Raising Capital through Private Securities Offerings
The offer and sale of securities in the US is regulated by the federal Securities and Exchange Commission (SEC) and by each state under what are commonly knows as the Blue Sky Laws. Every offer or sale of a security must be registered with the federal and appropriate state agency unless the offering is subject to an exemption from registration.
Registration is a very time consuming and expensive process that typically involves conducting a public offering through underwriters and the preparation of a prospectus. Registration should be avoided by early-stage start-ups, by issuing stock pursuant to an exemption from registration. Anti-fraud rules apply to all transactions involving the exchange of securities, whether or not the offering is exempt from registration under federal or state law.
Anti-Fraud rules require the persons offering securities disclose any material information about the business. Material information is anything that a reasonable investor would want to know prior to making an investment decision. Promotors of securities offerings should be careful to comply with state and federal broker-dealer registration requirements.
INTRASTATE OFFERING EXEMPTION
Section 3(a)(11) of the Securities Act provides an “intrastate offering exemption” from the registration requirements of the federal securities law with respect to securities issued to investors within a single state. To qualify for the intrastate offering exemption, the issuing company must:
- Be incorporated in the state where it is offering the securities;
- Carry out a significant amount of its business in that state; and
- Make offers and sales only to residents of that state.
There is no monetary limit on the offering or the number of purchasers. If any of the securities are offered or sold to a single non-resident, the exemption may be lost. Thus it is critical to determine and document the residence of each offeree by means of an investor suitability questionnaire. If a purchaser resells any of the unregistered securities to a person who resides outside the state within a period of approximately nine months the entire transaction, including the original sales, may violate the Securities Act. Accordingly, the securities issued under this exemption should be treated as restricted securities and should bear a legend to that effect.
PRIVATE OFFERING EXEMPTIOS UNDER REGULATION D
This rule exempts certain offerings from the registration requirements of the federal securities laws when the issuing company:
- Does not sell more than $5 million of its securities in any 12-month period;
- Sells the securities to an unlimited number of “accredited investors” and up to 35 other persons (who do not have to meet any sophistication or suitability requirements);
- Informs purchasers that they are acquiring “restricted” securities, (i.e., the securities cannot be sold for at least a six months without being registered); and
- Does not use general solicitation or advertising to sell the securities.
For purposes of Rule 505 and Rule 506, discussed below, an “accredited investor” is:
- A bank, insurance company, registered investment company, business development company, or small business investment company;
- An employee benefit plan, within the meaning of the Employee Retirement Income Security Act, if a bank, insurance company, or registered investment adviser makes the investment decisions, or if the plan has total assets in excess of $5 million;
- A charitable organization, corporation, or partnership with assets exceeding $5 million;
- A director, executive officer, or general partner of the company selling the securities;
- A business in which all the equity owners are accredited investors;
- A natural person with a net worth of at least $1 million;
- A natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,00 for those years and a reasonable expectation of the same income level in the current year; or
- A trust with asset of at least $5 million, not formed to acquire the securities offered, and whose purchases are directed by a sophisticated person.
Rule 505 allows companies to decide what information to give to accredited investors, so long as it does not violate the antifraud prohibitions of the federal securities laws. But companies must give non-accredited investors disclosure documents that generally are the same as those used in registered offerings, including financials (i.e., a private placement memorandum). The company must also be available to answer questions by prospective purchasers.
Issuing companies using the Rule 505 exemption do not have to register their securities and usually do not have to file reports with the SEC. However, such companies must file as “Form D” electronically upon selling their securities. Form D is a brief notice that includes the names and addresses of the company’s owners and stock promoters.
Rule 506 of Regulation D is considered a “safe harbor” for the private offering exemption. Companies using the Rule 506 exemption can raise an unlimited amount of money. This safe harbor is available if the following standards are met:
- The issuing company cannot use general solicitation or advertising to market the securities;
- The issuing company may sell its securities to an unlimited number of “accredited investors” and up to 35 other purchasers. Unlike Rule 505, all non-accredited investors, either alone or with a purchaser representative, must be sophisticated that is, they must have sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment;
- Issuing companies must decide what information to give to accredited investors, so long as it does not violate the antifraud prohibitions of the federal securities laws. Issuing companies must give non-accredited investors disclosure documents that are generally the same as those used in registered offerings (i.e., A private placement memorandum).
- The issuing company must be available to answer questions by prospective purchasers; Financial statement requirements; and
- Purchasers receive “restricted” securities, meaning that the securities cannot be sold for at least a year without registering them.
As with the Rule 505 exemption, issuing companies using the Rule 506 exemption do not have to register their securities and usually do not have to register their securities and usually do not have to file reports with the SEC. However, such companies must also file a “Form D” within 15 days for the first sale of securities, just as with Rule505.