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Raising Money Through Private Placements

By: Andrew Sherman, Esq.
McDermott, Will and Emery
Washington, DC

03/29/01

FEDERAL SECURITIES LAWS APPLICABLE TO PRIVATE PLACEMENTS

STATE SECURITIES LAWS APPLICABLE TO PRIVATE PLACEMENTS

SCOR OFFERINGS

COMPLIANCE ISSUES


During these turbulent financial markets where the availability of venture capital has grinded to a near halt, one equity financing strategy available to early-stage, emerging growth companies and netpreneurs in the greater Washington, D.C. region is the private placement offering, which generally refers to any type of offering of securities by a small or growing company that doesn’t need to be registered with the Securities and Exchange Commission (SEC). To determine whether a private placement is a sensible strategy for you, you must: (a) have a fundamental understanding of federal and state securities laws affecting private placements (which are provided below as an overview); (b) be familiar with the basic procedural steps that must be taken before this capital formation alternative is pursued; and (c) have a team of qualified legal and accounting professionals to assist in preparing the private placement offering documents, usually referred to as the Private Placement Memorandum or PPM. The PPM is essentially an offering of your securities to a combination of family, friends and angels, but the biggest difference is that instead of an arm’s length negotiation with one or a few investors, you’re now targeting a large-enough number of investors that a set of offering documents is required under federal and state laws.

The private placement can offer you (as the “offeror” or “issuer”) reduced transactional and ongoing costs because a private placement is exempt from many of the extensive registration and reporting requirements imposed by federal and state securities laws. Private placements usually also offer the ability to structure a more awarded and confidential transaction, because the offerees will typically consist of a small number of sophisticated investors.  In addition, a private placement permits a more rapid penetration into the capital markets than would a public offering of securities requiring registration with the SEC.

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FEDERAL SECURITIES LAWS APPLICABLE TO PRIVATE PLACEMENTS

As a general rule, the SEC requires that you file a registration statement before you offer to sell any security in interstate commerce. However, the Securities Act of 1933 allows for some exemptions, all of which are found under Sections 3 or 4. The most commonly recognized transactional exemption is a private placement.

To qualify for a private placement, you’ll have to work with your attorney and the investment banker to structure the transaction within the categories of available exemptions, such as Section 4(2), Section 3(a)(11) and Regulation D. Section 4(2) is designed for transaction “not involving any public offering"; Section 3(a)(11) is an intrastate exemption; and the most common is Regulation D, which covers three specific exemptions under Rules 504, 505 and 506 from the registration provisions as set forth below.

Rule 504 (the first of the three exemptions under Regulation D) permits offers and sales of not more than $1,000,000 during any 12-month period by any issuer that is not subject to the reporting requirements of the Securities Exchange Act of 1934 (the "Exchange Act") such as most publicly-traded companies and that is not an investment company. Rule 504 places very few limits on the number or the nature of the investors that participate in the offering.  It is strongly recommended, however, that certain baseline criteria be developed and disclosed in order to avoid unqualified or unsophisticated investors. Rule 504 doesn’t require that you register a formal disclosure document (also known as a "prospectus") or even send one to offerees. However, there’s still a great deal of information potential investors must understand, and procedures they’ll have to follow, so I recommend you have a prospectus—it will protect you, your management team and your company against any subsequent claims by disgruntled or confused investors. Remember that an offering under Rule 504 is still subject to the general anti-fraud provisions of the Exchange Act; all information that you provide to the prospective investor must be accurate and not misleading in its content or its omissions in any material respect. (If you file under Regulation D, the SEC requires you to file a Form D within 15 days of the first sale, which is a simple form which summarizes your offering and the basis for the exemption)  Finally, if you’re looking to raise capital under Rule 504, be sure to examine applicable state laws very carefully. Although many states have adopted overall securities laws similar to Regulation D, many don’t include an exemption similar to 504—as a result, you may have to prepare a more formal offering memorandum.

