What Are Private Securities & How Do They Work?

Financial markets offer various avenues for companies to raise capital and for individuals to invest. While publicly traded stocks and bonds often dominate discussions, a significant segment of the financial landscape exists beyond traditional exchanges. This area involves private securities, which function distinctively compared to their public counterparts. Understanding private securities is important for anyone seeking a comprehensive view of investment opportunities and the mechanisms companies use to fund their growth.

Defining Private Securities

Private securities are investment instruments issued directly by companies to investors, bypassing the need for public registration with regulatory bodies. These securities are not traded on public stock exchanges, such as the New York Stock Exchange or NASDAQ. Instead, their issuance and transfer occur through private transactions. Companies opt for private offerings to raise capital without undergoing the extensive and costly public registration process associated with an Initial Public Offering (IPO).

A core characteristic of private securities is their limited disclosure requirements compared to publicly traded assets. This offers companies greater flexibility and privacy due to less stringent reporting obligations. This direct issuance model allows companies to secure funding from a select group of investors, often facilitating quicker access to capital. The types of private securities vary widely, encompassing equity interests like shares in private companies, private equity funds, and venture capital investments.

Private securities also include various forms of debt, such as private credit, private debt, and fractional loans. Offerings made through certain crowdfunding exemptions also fall under this umbrella. These instruments represent ownership stakes or creditor relationships with a firm, operating under a different regulatory framework than public securities. The structure of private securities can be tailored, allowing for customized products that meet specific investment or capital-raising needs.

Key Differences from Public Securities

Private securities contrast sharply with public securities across several fundamental aspects, beginning with disclosure requirements. Public companies must provide extensive financial and operational information to the public through regular filings with the Securities and Exchange Commission (SEC). This robust disclosure ensures transparency and helps inform a broad base of investors. Private companies, conversely, operate with significantly reduced public disclosure obligations, providing information directly to their investors without public scrutiny.

Trading and liquidity represent another primary distinction between private and public securities. Public securities are highly liquid, meaning they can be easily bought and sold on open markets at prevailing prices. This ease of transaction allows investors to enter and exit positions quickly. Private securities, in contrast, are generally illiquid, making them difficult to sell quickly or at a desired price due to the absence of an active secondary market. Investors in private securities typically expect to hold these assets for longer periods, often years, without a guaranteed exit.

Access for investors also differs considerably. Public securities are generally available to any investor who wishes to purchase them. Private securities, however, are typically restricted to specific categories of investors, often those with greater financial resources or knowledge. This limitation is a protective measure by regulators, ensuring that investors in less transparent and less liquid private offerings can bear the associated risks.

Valuation methods also diverge. Publicly traded assets have readily observable market prices that update continuously, providing transparent and frequent valuations. This market-driven pricing offers a clear benchmark for performance. The valuation of private securities can be less transparent and frequent, often relying on periodic appraisals or specific financial events rather than daily market activity. This lack of continuous market pricing can make it challenging to quantify investment performance or assess risks precisely.

Regulatory Environment

The existence of private securities outside stringent public registration requirements is enabled by specific legal and regulatory frameworks. Federal securities laws, such as the Securities Act of 1933, generally require that any offer or sale of securities be registered with the SEC unless an exemption applies. These exemptions allow companies to raise capital privately without the time-consuming and expensive process of full public registration. The purpose of these exemptions is to facilitate capital formation for companies, particularly smaller or emerging businesses, while still aiming to protect investors.

One of the most frequently used exemptions is Regulation D, which provides rules for private offerings. Rule 506(b) permits companies to raise an unlimited amount of money from an unlimited number of accredited investors and up to 35 non-accredited but sophisticated investors. Under Rule 506(b), companies cannot use general solicitation or advertising to market the securities, relying instead on pre-existing relationships. If non-accredited investors participate, they must receive disclosure documents similar to those required in public offerings, including financial statements.

Another provision under Regulation D is Rule 506(c), which allows companies to broadly solicit and advertise their offerings. However, all purchasers in a Rule 506(c) offering must be accredited investors, and the issuer must take reasonable steps to verify their accredited status. Verification might involve reviewing tax returns, bank statements, or other financial documentation. Both Rule 506(b) and Rule 506(c) offerings require the issuer to file a Form D notice with the SEC within 15 days after the first sale of securities.

Regulation A+, often referred to as Reg A, offers another exemption from registration, particularly for smaller and mid-sized companies. This regulation has two tiers. Tier 1 allows companies to raise up to $20 million within a 12-month period, while Tier 2 allows for offerings of up to $75 million in a 12-month period. Tier 2 offerings have additional requirements, such as audited financial statements and ongoing reporting obligations to the SEC, but they allow for general solicitation and pre-emption from state securities laws for qualified purchasers.

Investor Participation

Participation in private securities offerings is typically limited, focusing on individuals and entities capable of assessing and bearing the inherent risks. This framework relies on the concept of an “accredited investor.” An accredited investor is an individual or entity that meets specific financial or professional criteria established by the SEC, allowing them to invest in unregistered securities. This distinction is made because regulators assume these investors possess the financial sophistication and resources to understand the risks of less liquid and less transparent investments, thereby not requiring the same protections as the general public.

For individuals, the most common pathways to qualifying as an accredited investor involve income or net worth thresholds. An individual may qualify if they have earned income exceeding $200,000 in each of the two most recent years, or joint income with a spouse or spousal equivalent exceeding $300,000 for those years, with a reasonable expectation of the same income level in the current year. Alternatively, an individual can qualify if their individual net worth, or joint net worth with a spouse or spousal equivalent, exceeds $1 million, excluding the value of their primary residence. This exclusion of primary residence value prevents individuals from inflating their investable net worth with illiquid assets.

The SEC has expanded the definition to include other categories.
Certain financial professionals holding specific licenses, such as Series 7, Series 65, or Series 82, can qualify as accredited investors based on their professional knowledge and experience.
“Knowledgeable employees” of a private fund can be considered accredited investors for investments in that specific fund.
These changes aim to broaden access to private markets for individuals with demonstrated financial expertise, even if they do not meet traditional wealth thresholds.

Institutional investors also constitute a significant category of participants in private securities. This group includes:
Banks
Insurance companies
Registered investment companies
Certain business development companies
Corporations, partnerships, limited liability companies, trusts, and charitable organizations with assets exceeding $5 million can also qualify as accredited investors. These institutional participants often have dedicated teams for due diligence and risk assessment, allowing them to engage in complex private market transactions.