This is the second part of our Securities Law 101 series. Because capital raising is such a critical function for emerging start-up companies, we designed this series to introduce their management teams to some of the fundamental concepts in securities law. We hope that this series will prevent some of the most common mistakes management teams of start-up companies make. We will periodically publish posts examining different aspects of securities law.
So your company would like to raise money? These days it seems like every company is in need of more capital, even banks that are in the business of lending their funds out to others. Whether your business needs new funding for growth, or more funding to meet regulatory capital requirements, or your company has not been able to secure that loan the business needs, there are a lot of reasons to consider a private placement. Here, we will explore the use of the private placement to raise funds and the recent changes in securities laws that make this a better alternative than it was before.
We all know that there are many ways to raise money out there (and sales of stock through crowdfunding isn’t one of them yet), but one typical way would be to sell equity in your company to private investors. All securities offerings must be registered unless an exemption exists. Therefore, these deals are generally set up as private placements exempt from registration under SEC Rule 506, which allows an unlimited amount of money to be raised from an unlimited number of accredited investors (and up to 35 non-accredited investors). Accredited investors are those individuals whose joint net worth with their spouse is at least $1 million, excluding the value of any equity in personal residences but including any mortgage debt to the extent it exceeds the fair market value of the residences. The term also includes individuals with income exceeding $200,000 in each of the two most recent years, or joint income with their spouse exceeding $300,000 in each of those years, plus a reasonable expectation of reaching these income levels in the current year. There are also other types of accredited investors such as companies with total assets in excess of $5 million. Consequently, there are several categories of accredited investors out there that can potentially help with funding.
We recommend limiting the offer of securities in a private offering to only accredited investors. The reason for this is that accredited investors are deemed to be able to protect themselves in financial matters, are thought to have better access to information and therefore don’t require the amount of disclosures non-accredited investors would. Thus, a Rule 506 private placement to only accredited investors would require less disclosure in a private placement memorandum (PPM), and may be somewhat less likely to sue you if your company’s business prospects go south.
So why isn’t every company running out to do a private placement? Well, of course, there are some limitations that come along with these types of offerings. In particular, the securities that are sold in a private offering cannot be resold without an exemption and, unless the issuer is a public company, have a limited resale market. Additionally, until the JOBS Act recently lifted the ban on general solicitation and advertising for private offerings to all accredited investors (although the implementing regulations are not yet final), no general solicitation or advertising was allowed for Rule 506 offerings. This made it difficult in the past to find accredited investors that were willing to invest. For these reasons and others, companies may have looked to different sources of capital such as bank loans. However, due to the lingering downturn in the U.S. economy and the heightened restrictions on banks and other lenders, alternative sources of capital such as lines of credit are not as easy to come by now. If you are considering a private offering, here are some tips to keep in mind:
- You Are Responsible for the Offering. Bear in mind that your company and its officers and directors are legally responsible for conducting the offering in the manner required by the securities laws. You may be liable to your investors, as well as in civil – or criminal – actions that can be brought by SEC and/or state securities regulators, for any violations of those laws.
- Be Careful of the Information You Give to Investors. Under both federal and state securities laws, your company and its officers and directors will be liable to the investors if any information given in connection with the offering contains material misstatements or omissions. Further, each investor must be given the opportunity to ask questions and receive answers concerning the offering and to inspect any material books, records, contracts, and other documents.
- Keep the Private Offering “Private”. Until the rules are changed to allow general solicitation or if you choose to offer securities to any unaccredited investors, then you must keep the private offering “private.” This means that, rather than soliciting the general public, you may generally only contact potential investors with whom you have a prior substantive relationship. The relationship must be the kind that enables you to know whether the person solicited has the knowledge and experience to be a qualified purchaser. You also cannot announce your offering in the media or at seminars.
- Don’t be Fooled into Using So-called “Finders”. Often, issuers that are having a difficult time finding investors will be lured into arrangements with unregistered broker-dealers who will offer to “find” qualified investors for a fee. Anyone who receives compensation for introducing you to an investor is a broker-dealer and must be registered as one. If you use an unregistered broker-dealer then you are violating the securities laws and your investors have the right to demand their money back.
- Always Provide the Entire PPM, Including Exhibits. It is critical that the same information be furnished to all potential investors. You should be sure to give a complete copy of the PPM, including all of the exhibits, to each potential investor and – even if they ask – you should never give a potential investor just specified portions of the PPM. You should also keep records of any questions asked by potential investors, as well as the answers you give them and any additional documents you give them.
- Be Careful How and to Whom You Provide the PPM. You must keep careful track of the potential investors to whom you provide the PPM. Remember that your offering is exempt from registration under U.S. federal and state securities laws. If your PPM ends up in the hands of unintended parties, you may cause some of these exemptions to be unavailable. You should carefully number each PPM on the front page and keep an accurate log noting to whom each PPM is distributed. Never distribute your PPM by e-mail, because you then lose control of who sees, and who can access and change, your offering materials. You should also attempt to recover your PPM from potential investors who decide not to invest after reviewing it.
- You May Be Required to Update the PPM. It is critical that you evaluate any developments in the economy, your industry and/or your company that could be considered material to determine whether you need to advise potential investors and, if so, what to tell them. Generally, you will be able to advise potential investors of any material developments by means of a supplement to your PPM; however, in some cases, it may be necessary to revise the entire PPM to reflect material developments.
- Don’t Forget High School Civics Class. We live in a federal republic. Forget what that means? This just means that both the federal government and each of the 50 states regulate certain activities, including securities offerings. Federal law has pre-empted state law in offerings exempt under Rule 506 (except for certain notice filings that must be made), but if for some reason your offering no longer qualifies for Rule 506, you may have 50 state securities regulators knocking on your door.