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Private Placement Offerings

Andrew J. Sherman, Partner, Dickstein Shapiro Morin and Oshinsky LLP

A private placement offering generally means any type of shares issued by a small or growing company to raise capital. These offerings need not be registered with the Securities and Exchange Commission (SEC). Since commercial bankers' loan criteria and institutional venture capitalists' investment criteria are tightening, the private placement offering remains one of the most viable capital formation alternatives available for such companies.

The private placement has the advantage of reducing transactional and ongoing costs because of its exemption from many of the extensive federal and state registration and reporting requirements. It also enables a company to structure a more complex and confidential transaction, since those to whom it is offered are typically a small number of sophisticated investors. In addition, a private placement permits more rapid penetration into the capital markets than would a public offering of securities requiring registration with the SEC.

To determine whether private placement is a sensible strategy for your company, you should understand the federal and state securities laws affecting private placements and become familiar with the basic procedural steps that must be taken before pursuing this alternative. You'll also need to consult a team of qualified legal and accounting professionals.

Federal Securities Laws

Private placement is the most commonly recognized transactional exemption from Section 5 of the Securities Act of 1933, which requires companies to file a registration statement with the SEC prior to an offer to sell any security in interstate commerce. Registration under Section 5 is an expensive and time-consuming process, and a network of underwriters and brokers/dealers must be assembled to make a market for the security. An issuer registering under Section 5 is also subject to strict periodic reporting requirements, and the penalties for failing to register, or for disclosing inaccurate or misleading information, are quite stringent.

To qualify for a private placement, a company must structure the transaction within the various categories of exemptions available, such as Section 4(2), considered the broad "private offering" exemption; Section 3(a)(11, the intrastate exemption; or the most common, Regulation D, which specifies three distinct exemptions from the registration provisions.

Section 4(2) allows an exemption from registration for "transaction(s) by an issuer not involving a public offering." This language has been a source of much controversy and confusion in the legal and financial communities. Over the years, court cases have established that targeted investors in a 4(2) offering must have access to the same kind of information that would be available if the issuer were required to register its securities under Section 5 of the Securities Act. However, terms like "access to" and "same kind" generally leaves discretion to the company and its attorney regarding the exact method of presenting the necessary information.

When relying on an exemption under Section 4(2), the company must structure the offering in accordance with the following additional (although vague) guidelines:

The offering should be made directly to prospective investors without the use of any general advertising or solicitation.

  • The number of offerees should be kept as small as possible
  • The offering should be limited to insiders (such as officers of the company or family members) or sophisticated investors who have a pre-existing relationship with you or the company.
  • The prospective investor should be provided with, at least, a set of recent financial statements, a list of critical risk factors (which influence the investment) and an open invitation to inspect the company's facilities and records.

If you are in doubt as to whether Section 4(2) applies to a particular offering, do not rely on it. Attempt instead to structure your transaction within one of the Regulation D exemptions.

Section 3(a)(11) allows an exemption from registration for "any security which is part of an issue offered and sold only to persons resident within a single state by an issuer which is a resident and doing business within such state." It is not quite as controversial as Section 4(2). The key issue here is ensuring that the offering is truly an intrastate offering. The SEC has adopted Rule 147 to assist in determining whether the requirements have been met. Make sure that all offerees are residents of your state, because even one non-residential offeree will jeopardize the availability of the exemption. Steps should also be taken to ensure that all applicable state regulations have been satisfied.

Regulation D, Rule 504: One Million, All Investors

This rule 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") and that is not an investment company. Rule 504 places virtually no limit on the number or the nature of the investors that participate in the offering. However, I strongly recommend developing and disclosing certain baseline criteria, in order to avoid unqualified or unsophisticated investors.

