An Overview To Private Placement Of Securities

By: Jeffrey T. Petersen, Esq.       

When a company wishes to raise money by offering its securities for sale, whether it’s the in the more typical form of equity securities, or it’s an offering of debt securities, in general that company must make the offering by either registering the securities under the federal and state securities laws, or pursuant to an exemption from those laws. A private placement of securities is one that is done pursuant to exemption, where the securities being offered are not registered with federal and state authorities.

1. Policy Reasons behind Private Placement Exemptions

Federal law requires registration of securities offers and sales as a way to ensure that companies are providing accurate, current and complete information about themselves before people invest in their companies. If an offering is small enough in nature, however, either because a modest amount of money is being raised, and/or the company is only soliciting investors who are wealthy and savvy enough to be presumed to understand the risks of investment, then the laws allow that smaller offering to be done without registration. Federal and state anti-fraud laws will still apply to a private offering, however, so if a material misstatement or omission is made in the course of the offering, the buyers can still file suit to rescind the purchase.

A supporting policy rationale for exemption is the recognition that many smaller companies do not have the funds to go through the expensive, time-consuming process of registering their securities for sale. Attorneys’ fees, accounting fees, and the highly technical and long-spanning process of registration make it cost prohibitive for most small businesses. Exemption strikes the balance between control (antifraud laws still apply, the federal and state government will be notified of the offering) and fostering business growth (reducing costs and fees significantly by not forcing the company through the registration process).

2. Common Requirements Applicable to Regulation D Private Placements

For this overview, we will focus on the three Regulation D exemptions from registration. There are other exemptions, but focusing on the most popular exemptions will give you a general understanding of the requirements for exemption for the majority of private placements.

Rules 504, 505 and 506 of Regulation D set forth the three different exemptions a company may use. Although each has different aspects, there are some general rules that are applicable, summarized below.

  • A. Integration

    A company must be aware that any offerings of securities within six months of the start of the Regulation D offering, or within six months of the conclusion of that offering, will be “integrated” to determine whether the issuer complied with any applicable monetary cap for the offering. And sales within that six month period on either side can be further integrated with other sales outside those periods to increase even further the amount the SEC will consider having been raised in one offering.

    For example, if a company is trying to use the Rule 504 exemption with a maximum cap on raising money of $1,000,000, and begins the offering on June 30th of a particular year, any monies the company raised in a prior offering from January 1st through June 30th would be added to the amount raised in the offering beginning July 1st. Therefore, a company raising only $700,000 after July 1st in the offering would still exceed the maximum threshold if it had raised any monies above $300,000 from January through June.

  • B. The Private Placement Memorandum

    During the offering process, the company will generally give investors a Private Placement Memorandum (“PPM”) that summarizes, among other things: (1) the terms of the offering (the price for each share of the security, minimum investment requirements, etc.); (2) the company’s business, including its strategic plan, competitors and management; and (3) the specific risks the company will face in its operations. Other specific information required under certain Regulation D offerings will be addressed below.

  • C. The Anti-fraud Laws

    As mentioned above, whether or not the securities are registered, federal and state law still prohibit making any material misrepresentation in connection with the offering or sale, or omitting a material fact necessary to make a statement in the PPM, in light of the circumstances in which it was made, not misleading. The company’s officers and directors may be personally liable for an investor’s damages in a fraud case, so providing the reasonably necessary information is obviously crucial here.

  • D. Resale Limitations

    The securities sold in a private offering are restricted, meaning that they cannot be resold without either an effective registration statement being filed, or a separate exemption for the resale.

    The company also must take reasonable steps to make sure the securities are not being purchased for resale, generally by: (1) asking if the purchase is for an investor or third party; (2) disclosing to each purchaser that the securities have not been registered and cannot be resold except as set forth above; and (3) placing a legend on the securities setting forth the restrictions per item 2 above.

  • E. Advertising Limitations

    The use of advertising is generally restricted when conducting a private placement under Regulation D. Advertising can be utilized in certain circumstances in a Rule 504 offering (though those circumstances are discrete enough that such advertising typically does not occur with a Rule 504 offering), and if the issuer complies with the requirements for advertising under Rule 506(c), which will be discussed in more detail in the section examining that rule.

3. The Three Regulation D Exemptions to a Public Offering

The three Regulation D exemptions, in order of amount allowed to be raised under each, are: (1) Rule 504; (2) Rule 505; and (3) Rule 506.

There are three general categories of requirement an issuer must meet in order to qualify for exemption, not all of which apply to each of the three exemptions: (1) entity restrictions (the type of entity that can offer the securities); (2) transaction restrictions (how much can be raised in the offering); and (3) purchaser restrictions (who can purchase the securities).

