1. Private Placements and Venture Capital Chapter 28 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company1 What is it? Private Placements –A private placement occurs when new securities are sold directly to a single buyer, or a small group of buyers, without going through a public offering Buyers of these issues include banks, mutual funds, insurance companies, pension funds, foundations, hedge funds, and other institutional investors. –Lower costs for issuer –Do not have to meet SEC’s normal standard of disclosure –Advantages for buyers They can earn a return that is 50 to 75 basis points higher from a private issue than from a public offering –“Lettered Stock” Subject to certain restrictions –Flexibility to fully negotiate the issue

2. Private Placements and Venture Capital Chapter 28 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company2 What is it? Venture Capital –Venture capital is a source of funding typically made available to startup firms and small businesses with strong growth potential Usually provided in stock investments provided by venture capital funds –Convertible debt may be used –Venture capital firms obtain capital from a variety of sources: Private and public pension funds Endowment funds Foundations Corporations Wealthy individuals Foreign investors –High degree of risk associated with venture capital investing

3. Private Placements and Venture Capital Chapter 28 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company3 What is it? Venture Capital –Venture capital firms are rarely passive investors. They normally take an active role in the businesses they finance, performing some or all of the following activities: –Assisting in the development of new products and services –Contributing management expertise –Sharing experiences from other venture capital investments –Venture firms generally do not see their investments as being permanent in nature. Most seek to exit their investment in 3 to 7 years.

4. Private Placements and Venture Capital Chapter 28 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company4 When is the use of this tool indicated? Attractive to investors who: –Are willing to commit relatively large amounts of capital for a significant period of time –Generally have no need for current income from their investments –Are able to accept a relatively high degree of risk in anticipation of substantial capital gain potential –May be able to contribute significant managerial or business expertise to the new venture –Desire the relative secrecy and flexibility of negotiating the sale and purchase of securities privately

5. Private Placements and Venture Capital Chapter 28 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company5 Advantages A private placement does not have to be registered with SEC. –It is not a public offering. –The securities must be purchased for investment purposes rather than resale. Privately-placed debt issues normally offer a higher yield than publicly offered debt. –Buyers can negotiate a higher rate of return in exchange for the cost savings and convenience of a non-public offering. A venture capital investment may offer the opportunity to actively participate in running one or more business organizations. –Particularly for individuals with specific business expertise in areas like management, marketing, engineering, or finance

6. Private Placements and Venture Capital Chapter 28 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company6 Disadvantages Lack of Investment Liquidity –Both types of investments should be considered long-term in nature. Lack of Current Income –Startup firms and small businesses need to retain most if not all of their earnings to reinvest in the business. Dividends cannot often be paid out early on High Degree of Investment Risk –A very large percentage of new businesses fail for many different reasons A debt (bond) issue with a well-established firm can be a fairly conservative private placement investment.

7. Private Placements and Venture Capital Chapter 28 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company7 Disadvantages Lack of Management Control –Many venture capital and private placement investments are structured as limited partnerships. General partner has control over the day-to-day activities Uncertainty of Investment Timing –Investor subject to “capital calls” Occur when the fund actually begins to invest in various businesses and collects the needed funds from its partners The timing of these requests may be somewhat uncertain and extend over a substantial period of time Size of Required Investment –Minimum investment is quite large Not unusual to be $1,000,000 or more

8. Private Placements and Venture Capital Chapter 28 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company8 Tax Implications Private Placements –Similar to tax consequences on sales of stock or of corporate bonds Venture Capital –Similar to tax consequences of limited partners –May seek to exit through an: Initial Public Offering (IPO) –Receives stock in the company but Venture capital firm restricted in how that stock can be sold Merger or acquisition –Receives stock or cash for ownership –Distribution to owners –Tax deferred reorganization (tax is deferred until sale of shares)

9. Private Placements and Venture Capital Chapter 28 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company9 Alternatives Private placements and venture capital funds (partnerships) are somewhat unique in nature. –They do not have many comparable alternative investments Mutual funds REITs

10. Private Placements and Venture Capital Chapter 28 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company10 Where and How do I get it? Private placements –Available to institutional investors and “accredited” individual investors Venture capital funds –Sometimes marketed through major brokerage firms and investment bankers –The minimum initial investment is usually very large and not really practical for the average investor.

11. Private Placements and Venture Capital Chapter 28 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company11 What fees or other costs are involved? A participant in a venture capital operation should expect to pay a sales commission as well as various legal and management fees. –Should be carefully spelled out in the partnership agreement –Investor should examine them carefully Some venture capital limited partnerships are structured so that a large proportion of their gains go to the management and the general partner(s), rather than to the limited partner.

12. Private Placements and Venture Capital Chapter 28 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company12 How do I select the best of its type? Private Placements –Very wealthy individuals who are solicited for this type of investment should consider: The nature of the investment The terms of the particular offering The risk factors associated with the specific investment

13. Private Placements and Venture Capital Chapter 28 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company13 How do I select the best of its type? Venture Capital –Nature of the Investment Established to invest in a wide range of business areas with varying degrees of risk –Partnership Terms and Conditions A careful reading of the partnership agreement is essential –An investor may require legal and accounting consultants –Payments and fees to limited partners –Track Record of the General Partner General partner’s background Prior experience in the business His (its) ability to engage in the proposed business activities

14. Private Placements and Venture Capital Chapter 28 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company14 Where can I find out more about it? There is generally little information available to individual investors. The National Venture Capital Association (NVCA) –Industry overview –NVCA members –NVCA publications –Calendar of NVCA events The Investment Company Institute –A Guide to Closed-End Funds