Even though no formal disclosure document (also known as a "prospectus") has to be registered and delivered to offerees under Rule 504, there are many procedures that still must be understood and followed, and a disclosure document is nevertheless strongly recommended. Offerings under Rule 504 are still subject to the general anti-fraud provisions of the Exchange Act. Therefore, every document or other information that is actually provided to the prospective investor must be accurate and not misleading by virtue of its content or its omissions in any material respect. The SEC also requires that its Form D be filed for all offerings under Regulation D within 15 days of the first sale.

Finally, a growing company seeking to raise capital under Rule 504 should examine applicable state laws very carefully because although many states have adopted overall securities laws similar to Regulation D, many of these laws do not include a similar exemption. As a result, a formal memorandum may need to be prepared.

Regulation D, Rule 505: Five Million, Accredited Investors

Many companies prefer offering securities under this rule because its requirements are consistent with many state securities laws. Rule 505 allows for the sale of up to $5,000,000 of the issuer's 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 within one of) one or more of the eight categories set out in Rule 501(a) of Regulation D. Included in these categories are officers and directors of the company who have "policy-making" functions, as well as 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 (such as the need to file a Form D). In addition, it contains an absolute prohibition on advertising and general solicitation for offerings and restrictions on which companies may issue the securities. Any company that is subject to the "bad boy" provisions of Regulation A—which apply to persons who have been subject to certain disciplinary, administrative, civil or criminal proceedings, or sanctions which involve the company or its predecessor—is disqualified from offering securities under Rule 505.

Regulation D, Rule 506: No Dollar Limit

This rule is similar to Rule 505 but allows the issuer to sell its securities to an unlimited number of accredited investors and up to 35 non-accredited investors. For those requiring large amounts of capital, this exemption is the most attractive because it has no maximum dollar limitation.

The key difference under Rule 506 is that any non-accredited investor must be "sophisticated." A "sophisticated investor" (in this context) is one who does not fall within any of eight categories specified by Rule 501(a), but is believed by the issuer to "have knowledge and experience in financial and business matters that render him [or her] capable of evaluating the merits and understanding the risks posed by the transaction (either acting alone or in conjunction with his [or her] "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. Rule 506 does eliminate the need to prepare and deliver disclosure documents in any specified format, if exclusively accredited investors participate in the transaction. As with Rule 505, there is an absolute prohibition on advertising and general solicitation.

State Securities Laws

Full compliance with the federal securities laws is only one level of regulation that must be taken into account. You must also consider the expense and requirements on the state level. Regulation D was designed to provide a foundation for uniformity between federal and state securities laws. This objective has been met in some states but still has a long way to go on a national level. Whether or not the offering is exempt under federal laws, registration may still be required in the states where the securities are to be sold, under applicable "Blue Sky" laws.

Every state in the nation has some type of statute governing securities transactions and securities dealers. There are a wide variety of levels of review among the states, ranging from very tough "merit" reviews (designed to ensure that all offerings of securities are fair and equitable) to very lenient "notice only" filings (designed primarily to promote full disclosure). The securities laws of each state where an offer or sale will be made should be checked very carefully prior to drafting and distribution of the offering documents. Review the specific requirements of each such state to determine:

  • whether the particular, limited offering exemption selected under federal law will also apply 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 remedies are available to an investor who has purchased securities from a company that has failed to comply with applicable state laws
  • who may offer securities for sale on behalf of the company.

A New, Simpler Form

Most states have now adopted the Small Corporate Offering Registration ("SCOR") which makes the use of Regulation D a more viable capital-formation strategy for small businesses. It simplifies and streamlines the preparation of disclosure documents for exempt offerings by using a form in question-and-answer format, which you can fill in directly with the assistance of your accountant or attorney. This new form significantly reduces the cost of compliance without sacrificing the information necessary to allow prospective investors to reach an informed decision.

There are certain restrictions on the structure of offerings that can be made using Form U-7, the details of which should be discussed carefully with your attorney. You'll find that if the form is completed properly, it reads almost like an outline of a well-written business plan.

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