Private placements are the nation’s most frequently used method for startups and small businesses to raise capital. For smaller businesses, public offerings are not a viable option due to the high expenses and disclosure requirements associated with registration. While the Securities Act of 1933 (Securities Act) generally requires that companies register with the SEC whenever a security is sold, some businesses can sell securities under certain exemptions without registering. Securities sold under one or more exemptions are referred to as “private offerings.”
In general, in order to qualify for an exemption, companies must adhere to several restrictions, such as the manner in which the offering is made, who can participate in the offering, verification of investors, and the maximum amount of capital that can be raised. Traditionally, only public offerings allowed the use of general advertising and solicitation to attract investors. However the recent adoption of Rule 506(c) has extended this ability to private offerings as well, so long as specific requirements are met.
This post will broadly explore a roadmap for conducting a private offering with the following steps:
- Choosing an exemption,
- Finding investors,
- Qualifying investors,
- Negotiating the terms of the offering,
- Preparing private placement and offering documents, and
- Closing the deal.
1. Choosing an Exemption
Section 5 of the Securities Act mandates that every time a security is sold (and for avoidance of doubt, a convertible note is considered a security), it must either be registered with the SEC or exempt from registration. In a private offering, a company can obtain its capital needs while avoiding complex registrations and associated costs.
The following descriptions of exemptions are only meant to highlight some key characteristics and not meant to serve as an in-depth overview. Please work with an attorney to consider what exemption is right for you.
i. Regulation D
Regulation D is a “safe harbor” private offering exemption that allows for a limited offer and sale of a company’s securities without registration with the SEC. There are several different types of exemptions under Regulation D that are briefly discussed below.
ii. Rule 504
Rule 504 allows for an unlimited number of investors and a maximum aggregate offering price of $1 million in a 12-month period. Companies are not required to provide disclosure materials about the offering to investors, but it is frequently done as best practice over considerations of fraud and misrepresentation. General advertising and general solicitation may be permitted only if state registration requirements are met. Overall, Rule 504 is used less frequently because of its $1 million cap on the amount of possible capital raised.
ii. Rule 505
Rule 505 provides a $5 million ceiling on the amount of capital that can be raised, but it limits the number of possible accredited investors and only allows up to 35 non-accredited investors. Companies must provide these investors with substantive disclosure documents that include financial statements. Whether an investor is considered an accredited investor will be discussed below.
iii. Rule 506(b)
Rule 506(b) has no limit on the amount of capital that can be raised, but issuers cannot engage in general advertising or general solicitation. The rule allows for an unlimited number of accredited investors, but only up to 35 non-accredited investors, and investors must receive detailed disclosure documents including financial statements. Additionally, companies relying on 506(b) are required to take “reasonable steps” to verify the accredited investor status of investors.
iv. Rule 506(c)
Rule 506(c) for the most part is the same as 506(b) in that it allows for an unlimited amount of capital to be raised and requires certain investors to receive disclosure documents. The key difference is that under Rule 506(c), companies can use general advertising and general solicitation if specific conditions are met, including the issuer taking “reasonable steps” to verify that each person is an accredited investor.
v. Section 4(5)
Section 4(5) differs from Regulation D in that securities can only be offered to accredited investors. Section 4(5) has a maximum aggregate offering price of $5 million. Under this section, companies cannot rely on general advertising or general solicitation to market their securities. This exemption is not used often because it is similar to Rule 505, but lacks Rule 505’s flexibility of being able to offer securities to non-accredited investors.
vi. Rule 147: The Intra-State Offering Exemption
Rule 147 grants an exemption from registration to issuers through an intra-state offering provided the following conditions are met:
- The company must be organized and doing business within the state
- Advertising and solicitation methods are allowed only within the state
- Resales are permitted beginning nine-months after the last sale of securities to in-state residents only.
There is no limit to the amount of securities sold, provided you meet the criteria above.
