Private Placements to Accredited Investors Using Rule 506
What does it mean to raise money through a private placement?
A private placement (also known as a private offering) occurs when a company solicits investors “privately,” i.e. without advertising to the public, in most cases to investors with whom the company has a pre-existing relationship. The investment could be in the form of a note (loan), the purchase of common or preferred stock, or any other instrument that promises some kind of financial return to investors. These instruments are all considered securities, which means that offering them and selling them to investors is a highly regulated activity.
The general rule of securities law is that any offering of securities must be registered with the federal Securities and Exchange Commission and the securities regulators of all states in which the securities are being offered. The process of registering a securities offering is extremely time consuming and costly. When a company engages in a private placement, it is taking advantage of one of the exemptions to the general rule that all securities offerings must be registered.
While there are several ways to do a private placement, this article will focus on the most popular method – using Rule 506 under Regulation D of the federal Securities Act to offer securities to accredited investors.
What is an accredited investor?
The following is the definition of an accredited investor under Regulation D:
Accredited investor shall mean any person who comes within any of the following categories, or who the issuer reasonably believes comes within any of the following categories, at the time of the sale of the securities to that person:
(1) Any bank . . . or any savings and loan association . . .; any broker or dealer . . .; any insurance company . . .; any investment company . . .; . . . any employee benefit plan;[1]
(2) Any private business development company as defined in section 202(a)(22) of the Investment Advisers Act of 1940;
(3) Any organization described in section 501(c)(3) of the Internal Revenue Code, corporation, Massachusetts or similar business trust, or partnership, not formed for the specific purpose of acquiring the securities offered, with total assets in excess of $5,000,000;
(4) Any director, executive officer,[2] or general partner of the issuer of the securities being offered or sold, or any director, executive officer, or general partner of a general partner of that issuer;
(5) Any natural person whose individual net worth, or joint net worth with that person’s spouse, at the time of his purchase exceeds $1,000,000;[3]
(6) Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year;
(7) Any trust, with total assets in excess of $5,000,000, not formed for the specific purpose of acquiring the securities offered, whose purchase is directed by a sophisticated person as described in §230.506(b)(2)(ii); and
(8) Any entity in which all of the equity owners are accredited investors.
Securities laws assume that unaccredited investors need much more protection than accredited investors from unscrupulous promoters of investment opportunities. The minute you solicit even one such investor, the legal requirements become more complicated. This article will not describe these requirements because it only addresses offerings to accredited investors.
How does the issuer ensure compliance with the prohibition on general solicitation?
In a private placement the investment opportunity is not advertised to the general public but only to potential investors who have a pre-existing relationship with the company or its founders. The private placement exemption is based on the premise that potential investors who have a pre-existing relationship with the company need less protection than members of the general public because they know something about the character of the people involved and the soundness of the company.
According to Regulation D, “neither the issuer nor any person acting on its behalf shall offer or sell the securities by any form of general solicitation or general advertising, including, but not limited to, the following:
(1) Any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio; and
(2) Any seminar or meeting whose attendees have been invited by any general solicitation or general advertising.”
While advertisements on the radio, the Internet, or other media clearly constitute general solicitation, there are other less obvious ways to violate the prohibition of general solicitation. For example, the U.S. Supreme Court ruled that when Ralston Purina made a stock offering to its employees, the offering did not qualify for the private offering exemption. The court said “employees are just as much members of the investing ‘public’ as any of their neighbors in the community.”
Unfortunately, it is sometimes hard to determine what would be considered general solicitation by the courts. It is important to keep records of all of the contacts made with potential investors and document the company’s relationship with each one.
When conducting a private placement through a broker-dealer, the broker-dealer establishes the relationships with the prospective investors and conducts due diligence to ensure that all prospective investors are accredited. The Securities and Exchange Commission has approved internet-based private placements conducted through broker-dealers.
Requirements to Provide Information to Prospective Investors
As long as all prospective investors are accredited, there are no specific requirements of information that must be provided. However, it is wise to offer sufficient information to prospective investors to ensure that they are well informed about the investment and the company. Examples of offering documents and terms sheets for accredited investors can be found at the following links:
http://www.seclaw.com/docs/ref/sampleprivateplacementmemorandum.pdf
http://www.faqs.org/sec-filings/100330/DIAMONDHEAD-CASINO-CORP_8-K/g22704exv99w4.htm
http://www.digitalworktools.com/pdf-portfolio/private-placement-memorandum.pdf
Filing Requirements
The issuer must file Form D with the Securities and Exchange Commission no later than 15 calendar days after the first sale of securities, unless the end of that period falls on a Saturday, Sunday or holiday, in which case the due date would be the first business day following.