  • i. Rule 504 Because the Rule 504 exemption has the lowest ceiling for the amount of money that can be raised, it has the least amount of other restrictions that go along with it.

Entity Restrictions.

For a startup or a typical operating company, the entity restrictions in Rule 504 will not be any issue. These restrictions are imposed to ensure that companies that already have securities reporting obligations cannot avoid registering securities, nor can companies that do not intend to be an actual operating business.

In order to take advantage of the Rule 504 exemption, then, the issuing entity cannot be: (a) an SEC reporting company, i.e., subject to the reporting requirements of section 13 or 15(d) of the Securities Exchange Act of 1934 (the “Exchange Act”); (b) an investment company; or (c) a shell company, i.e., a development stage company that either has no specific business plan or purpose, or has indicated that its business plan is to engage in a merger or acquisition with an unidentified entity or entities.

Transaction Restrictions.

The offering must be no more than $1,000,000 during any twelve-month period, keeping in mind the integration rules also apply.

There is no limit on the number of purchasers under Rule 504(b), nor is there any requirement that investors meet certain threshold levels of income or net worth in order to purchase the securities being offered. Investors that do meet these requirements, called “accredited investors”, will be discussed in Rules 505 and 506.

There are no specific information disclosure requirements under Rule 504, although the issuer is always subject to the anti-fraud provisions of the securities laws, meaning that sufficient information has to be provided about the company and the offering so that the investor will not have been misled in connection with the purchase. The absence of specific disclosure requirements (which will be discussed in more detail for Rules 505 and 506), means that a Rule 504 offering is a significantly easier undertaking for the issuer. The tradeoff for that, of course, is the lower limit on the amount of money that can be raised.

  • ii. Rule 505 There is no general entity restriction for a Rule 505 offering.

Transaction Restrictions.

The offering must not exceed $5,000,000 during any twelve-month period, keeping in mind the integration rules apply.

Purchaser Restrictions.

No more than 35 unaccredited investors1 may purchase securities in the offering, but an unlimited number of accredited investors may purchase the securities.

Information Disclosure Requirements.

The issuer must provide information to non-accredited investors (not accredited investors) that is generally equivalent to disclosures seen in registered offerings, including financial statements, with a requirement of providing audited financial statements subject to some exceptions. Because of the intensive disclosure requirements for non-accredited investors here, many issuers choose to deal only with accredited investors in a Rule 505 offering.

  • iii. Rule 506 There is no general entity restriction nor an offering size restriction for a Rule 506 offering. In the past few years, Rule 506 has been amended to provide for two separate offering options, Rule 506(b) and Rule 506(c). The chief difference between the two is that Rule 506(c) allows for general advertising in connection with sale of the securities, and thus has some additional restrictions which accompany it.

Purchaser Restrictions.

  • Rule 506(b)

    No more than 35 unaccredited investors may purchase securities in the offering, but the unaccredited investors in a Rule 506 offering must meet the additional requirement of having, either alone or in conjunction with his or her purchaser representative, such knowledge and experience in financial and business affairs to be able to evaluate the merits and risks of the investment, and the company must reasonably believe immediately prior to making any sale that the unaccredited investor fits within this description. An unlimited number of accredited investors may purchase securities through the offering.

  • Rule 506(c)

    All the investors in this offering must be accredited investors. Moreover, the company must take reasonable steps to verify that its investors are accredited investors, which could include reviewing documentation, such as W-2s, tax returns, bank and brokerage statements, credit reports and the like.

Information Disclosure Requirements.

The requirements to disclose information to unaccredited investors in a Rule 506(b) offering is the same as in Rule 505. And again, there are no unaccredited investors allowed under Rule 506(c), so that information requirement does not come into play.

4. Conclusion

Regulation D provides a safe harbor from registration allowing companies to raise money more quickly and at a lower cost, so long as the rules of the road are followed. An upfront examination of which exemption or exemptions is appropriate for a capital raise is crucial, as is adherence to the requirements of same.

DISCLAIMER: The following is intended as an overview and does not constitute legal advice. Any potential private placement of securities contains its own unique issues and requires specialized legal advice.

1 A full examination of each and every type of “accredited investor” is beyond the scope of this chapter, but in general for purposes of raising funds for most startups and operating companies, an “accredited investor” is an individual (including a spouse) with a net worth over $1,000,000 or with income in excess of $200,000 for the past two years and expected for the current year ($300,000 if including the spouse); or entities such as banks, insurance companies, and investment companies.

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