Rule 505. Many companies select this rule instead of 504 because its requirements are consistent with many state securities laws. Rule 505 allows for the sale of up to $5,000,000 of the your securities in a 12-month period to an unlimited number of "accredited investors" and up to 35 non-accredited investors (regardless of their net worth, income or sophistication). An "accredited investor" is any person who qualifies for—and must fall into—one or more of eight categories.  The categories include officers and directors of the company who have "policy-making" functions, and outside investors who meet certain income or net worth criteria.  Rule 505 has many of the same filing requirements and restrictions imposed by Rule 504 in addition to an absolute prohibition on advertising and general solicitation for offerings, and restrictions on which companies may rely on the exemption. This applies to persons who have been subject to certain disciplinary, administrative, civil or criminal proceedings, or sanctions which involve the company or its predecessors.

Rule 506. This rule is similar to Rule 505 in that you may sell your securities to an unlimited number of accredited investors and up to 35 non-accredited investors. For companies needing more than $5,000,000 to complete the proposed acquisition, this exemption is the most attractive because it has no maximum dollar limitation. The big difference under Rule 506 is that any non-accredited investor must be "sophisticated."  You must have good reason to believe that the investor "has knowledge and experience in financial and business matters that render him capable of evaluating the merits and understanding the risks posed by the transaction (either acting alone or in conjunction with his "purchaser representative"). The best way to remove any uncertainty over the sophistication or accreditation of a prospective investor is to request that a comprehensive Confidential Offeree Questionnaire be completed before the securities are sold. If exclusively accredited investors participate in the transaction, then Rule 506 does eliminate the need to prepare and deliver disclosure documents in any specified format. Here too, there is an absolute prohibition on advertising and general solicitation exists.

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STATE SECURITIES LAWS APPLICABLE TO PRIVATE PLACEMENTS

Every state in the nation, including Maryland and Virginia, has some type of statute governing securities transactions and securities dealers, and Regulation D was designed to provide uniformity between federal and state securities laws. It’s worked in some states, but there’s still a long way to go on a national level. Whether or not your offering is exempt under federal laws, registration may still be required in the states where the securities will be sold under applicable "Blue Sky" laws. (These are laws that require securities issuers to register the offering and provide financial details so investors have solid information on which to base their decisions. The story goes that a judge once said that an offering in question had as much value as a patch of blue sky.) You and your team will have to consider the expense and requirements on both the federal and state levels.

There are many levels of review among the states, ranging from very tough "merit" reviews (which ensure that all offerings of securities are fair and equitable) to very lenient "notice only" filings (which primarily promote full disclosure). The securities laws of each state where an offer or sale will be made, should be checked very carefully prior to the distribution of the offering documents and you must also be keenly aware of the specific requirements of each such state. Although a comprehensive discussion of state securities laws is beyond the scope of this book, you should review these laws to determine:

  • whether the particular limited offering exemption you’ve
                selected under federal also applies in the state;

  • whether pre-sale or post-sale registration or notices are
                 required;

  • whether special legends or disclosures must be made in the  
                offering documents;

  • what the available remedies are to an investor who has
                purchased securities from a company that has failed to
                comply with applicable state laws; and

  • who may offer securities for sale on behalf of the company.

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SCOR OFFERINGS

Most states have now adopted the Small Corporate Offering Registration ("SCOR") which makes the use of Regulation D a more viable source of growth capital for entrepreneurs and smaller companies. It does this by using the Form U-7, a question-and-answer format disclosure document, which you can complete with assistance from your accountant or attorney. The form simplifies and streamlines the disclosure process, and reduces your cost of compliance without sacrificing information that prospective investors need to reach informed decisions.

Armed with a basic overview of the regulatory issues, you’re now ready to begin preparing your offering documents. You’ll be working with your attorney and banker to assemble the documents and exhibits that will constitute the "Private Placement Memorandum" (the "PPM"). The PPM describes your company’s background, the risks to the investor and the terms of the securities being sold. You’ll also have to determine the exact degree of "disclosure" that should be included in the document, and several factors affect the type and format of information that must be provided. These include the:

  • minimum level of disclosure you must make under federal securities laws (this depends, in part, on the registration exemption you’re using);

  • minimum level of disclosure you must make under an applicable state's securities laws (which depends on the state or states in which an offer or sale of the securities is to be made);

  • sophistication and expectations of the targeted investors (for example, some investors will expect a certain amount of information presented in a specific format regardless of what the law require); and

  • complexity or the nature of the company and the terms of the offering (for example, many entrepreneurial companies should prepare a set of disclosure documents (regardless of whether or not they are required to do so) in order to avoid liability for misstatements, fraud or confusion, especially if the nature of the company and/or the terms of its offering are very complex).

