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Private-placement shares are basking in a new limelight as a flurry of cannabis and blockchain companies raise capital.

The purchase of stock in these smaller-cap firms through a private offering is commonly the playground of money managers, but it can also be a lucrative bet for higher-net-worth investors willing to take on additional risk.

These investments are usually issued by publicly traded companies or concurrent with a reverse takeover when a private firm gets listed by acquiring shares of a public shell company. As well, they may also be offered to investors just before a company’s initial public offering (IPO) hits the market.

Cannabis companies are raising capital through private placements. Here, a worker collects cuttings at a Canopy Growth facility in Ontario.Chris Wattie/Reuters

“If you are investing in a pre-IPO placement, you are betting on the IPO price being higher than what you are investing at today,” says Devon Cranson, president of Cranson Capital, a boutique investment banking firm in Toronto.

“The only reason you do a pre-IPO is for that pop,” said Mr. Cranson. “The value should automatically go up because of your ability to trade [the shares].” Similarly, private-placement shares issued by a public company are offered at a discount to its current stock price.

Smaller firms often go the private-offering route for financing because it is quicker and cheaper than filing a prospectus with regulators. A company’s financial situation and relevant risks are detailed in a prospectus document.

Private placements are available to accredited investors, who must earn more than $200,000 annually ($300,000 with a spouse) in the two previous years, have $1-million in investable assets, or net assets of at least $5-million. Non-accredited investors may qualify under certain conditions.

The securities are typically sold as a unit, which includes one common share and a warrant giving the investor the right to buy more stock at a set price within a certain period, such as two years. In most cases, investors cannot sell the shares for four months after the offering closes.

“Four months doesn’t sound like an awfully long period until you are actually living it,” and are unable to sell in a market downturn, says Robert McWhirter, president of Toronto-based Selective Asset Management Inc., who has invested in private placements for his own portfolio. “Now, that big buffer you had when you bought this stock has evaporated.”

Mr. McWhirter says he will sometimes hang onto private-placement shares beyond four months, but it depends on how they have performed, the outlook for the company and how it compares with industry peers. In a bear market, he will look to sell because small-cap stocks “can decline significantly” regardless of the outlook.

One of his recent successful private-placement bets was the Ottawa-based medical cannabis producer Indiva Ltd. before it became public in December after doing a reverse takeover of Rainmaker Resources Ltd. Indiva was raising money to expand its London, Ont., production facility to 40,000 square feet.

He found the company appealing because its shares were issued at a cheaper valuation than its peers. But in its document to investors, he says, Indiva also issued this warning: “This investment is risky. Don’t invest unless you can afford to lose all the money you pay for this investment.”

Mr. McWhirter spent $20,250 to acquire common shares at 75 cents each along with a one-half warrant that will expire in two years. (Two half-warrants give him the right to buy one share of Indiva common stock for 90 cents.)

After the four months, he sold his stock at $1.1436 per share on Dec. 28. His profit was $10,627, or a gain of 52 per cent. It was a wise move; the stock price slid to 67 cents recently before rebounding to the 75-cents-a-share range.

He sold on concerns over the ability of Indiva to compete against big players, such as Canopy Growth Corp., which is expected to have 5.6 million square feet of domestic growing space within a year and $1.2-billion in sales during the first full year of Ottawa’s legalization of recreational cannabis.

“The business is moving to massive economies of scale,” says Mr. McWhirter. “It will be hard for smaller producers to compete.” Meanwhile, he still owns his warrants in case Indiva shares rally above 90 cents again.

Warrants are a “risk-free opportunity” to participate in the potential upside of a company, and the expiry date can sometimes be extended, he says. “At least, it gives you optimism that your lottery ticket might have some value.”

Some companies may even move up the warrant-expiry date if the shares trade higher than the exercise price for a certain period. Investors usually then get 30 days’ notice to exercise the warrants or they become worthless, he says.

Investors, meanwhile, don’t pay a commission to buy private-placement shares. The issuer pays a cash commission – often in the 6- to 8-per-cent range – and also a sweetener in the form of warrants to the brokers or agents involved in the sale. With incentives to promote a stock, and limited disclosure obligations, investors are “pretty much on their own,” he warns. “It’s caveat emptor,” or buyer beware.

Retail investors might want to take a page from Peter Lynch, a former star manager with the Boston-based fund giant Fidelity Investments Inc., who recommends “investing in something that you know.”

For instance, dermatologists might consider investing in a company, such as MedX Health Corp., listed on the TSX Venture Exchange, because they are familiar with the company’s hand-held skin-cancer detection device, says Mr. McWhirter. “They can use that personal experience as their own version of due diligence.”

Still, retail investors may be up against hedge-fund and other money managers who are employing strategies such as short selling to protect their investments. Their moves can put downward pressure on share prices.

Some big investors will dump their stock after four months as part of a game plan to simply bet on the potential upside of their warrants, said Sruli Weinreb, founder of Toronto-based Plaza Capital Ltd., who runs microcap investment funds.

Retail investors can mimic this strategy, but it is frowned upon by issuers, he says. “A company looks to cultivate a committed group of shareholders. They are not looking for people to get in and out, which typically will penalize the stock price.”

Investors in private placements need to “take a deep look at what a company does to ensure that it is not just hype,” Mr. Weinreb warns. “It’s very easy to get taken up by the excitement of cannabis and blockchain. But there has to be good value and … ideally management that has a track record of building real businesses.”

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