In today’s market, raising capital is tough. One method is the private sale of securities. This may involve passing the hat with friends, family and "angels," or structuring more formal deals with venture capital funds and institutions. But before you even think about approaching these potential investors, it is critical to plan ahead. The consequence of improper planning is much more severe and costly than you probably imagine.
Under Section 5 of the Securities Act, all offers and sales of securities must be registered with the SEC unless there is an available exemption. The Act requires extensive registration with the SEC —pounds of paper. Individual states also have registration requirements. This is why IPOs are so incredibly expensive. Luckily, there are exemptions to avoid all that if you don’t make an offering to the "public," but instead offer your securities "privately" to a limited number of investors. That’s why we call this a private placement.
There are certain requirements that you have to meet to have a private placement. Regulation D is a series of three separate exemptions that provide a "safe harbor" for non-public offerings. The most frequently used of these exemptions falls under Rule 506, which is highly favored for two main reasons: (1) an unlimited amount of capital can be raised; and (2) state registration requirements are preempted. Accordingly, we highly recommend that companies determine whether they can fit within the parameters of Rule 506.
WARNING: The folks in Washington snuck in a few changes to the accredited investor standard when they passed the Dodd-Frank Act last summer. So, if you or your investors have been involved in private placements in the past, do not assume that it is business as usual. For purposes of determining whether a person qualifies as an accredited investor on the basis of having a net worth in excess of $1 million, the value of his or her primary residence must now be excluded. This will knock many investors who used to be accredited out of the game.
If you want to structure a cost-effective private placement that involves fewer headaches, accredited investors really should be the only ones invited to the party. Although a Rule 506 offering allows you to include some non-accredited investors ("NAIs"), such investors can be more trouble than they are worth.
The amount of information that must be disclosed to each NAI is burdensome. Essentially, disclosure mirroring a registration statement is required, which means increased legal and accounting costs and more management time.
NAIs tend to be more difficult and needy than accredited investors. By definition, accredited investors have a larger net worth than NAIs, so their concentration of risk in your offering is not as great. Accredited investors also are more likely to have invested in various other offerings. They tend to be more investment savvy, more financially sophisticated, and more familiar with required paperwork and procedures.
The SEC reasons that unsophisticated investors with a small net worth particularly need protection, while big boys and girls are better able to take care of themselves. This is why you do not have to give accredited investors the extensive disclosure required for NAIs. You will instruct an accredited investor that he or she has a right to ask questions, and they will certify that they have asked all questions to their hearts’ content. Practically, this means the chance of successfully being sued down the road by an NAI is probably greater than with an accredited investor.
What exactly is an Accredited Investor?
Accredited investors include the following:
Certain types of financial institutions;
Generally, entities with total assets in excess of $5 million;
Directors, executive officers or general partners of the issuer;
Individuals whose net worth, or joint net worth with that person’s spouse, exceeds $1 million; and
Individuals whose income regularly exceeds $200,000 or joint income with spouse regularly exceeds $300,000.
The burden actually falls on the company issuing the securities to determine the status of potential investors. An investor questionnaire is used to confirm and document this. Each potential investor should complete a questionnaire in which they disclose certain personal and financial information and certify that they are indeed an accredited investor. Because the burden falls on the issuer, if the documents are incomplete, or you do not believe an investor satisfies the listed criteria, do not let that person invest.
WARNING: In our experience, we are constantly asked by clients — “Can we just include Brother John, Cousin Mary? Nothing could ever go wrong. ” Although your lawyer could help structure a private placement involving an NAI, it will be a lot more time consuming and costly. And you never want to try to sneak in just one NAI. Just one would completely blow your exemption.
Don't Forget These Other Details
Do Not Engage in General Solicitation or Advertising
Any general solicitation or advertising (i.e., via newspapers, television, magazines, radio, public seminars, cold calls or the Internet) of the offering by an issuer or any person acting on its behalf is strictly prohibited. A violation of this prohibition could practically mean delaying the offering for a “cooling off” period of six months to a year. Although a company can still continue generic advertisements completely unrelated to the offering (e.g., for its products), it must pay careful attention to and review all promotional materials and reports to ensure that those materials are not related to the offering.
Be Wary of Using Intermediaries to Find Investors
Issuers often engage associated persons, unregistered finders or registered broker-dealers to act on their behalf to locate potential investors. There are two main concerns with such intermediaries. First, to avoid claims of general solicitation, the intermediary should have a substantive and pre-existing relationship with each prospective investor. Second, if the intermediary is only an associated person or finder, he or she must not engage in activities that would require registration as a broker-dealer, such as participating in presentations or negotiations, making any recommendations concerning securities, or receiving transaction-based compensation. If a finder or associated person engages in such activities, the entire offering may be jeopardized.
Because the consequences of non-compliance are so severe, it is important to document everything.
- Offering Memoranda. If you are just selling to accredited investors, an offering memorandum is not technically required. However, in most cases we recommend distributing summary disclosure documents to all prospective investors to help satisfy securities’ laws antifraud provisions. These offering memoranda -- which should touch on all major investment issues so as to put investors on notice to ask relevant questions -- should be drafted in cooperation with your management, attorneys and accountants.
- Form D. If you decide to make a private placement under Rule 506, you must electronically file a Form D no later than 15 days after the first sale of securities.
- Payments and Final Subscription Documents. Incoming checks and subscription documents should be regularly tracked. This is important for various reasons, including proper and timely filings with the states. States often require that issuers provide notice filings no later than 15 days after the first sale of securities in that state. It is important to regularly update your lawyers about new sales, especially if it involves a sale in a new state, so that they can make the proper notice filings.
WARNING: There are other changes on the horizon. The SEC has proposed a rule whereby an issuer would not be able to rely on Rule 506 if the issuer or certain related parties are subject to a disqualifying event such as a criminal conviction, court injunction or restraining order. These “bad actor” disqualifications are still being considered. In fact, this is just one of many rules coming out of Washington after the passage of the Dodd-Frank Act. It is important to consult with your legal counsel before starting any private placement to make sure there are not any new rules applicable to your company.
Consequences of Non-Compliance can be Devastating
You may be bracing yourself for the typical lawyerly conclusion of doom. But many of our clients are surprised to learn how severe the consequences of non-compliance can be. If you fail to abide by the rules discussed above, you may be deemed to be selling unregistered securities, which is a violation of the Securities Act. Such a violation may subject you to an SEC enforcement action. Of greater consequence, you will have given all of your investors a “put,” or the right to ask for their money back. The general remedy for the sale of unregistered securities is the purchaser having the right to rescind or cancel its purchase and recover the purchase price (and interest) from the issuer for one year after the sale. Thus, if a venture is not successful, investors would not have to prove fraud; they would just have to show that you did not comply with private placement requirements.
That incredibly low benchmark is sobering, which is why we encourage you to plan ahead.
Click here to view the full digital version of the The Economic Development edition of SML Perspectives.