2. Finding Investors
After choosing a type of offering, companies must obtain investors. Depending on the type of offering, general advertising and general solicitation may be permitted. In order for the marketing of a security to not be considered “general” advertising, there must be a substantive and pre-existing relationship between the company and potential investors. In addition, an unsolicited investor can express interest in buying the security.
If general advertising and general solicitation is not permitted, issuers can establish a pre-existing relationship with investors through intermediaries. One type of intermediary is associated persons, including the companies’ officers, directors, and employees. Further, unregistered finders and registered broker-dealers are third parties that help issuers find investors. Issuers shall require finders and brokers to sign compliance certificates, mandating that they comply with the offering’s conditions and regulations. They should also make sure that finders and brokers have the proper experience and a successful track record.
III. Qualifying Investors
For the exemptions discussed above, some or all of the investors need to be “accredited investors.” An accredited investor is a person who meets one of eight different enumerated definitions. Under these definitions, an accredited investor may be a certain type of business, including a business with assets over a certain amount, or it can be a natural person. Generally, a natural person is an accredited investor if he or she has a net or joint net worth of at least $1 million, or if he or she has income exceeding $200,000 ($300,000 including spousal income) in the past two years, and expects to have the same income in the current year.
For a closer look at whether your prospective investors are accredited, please consult an attorney as there are numerous and nuanced characteristics that meet the definition of accredited investor (including trusts and other small businesses). To help document the company’s attempt to vet investors, it’s advisable to request that prospective investors complete a purchaser suitability questionnaire, which will allow the placement agent and counsel determine whether the investor meets the suitability requirements of a specific exemption.
IV. Negotiating the Terms of the Offer
Negotiating the terms of the offering should include a discussion of various important terms. An experienced attorney can help walk you through the important details.
Generally, terms to discuss include type of security, price of security, voting rights, registration rights, right to designate board members, protective provisions which include a vote on key business decisions, information rights, conversion rights, anti-dilution protections, and liquidation preference.
Furthermore, you should consider tax implications when it comes to debt to equity ratios, how the current round will impact your common stock price, your anticipated burn rate, and when you forecast additional capital needs.
V. Preparing Private Placement and Offering Documents
Issuers offering securities to non-accredited investors must provide them with full, fair, and complete disclosure of material facts about the issuer, its board of directors and officers, and its finances, including audited financials. Even when not required, to meet investors expectations and to protect against anti-fraud provisions of the SEC, it’s advisable to provide some form of a disclosure document. Completing a Private Placement Memorandum (PPM) is aimed at fulfilling these requirements. You’ll likely work with your CPA and attorney to complete the PPM to ensure the proper narrative format and that information is presented to comply with Rule 502(b)(2).
Only after the prospective investors have been qualified, as discussed above, should the issuer provide the PPM and deal terms to the prospective investor. A subscription or investment agreement can be provided to the investor with detailed representations and supporting documents showing that reasonable steps have been taken to verify the accredited investor status.
VI. Closing the Offering
If the issuer accepts the investor’s subscription/investment documents, an agreement is formed and the offer is closed. If relying on a private offering under Regulation D, once the offering is closed a Form D must be filed with the SEC and at the state level within 15 days. When subscription funds are accepted into escrow, the 15 days filing requirement is triggered even though the security hasn’t technically been sold. Additional state and federal registration may be required depending on the type of exemption you are relying on, and preparing a strategy with an experienced attorney is crucial to maintaining the validity of your private placement.
As this roadmap reveals, the process of providing a private offering is still extensive and detailed, but with the help of an experienced attorney, small businesses can take advantage of its less stringent requirements than those required by public offerings. To set up a consultation to discuss your fundraising efforts in greater detail, please contact us at info@bendlawoffice.com, or at (415) 633-6841.
Disclaimer: This article discusses general legal issues and developments. Such materials are for informational purposes only and may not reflect the most current law in your jurisdiction. These informational materials are not intended, and should not be taken, as legal advice on any particular set of facts or circumstances. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction. Bend Law Group, PC expressly disclaims all liability in respect of any actions taken or not taken based on any contents of this article.