Joseph Stone Capital Insights: Understanding Investment Losses in Private Placements

Joseph Stone Capital believes the most important part of evaluating a private placement is understanding how it could lose money. Private placements are speculative, and investors can lose some or all of their investment. Knowing why losses happen helps investors size commitments and read offering documents with clearer eyes.

Business risk. Many private placements finance early-stage or emerging growth companies. These businesses may have limited operating histories, may not yet be profitable, and may depend on a small number of products, customers or managers. If the business does not succeed, the securities may become worthless.

Dilution. Companies often raise capital in several rounds. Each new round can issue additional shares, reducing an earlier investor's percentage ownership. If a later round is priced below an earlier one, called a down round, earlier investors may see the value of their position fall, sometimes sharply.

Where an investor sits in the capital structure. Private companies frequently issue different classes of securities. Preferred shares may carry liquidation preferences, meaning they are paid before common shareholders if the company is sold or wound down. Debt holders are generally paid before equity holders. In a sale at a modest price, junior securities may receive little or nothing even if the company is not a failure.

Valuation uncertainty. Private securities do not trade on an exchange, so there is no daily market price. Values shown on statements may be based on the most recent financing round, an independent appraisal or a cost basis, and may not reflect what the securities could actually be sold for. An unrealized loss can appear, grow or shrink as new information arrives. A realized loss occurs when the investment is sold, written off or the company is dissolved.

Illiquidity and transfer restrictions. Private placement securities are generally "restricted securities" under federal securities laws and cannot be resold unless registered or an exemption from registration is available. An investor who needs money may be unable to exit, or may only be able to sell at a significant discount. The investment may need to be held until a sale of the company or a public offering, which may never occur.

Fees and expenses. Placement fees, management fees and other costs reduce the amount actually invested in the business and can reduce net results. These charges should be disclosed in the offering documents.

No SEC review. Private placements are not registered with the SEC. Neither the SEC nor any state regulator reviews or approves the offering or the private placement memorandum.

Limited information. Private companies are not required to file the same ongoing reports as public companies. Investors may receive less frequent or less detailed updates, which can make it harder to monitor an investment.

Reviewing a position that has declined. Investors who hold a private investment that has fallen in value can ask how the current value was determined, what information the company has provided, and whether any transfer or liquidity options exist. Questions about the tax treatment of a loss should go to a qualified tax professional.

Planning before investing. Before committing capital, investors can ask:

• How much of my portfolio does this represent, and could I afford to lose all of it?
• Where does this security sit in the company's capital structure?
• How will it be valued and reported to me?
• How long might my money be committed?

Private placements are suitable only for investors who understand these risks in advance and can afford to have capital tied up for a long time, or lose it entirely.

Related Insights: Questions investors should ask before any private placement · How investors can review a brokerage firm · All Insights

Disclosure: Informational and educational only. Not an offer or recommendation to buy or sell any security, and not investment, tax or legal advice. Investing involves risk, including loss of principal. Joseph Stone Capital, LLC, member FINRA/SIPC. 585 Stewart Avenue, Suite L60C, Garden City, NY 11530.