Why private placement financing is making a comeback

On the Money
From the  February 1, 2002 print edition

One of the most straight-forward resources for obtaining capital for a small business is also one of the oldest: private placement financing.

One example of private-placement financing is this true story:

A fellow was enjoying a cigar at Churchill’s Lounge at the Brown Palace Hotel. Three gentlemen, also smoking cigars, were discussing the oil business.

The first man, who was in a related business, overheard their conversation. He walked over to the group of three and said “Here’s what I’m up to,” so they reached in their pocket and handed him $200,000. He wrote them an IOU on a napkin.

Simply put, private placement financing issues security directly to an investor and secures capital for the business owner without the banking industry’s intermediation.

Though it’s not always as serendipitous as the Churchill’s Lounge example, private or informal investors are now, more than ever, searching for exceptional small business investment opportunities.

Despite the sluggish economy, I’ve run into more people with “funds on the side” in the past month than I have in my entire career.

Professor William E. Wetzel of the University of New Hampshire says informal investors represent the largest pool of risk capital in the country; financing 20,000 or more ventures per year.

Time was before small-business loans, venture capitalists and other banking-industry funding options, all deals were private placements.

Those who held excess funds sat face-to-face with those who needed them and agreements were made. To the chagrin of the banking industry, those good old days of straight-shot deals are back.

Furthermore, remove banking-industry underwriting or brokerage fees from the equation, and face-to-face financing is not just simple, it’s economical.

Private placements come in three basic forms:

• Equity investment where the investor is given partial ownership of the venture;
• Debt investment where the investor is given a secured promissory note;
• Limited liability partnership/corporation.

Of these options, the limited partnership is most commonly used for transactions between $500,000 and $1 million. For the investor, limited partnerships serve two purposes:

• They allow investors to assume limited liability. Creditors cannot look to the personal assets of the limited partners to satisfy partnership debts; the general partner assumes this risk, and losses for the limited partners are limited to the investment;
• All gains and losses from the venture flow directly to the partners. This allows the investor to report the gains and losses of the limited partnership on a personal tax return.

How does the small-business owner locate and secure private investors? Recent research profiles what a typical private placement investor might look like: 47-years-old, post-graduate degree, management experience with new ventures, likely to invest $20,000 to $50,000 in any one venture, participates in a private placement about once every two years, participates with other financially sophisticated individuals, invests within 50 to 300 miles of home, expects to liquidate the investment in five to 10 years, expects annual rates of return of 20 percent to 50 percent, depending on risk, learns of opportunities through friends and business associates, and is concerned with the “psychic income” from the venture, such as industry recognition.

A few sources for uncovering individuals with the means and desire to invest in a $500,000 to $1 million transaction include: CPAs who specialize in tax matters or focus on smaller privately held companies; attorneys who specialize in estate planning, tax strategies, and bankruptcy; commercial bankers, particularly those in “special assets” departments; venture capitalists who specialize in smaller startup and second stage financing; small-business owners who have an older, established client base; and chief financial officers of large corporations with self-funded pension and retirement plans.

A written partnership agreement helps clarify the particulars of the deal. In this agreement, items such as allocations of net income, net losses, credits, and distributions are specified.

The agreement usually describes eventualities such as liquidation, sale of partnership interests, apportionment, timing of distributions, liabilities, and tax considerations.

Ultimately, the small-business owner seeking financing knows that there’s no substitute for sound business, financial and legal knowledge and seeks-out same, thereby ensuring that all parties understand the nature of the risks involved.

© C. Stephen Guyer for American City Business Journals Inc. All rights reserved.