basket." is more than true here. With private placement investing out of 10 well researched companies expect 4 or 5 to completely fail, 3 or 4 to have moderate success and 2 to be the home run you're looking for. With that in mind a 50% or more return on your investments is reasonable. Diversify but don't be stupid. This should be investing not gambling.

How Do I Cash Out?

In a corporation there are several ways to an exit strategy. The company may become a public company and you can sell your stock on the open market. The corporation may become the target of an acquisition and all shareholders will either receive cash or stock in the acquiring company. Lastly the corporation may declare dividends and return profits back to the shareholders. This last one is limited since most new companies invest most of the money back into the company for further growth.

An LLC or LLP will pass profits back to their investors in the form of distributions on a quarterly or monthly basis. This can be substantial and almost immediate for a successful company. In addition tax advantages in the form of write-offs or tax credits can be passed-through to the members or partners. As in the above, the company may also be acquired by a larger entity and the investors will realize a return on this.

In a note or debenture the investor will usually receive interest payments for the term of the note and return of their investment on maturity. Tha return is usually less than the above two but conversely is usually not at as much risk.

As in everything in life there is no guarantee of success. There are however other pluses to investing in a new startup. It maybe the satisfaction of helping a new company working in an area you find good about or socially helpful. It maybe the thrill of being with an up and coming company that succeeds from their outset and seeing them grow. Or it maybe back to the basics of making a good return on your money.

My personal preference to investing in a private placement is that of an LLC. The return maybe not as great as private stock in a private company but the return is usually quicker and the writeoffs can be taken usually immediately.

Here's to your success and good luck.

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.