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HELEN HUNTLEYAt best, putting money into a private company is high risk. At worst, it can turn out to be a scam.
Some investors looking for better returns are wading into the high-risk territory of "private placements," lending money to or buying stock in small private companies.
Often the investments are perfectly legal, but they are not low-risk alternatives to publicly traded stocks or bank CDs, which is how they sometimes are portrayed. And some of them turn out to be scams.
Last week the National Association of Securities Dealers warned investors of the potential for abuse when brokerages raise money from their clients for private offerings. The catalyst was a case the association brought against a New York company, Investprivate Inc., which raised about $17.6-million for itself and its affiliates.
The NASD said documents given to investors misrepresented the company's background and its use of the money it raised, which included paying personal expenses for the company chairman. The company and its chairman have the right to a hearing before any action is taken. However, the NASD said the case, and others like it, show investors need a better understanding of how private placements work and the potential for problems.
Federal law requires securities to be registered before they can be sold to the public. Companies must file disclosure documents and regular financial updates with the Securities and Exchange Commission. However, the law contains an exemption, known as "Regulation D," that allows qualifying companies to raise money without jumping through those legal hoops. That's good for companies that want to raise a few million dollars without the legal and accounting costs of a public offering, but it can be perilous for investors.
Here are some of the potential pitfalls, according to the NASD and the Securities and Exchange Commission:
- The company may not do well or may even go out of business, a particular risk if it is relatively new or has inexperienced management.
- Investors may have difficulty finding out how the company is doing financially.
- Investors may have difficulty getting their money out of the company since there is no public market for the securities.
- The company may never go public, disappointing investors who buy stock hoping for a big return.
- The offering might be found to be illegal if all the requirements for an exemption are not met. To meet these exemptions, securities generally cannot be advertised to the public.
- A conflict of interest may exist if the company selling the investment will benefit from it.
It isn't just brokerages that are trying to raise money for private placements. Florida Merchant Capital Investors (FMCI) of Tampa has been soliciting investors for private placements in two plumbing companies. The company calls itself a merchant bank.
Allen Martin, a Lutz businessman who owns FMCI, says the first deal is an opportunity for investors to buy notes in Pritchard Plumbing, a Bradenton business he also owns. He said the notes will pay between 5.95 percent for a two-year investment and 8.95 percent for an investment that's five years or more.
He said he sees the offering as a way to fix the interest rates on Pritchard's cost of capital, instead of paying an adjustable interest rate on a loan from a bank. "My concern is that we've been in a period of low interest rates and that may change."
FMCI's Web site describes the company's offerings to potential investors as a way to secure their retirement dreams and "preserve your money with minimum risk while you earn a predictable fixed income on your investment."
Martin said the investments are safe because he plans to direct investments only to companies that he controls and that are not heavily in debt.
"Safety is relative to the company's ability to pay its obligations as they come due," he said. "These are small transactions for which someone would want to get to know us and have a comfort level that we were honorable businessmen before they would make an investment."
Financial advisers say investing in private companies is inherently risky and those who want to attempt it should either be sophisticated investors or have the potential investment reviewed by someone who is.
"You're not going to get more than the market rate of return without taking additional risk," said financial adviser Ray Ferrara of ProVise Management Group in Clearwater.
"The people who market these kinds of products can be extremely persuasive," he said. "I would strongly urge anyone who is solicited to go into one of these programs to seek a second opinion from a financial planner or someone else in the securities business to help them understand what it is they're thinking of getting into."
- Helen Huntley can be reached at huntley@sptimes.com or 727 893-8230.