WHAT ARE THE BENEFITS OF A PRIVATE PLACEMENT?
- Flexibility both in the amount and type of financing
- Investors in a private placement are typically more patient than venture capitalists and banks
- Lower up-front and back-end costs than approaching venture capitalists
WHAT ARE THE DOWNSIDES OF A PRIVATE PLACEMENT?
- Loss of some control
- Possible dilution of equity
- Pain and Suffering
BRIEF OVERVIEW OF FEDERAL SECURITIES LAWS
The federal securities laws make it illegal to offer or sell securities unless the offering is registered or exempt from registration. Registration is an extremely expensive and time-consuming process: expense and time that a typical start-up or growing business cannot afford. Therefore, most of these companies look for exemptions from registration to offer and sell their securities.
The most commonly used exemption is found in Regulation D under the Securities Act of 1933. Specifically, companies elect to use Rule 506 under Regulation D, which allows a company to raise an unlimited amount of money. Companies may sell their securities to an unlimited number of accredited investors and up to 35 non-accredited investors.
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WHY IS IT CALLED A PRIVATE PLACEMENT?
A private placement usually involves the sale of securities of the company to a relatively small group of investors in a private offering. Among the terms and conditions contained in Regulation D, Rule 502 (c) states that a company cannot use general solicitation or advertising to market the securities.
General solicitation or advertising are not defined in the statutes or rules. Instead, the Securities and Exchange Commission (SEC) takes a case by case approach. However, SEC guidance indicates that if the company had a relationship with the investor prior to the offering, sufficient to understand the investor’s financial position, there is a presumption that there has been no general solicitation.
WHO IS AN ACCREDITED INVESTOR?
An accredited investor is any individual with: (1) a net worth of at least $1,000,000; OR (2) had taxable income of at least $200,000 in the last two calendar years, and reasonably expects to have taxable income of at least $200,000 in the current calendar year; OR (3) together with his/her spouse, had taxable income of at least $300,000 in the last two calendar years, and reasonably expects to have taxable income of at least $300,000 in the current calendar year. Confirmation of this information is memorialized in a subscription agreement. As of July 21, 2010, a primary residence cannot be factored in the calculation of net worth thanks to the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act).
If the offering is made only to accredited investors, the issuer is not required to give investors any prescribed offering document (disclosure material) in order to have a valid exemption. If, however, even one investor is non-accredited, the law dictates the type and scope of disclosure to be given to investors including the requirement to provide audited financial statements.
Even if an offering is limited to accredited investors, the “anti-fraud provisions” under the securities laws still apply. Under the anti-fraud provisions, the issuer is required to provide all information that is material to an investor in making his or her investment decision. The issuer is liable for material omissions and material misstatements. Therefore, it is prudent to prepare and deliver a disclosure document (often called a private placement memorandum or private offering memorandum) so the issuer has a documented record of the information that was given to investors.
WHAT SHOULD A PRIVATE PLACEMENT MEMORANDUM INCLUDE?
A private placement memorandum should include, at a minimum, the following.
- A description of the terms of the offering.
- A description of the company’s business and its history.
- The business history of all of the company’s principals for at least the preceding 5 years.
- A description of the company’s planned use of the proceeds received from the offering.
- Most importantly, a discussion of the risk factors associated with investing in the company. This discussion must address the specific risks of the business, it cannot be boiler-plate.
- A summary of the company’s governing document (the Articles of Organization and Operating Agreement if an LLC, the Limited Partnership Agreement if an LP or the Articles of Incorporation and Bylaws if a corporation) and rights and restrictions and investor would have if they subscribe for interests. Factors including distribution rights, withdrawal rights and voting rights should be addressed in the summary to provide investors with information pertinent to their investment in the company.
Companies using a Regulation D exemption must file what is known as a Form D within 15 days of the first sale of securities. Form D is a brief notice that includes the names and addresses of the company’s executive officers and stock promoters, but contains little other information about the company.
Most states have enacted statutes or rules similar to those of Regulation D. States have been preempted by federal law regarding rule 506 under Regulation D; however, they do have the ability to require that an issuer file a copy of the Form D filed with the SEC and charge a filing fee.