Form D must be filed with the Commission in electronic format by means of the Commission’s Electronic Data Gathering, Analysis, and Retrieval System (EDGAR).
State Filings
The general rule is that an issuer of securities must register its offering in all states where prospective investors will be solicited. However, federal law prohibits states from imposing such requirements on private placements conducted under Rule 506. States are permitted to require notice filings and fees (often several hundred dollars per state). Therefore it is necessary to determine the residency of all prospective investors and complete the required filings for all of those states (this is often referred to as the “blue sky” compliance). New York requires that the filing be completed before prospective investors are solicited. Other states permit the filing to made after an offering has already begun. Each state is different so it is important to ensure that you are aware of the state filing requirements for each state in which you plan to solicit investors.
Limitation on Resale
Securities acquired in a transaction under Regulation D cannot be freely resold – they are called “restricted securities.” The issuer must (1) conduct a reasonable inquiry to ensure that the purchaser is acquiring the securities for him/herself and not for resale to others; (2) provide written disclosure to each purchaser prior to sale that the securities have not been registered under the Act and, therefore, cannot be resold unless they are registered under the Act or unless an exemption from registration is available; and (3) place a legend on the certificate or other document that evidences the securities stating that the securities have not been registered under the Act and setting forth or referring to the restrictions on transferability and sale of the securities. It is a good idea to have all purchasers sign a document acknowledging their intention to purchase for themselves and their understanding that the securities may not be re-sold without additional compliance.
Integration
Offers and sales of securities that are made more than six months before the start of a Regulation D offering or are made more than six months after completion of a Regulation D offering will not be considered part of that Regulation D offering, so long as during those six month periods there are no offers or sales of securities by or for the issuer that are of the same or a similar class as those offered or sold under Regulation D. Thus it is important to carefully plan to the timing of a securities offering to prevent inadvertent integration of two offerings that each individually comply with Regulation D but when integrated into one offering do not.
The following factors are considered in determining whether offers and sales should be integrated for purposes of the exemptions under Regulation D:
(a) Whether the sales are part of a single plan of financing;
(b) Whether the sales involve issuance of the same class of securities;
(c) Whether the sales have been made at or about the same time;
(d) Whether the same type of consideration is being received; and
(e) Whether the sales are made for the same general purpose.
[1] Here is the full text of this section: “Any bank as defined in section 3(a)(2) of the Act, or any savings and loan association or other institution as defined in section 3(a)(5)(A) of the Act whether acting in its individual or fiduciary capacity; any broker or dealer registered pursuant to section 15 of the Securities Exchange Act of 1934; any insurance company as defined in section 2(13) of the Act; any investment company registered under the Investment Company Act of 1940 or a business development company as defined in section 2(a)(48) of that Act; any Small Business Investment Company licensed by the U.S. Small Business Administration under section 301(c) or (d) of the Small Business Investment Act of 1958; any plan established and maintained by a state, its political subdivisions, or any agency or instrumentality of a state or its political subdivisions, for the benefit of its employees, if such plan has total assets in excess of $5,000,000; any employee benefit plan within the meaning of the Employee Retirement Income Security Act of 1974 if the investment decision is made by a plan fiduciary, as defined in section 3(21) of such act, which is either a bank, savings and loan association, insurance company, or registered investment adviser, or if the employee benefit plan has total assets in excess of $5,000,000 or, if a self-directed plan, with investment decisions made solely by persons that are accredited investors.”
[2] Executive officer is defined as “the president, any vice president in charge of a principal business unit, division or function (such as sales, administration or finance), any other officer who performs a policy making function, or any other person who performs similar policy making functions for the issuer. Executive officers of subsidiaries may be deemed executive officers of the issuer if they perform such policy making functions for the issuer.”
[3] Under the recently passed financial reform act, a person’s primary residence is no longer included in net worth for the purpose of determining whether the person is accredited.
