An Overview To Private Placement Of Securities

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.

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.

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.

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

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

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.

• 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.

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.

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.