Your attorney must first carefully review each transaction or proposed offering of securities to determine the minimum level of disclosure required under applicable federal and state laws. After that, you should weigh the costs of preparing a more detailed document than may be required against the benefits of the additional protection you’ll get from a more comprehensive prospectus. Ultimately, the question will always be "What is the most cost-effective vehicle for providing the targeted investors with information that they require and that both applicable law and prudence dictate they must have?" There is no easy answer.

Practical Tips for Ensuring a Successful PPM Offering

To make sure your PPM is successful, you may want to consider the following tips:

            Be ready and have a hit list. You certainly don’t want to take the time and expense to prepare a PPM and not have any clue who to show it to when it’s completed. Prepare a list of targeted investors well in advance to make sure the offering is viable and to help your lawyers evaluate compliance issues. Remember that not everyone on the list will actually subscribe so the list should be considerably larger than the actual number of units that will be offered.  Analyze this list to ensure that you have properly determined the size of the units.  For example, a $10,000 unit may be attractive to investors but may be too small to get to your final capital targets or may allow an investor that may be otherwise committed to a larger unit to fallback to a $10,000 commitment.  Conversely, a $100,000-sized unit may get you to your goal faster but also exclude many of the otherwise qualified investors on your hit list.

            Make sure the economic terms are attractive. Remember that unlike a venture-capital deal, in which the business plan is presented and then a Term Sheet is negotiated, the PPM offering is not intended to be negotiated at all. Therefore, you must have a good sense of the attractiveness and fairness of the terms of the offering in advance of the distribution of the document. This may mean holding informal pre-offering meetings with prospective investors and others in the business community who can be a sounding board.

            Find some sizzle or special benefits or rights for the investors. For early-stage companies, the only real appeal to investors is typically the opportunity to get in on the ground floor of what might be the next Microsoft. Since that’s not likely to be the case for every company, your challenge is to find some special benefit or rights to entice investors to invest in your company. You may be surprised to learn that these special benefits may make all the difference regarding whether your offering will be successful.

            Do it right the first time. The adage that “you never get a second chance to make a first impression” applies to PPMs. Investors don’t want to see a lot of glitter or waste but they will expect to see a well written and properly formatted document, without typographical errors or poor grammar. They’ll want exhibits and other information that really helps them understand the business and the risks inherent in the offering. They may expect to be invited to a nice reception where they’ll have an opportunity to see a product demonstration and interact with the management team.

            Friend of a friend of a friend. One of the age-old questions with a PPM offering is “To whom can we send the document, and how well do we have to know them?” Well, remember that the offering is supposed to be private, not public. The offerees should be people with whom you and your team have a “pre-existing relationship.” It should not be sent to a blind list of the wealthiest people in your city—you know, the sort published by a local magazine. Naturally, there is a gray area as to whether “friends of friends” may be involved as offerees. Use your discretion and consult with counsel if in doubt.

Key Sections of the PPM

            The specific disclosure items you include in your PPM will vary depending on the size of the offering and nature of the investors (as defined by federal and state securities laws). The text should be descriptive, not persuasive and allow the reader to reach his or her own conclusion regarding the merits of the securities being offered by the company.  If in doubt as to whether a particular piece of information should be disclosed, go ahead and disclose it. The categories of disclosure items might include:

v     Introductory Materials introduce the prospective investor to the basic terms of the offering. A cover page should include a brief statement about the company and its core business, the terms of the offering (often in a summary table format), and all required disclosures on the cover page required by federal and state laws. The cover page should be followed by a summary of the offering, which serves as an integral part of the introductory materials and cross‑reference point for the reader. The third (and final) part of the introductory materials is usually a statement of the investor suitability standards, which includes a discussion of the federal and state securities laws applicable to the offering, and the definitions of an “accredited investor” as applied to the offering.

