Raising capital for a business can be a challenge. Business owners often look to debt or equity financing in order to raise capital to fund the desired venture. Typically, this capital is found via initial public offerings, business loans, venture capital funding and private placements, which this article will address.
Private placements are offerings of securities which are not required to be registered with the U.S. Securities and Exchange Commission (SEC), the federal regulatory agency responsible for protecting investors and securities markets. Frequently used by smaller companies or startups, private placements enable these operations to raise debt or equity from a relatively small group of investors—typically high-net worth individuals or entities—while bypassing burdensome registration requirements.
The determination to be classified as a private placement—as well as whether an issuer (that is, the person or entity selling the securities) should provide a private placement memorandum (PPM), the document disclosing terms of and vital information about the offering—depends on specific factors related to the offering and the proposed investors. Understanding the circumstances behind disclosure can save a company legal and financial headaches in the event of complaints.
How to Meet the Requirements to Be Classified as a Private Placement
To qualify under Rule 504, the offering of securities must be less than $5 million in any 12-month period. Additionally, a company may offer and sell such securities to an unlimited number of accredited and non-accredited investors. Purchasers of securities offered pursuant to Rule 504 receive “restricted” securities, meaning that the securities cannot be sold for at least six months or a year without registering them.
Rule 506, meanwhile, provides two distinct exemptions. Under 506(b) (commonly referred to as the “safe harbor” exemption), a company cannot use general solicitation or advertising to market the security, but unlike 504, it can raise an unlimited amount of money from an unlimited number of accredited investors and no more than 35 nonaccredited investors. Under 506(c), a company can broadly solicit and advertise the offering (while still maintaining compliance with the exemption requirements), if all investors are accredited, and the company must take reasonable steps to verify such status.
The definition of accredited investors is important. Under federal securities law, accredited investors, in the context of a natural person, are individuals who earned an income exceeding $200,000 (or $300,000 with a spouse) in each of the prior two years and reasonably expect the same for the current year, or they have a net worth of over $1 million, either alone or with a spouse (excluding the value of their primary residence and any loans secured for the residence). Accredited investors can also be any entity in which all of the equity owners are accredited investors, a bank, any director, officer or general partner of the issuer, as well as a partnership, corporation, trust or charitable organization, providing they satisfy certain criteria.
Along with the limited number of nonaccredited investors allowed under Rule 506(b), this rule also stipulates that nonaccredited must be “sophisticated,” meaning they have sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment.
What a Private Placement Memorandum Does
Once it is determined that an offering can fall into one of the exemptions under Regulation D, the terms of the investment and any such disclosures (legal or otherwise) about the offering are then presented in a document called a private placement memorandum (PPM). Generally taking the place of the preliminary prospectus used in public offerings, a PPM provides full disclosure of the offering’s legal structure, ownership information, objectives, risks and terms of the proposed investment into the company.
PPMs are not normally made available to the public at large. Rather, they are distributed to a number of pre-approved investors to solicit offers to purchase the securities of the company, as described in the PPM, thereby raising a determined amount of capital.
When a Private Placement Memorandum Is (and Is Not) Required
While Regulation D exemptions save a company or project from regulatory burdens associated with registering an offering, issuers are still bound by anti-fraud securities laws, including Rule 10b-5 of the Securities Exchange Act of 1934, which prohibits an issuer from making false or misleading statements to investors, regardless of the private or public nature of the offering. A well-drafted PPM, typically written with the aid of an attorney experienced in corporate and business law, helps protect against liability and potential litigation in the event investors lose money on the investments.
That said, the general rule is that the size of an offering dictates the use of a PPM. For offerings less than $5 million, or private placements that fall under the Rule 504 exemption, no PPM is required as long as anti-fraud prohibitions are not violated. For offerings over $5 million, no PPM is required either, as long as all are accredited investors. Thus, when considering Rule 506, a PPM is not needed for those issuers falling under the 506(c) exemption, but comprehensive disclosure may be required under 506(b), which allows for nonaccredited investors and typically involves offerings above $5 million.
What it comes down to is that seeking funding from nonaccredited investors requires greater disclosure requirements in connection to the offering.
What to Do About Family, Friends and Angel Investors
When a company is in its early stages, the investors often are limited to raising funds from family and friends as well as angel investors—who are, generally, high-wealth individuals trying to help the entrepreneurs starting the company take their first steps. Unlike venture capitalists, rather than focusing on the possible profit they may get from the business, they often inject capital into a new business in exchange for ownership equity or convertible debt.
Typically, family and friends are unaccredited investors and under Rule 504, as long as the offering to these individuals remains below $5 million, a PPM is not required. When offerings go over that threshold—and as long as these unaccredited investors have a degree of “sophistication”—it will be required and, most of all, wise for them to review a PPM document as part of the due diligence process.
Angel investors are almost always accredited investors, and thus, a company does not usually need to provide them the disclosure. It would be a mere formality since these types of investors usually perform their own extensive due diligence and risk assessment before going forward with an investment.
Issuers looking to save some money and avoid legal fees might think to draft their own PPM. Indeed, there are forms and pre-prepared documents that are more or less readily available, but the do-it-yourself approach, as with most contracts and business documentation, is not recommended and often detrimental.
These types of documents often fall short of what is necessary, using generic information for the investment risk, opposed to detailed information associated with the company’s industry and outlook. The lack of a well-rounded PPM may expose the company to a much higher risk of liability and potential litigation. Attorneys with experience in drafting business documents and working with startups, entrepreneurs and investors can help create a PPM that will protect a business or project as it seeks funding.
Finally, along with a layer of legal security, a PPM simply gives investors—especially those unfamiliar with the issuer or their company—more confidence in the endeavor.
Maxwell Briskman Stanfield is an attorney at Meyer, Unkovic & Scott. He focuses his practice on corporate, business, financial and commercial real estate law. Stanfield can be reached at MBS@MUSLAW.com.