v     Description of the Company is a statement of the company’s history (and that of its affiliates and predecessors). In addition to the history, it will include a discussion of the company’s principal officers and directors; products and services; management and operating policies; performance history and goals; competition; industry trends; advertising and marketing strategy; suppliers and distributors; intellectual property rights; key real and personal property; customer demographics; and any other material information that would be relevant to the investor.

v     Risk Factors is usually the most difficult section to write, but it's viewed by many as one of the most important to the prospective investor. Its purpose is to outline all of the factors that make the offering risky or speculative. Of course, the exact risks posed to the investors will depend on the nature of the company and the trends within that industry.

v     Capitalization of the Issuer provides the capital structure of the company both before and after the offering. For the purposes of this section in the PPM, all authorized and outstanding securities must be disclosed (including all long-term debt).

v     Management of the Company should include: the names, ages, special skills or characteristics, and biographical information of each officer, director or key consultant. It should detail compensation and stock option arrangements; bonus plans; special contracts or arrangements; and any transactions between the company and individual officers and directors (including loans, self‑dealing, and related types of transactions). You should also disclose the role and identity of your legal and accounting firms, and any other "expert" retained in connection with the offering.

v     Terms of the Offering should describe the terms and conditions of the offering, the number of shares to be offered (including the minimum and the maximum) and the price. If the securities are to be offered through underwriters, brokers or dealers, then the names of each "distributor" must be disclosed, as well as the terms and nature of the relationship between you and each distributor; the commissions you’ll pay; the distributor’s obligations for example, guaranteed or best efforts offering); and any special rights, such as the right of a particular underwriter to serve on the board of directors, any indemnification provisions or other material terms of the offering. Note: The terms and structure of the offering should be based on a series of preliminary, informal meetings with possible investors (without those discussions qualifying as a formal "offer" as that term is defined by the securities laws). You should also do research on current market conditions and recently closed, similarly situated offerings.

v     Allocation of Proceeds states the principal purposes for which the net proceeds will be used, and the approximate amount you intend to use for each purpose. You need to give careful thought to this section because any material deviation from the use of funds as described in the PPM could trigger liability. If you don’t have an exact breakdown, then try to describe why you’re raising additional capital, and what business objectives you expect to pursue with the proceeds.

v     Dilution should include a discussion of the number of shares outstanding prior to the offering, the price paid, the net book value, the effect on existing shareholders of the proposed offering, as well as dilutive effects on new purchasers at the completion of the offering. Often the founding shareholders (and sometimes their key advisers or the people who will help promote the PPM) acquired their securities at prices substantially below those in the prospective offering. As a result, the book value of shares purchased by new investors pursuant to the offering will be substantially diluted.

v     Description of Securities should explain the rights, restrictions and special features of the securities being offered, and any applicable provision of the articles of incorporation or by‑laws that affect its capitalization (such as pre‑emptive rights, total authorized stock, different classes of shares or restrictions on declaration and distribution of dividends).

v     Financial Statements you’ll need to provide will vary depending on the amount of money to be raised, applicable federal and state regulations, and the company's nature and stage of growth. Provide an explanation of these financial statements and an analysis of the company’s current and projected financial condition.

v     Exhibits such as the articles of incorporation and by‑laws, key contracts or leases, brochures, news articles, marketing reports, and resumes of the principals, may be appended as exhibits to the PPM.

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COMPLIANCE ISSUES

You must keep in mind that the PPM is nothing more than a memorandum that informs the public that there is an securities offering available. It does not constitute an offer. If a potential investor indicates (by returning the completed subscription materials with a check) that he or she would like to invest in the company, it constitutes an “offer to buy,” but is not a form of “legal acceptance” unless and until you decide to either accept or reject the offer. When you evaluate the completed subscription materials, you must use a reasonable standard of due diligence. You’re responsible for determining that a purchaser meets the suitability requirements set forth in the PPM questionnaire. If you know that a potential purchaser is particularly affluent and he or she chooses not to disclose fully his or her net worth, you should—as a precautionary measure—insist that the potential purchaser provide enough information to demonstrate that he or she is suitable to make a securities purchase.


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