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What are Private Placements?

Private Placements 101: A Guide to Offerings, Rules and Private Placement Memorandums

A private placement is a non-public offering of securities exempt from full SEC registration requirements. Placements are usually made directly by the company issuing stock, but they may also be made by an underwriter. The offering may be of debt or equity.

How Private Placements are Governed

Private placements are not an asset class. They are a technique by which capital is raised from non-institutional private capital sources, mainly individuals. They can be used as a vehicle for investments in private equity, venture capital, and some tangible assets, for example.

A multitude of state and federal laws and regulations govern private placements, including:

  • The Securities Act of 1933, which governs the issuance of securities by companies
  • The Securities Exchange Act of 1934, which governs the trading, purchase and sale of those securities
  • Regulations derived from the 1933 and 1934 Securities Acts, promulgated by the Securities and Exchange Commission — especially Regulation D (see below)
  • Regulations promulgated by the Financial Industry Regulatory Authority and the various stock exchanges
  • State securities laws and regulations, known as blue sky laws, administered by the various state securities commissions.
  • The JOBS Act of 2012

While placements occur that involve tens or hundreds of millions of dollars, this article primarily focuses on placement alternatives that enable a company to raise $5 million or less in a single year.

[Editor’s Note: As of January 2019, bipartisan support continues for the JOBS Act 3.0, which was passed by the House of Representatives, but failed to pass in the Senate. JOBS Act 3.0 is deregulatory legislation that would make it easier for small businesses and entrepreneurs to raise capital from ordinary investors. The legislation includes private offering reforms, including reforms to the definition of accredited investors.]

Private Placement Securities

In a private placement, the shares of stock or debt instrument are considered securities under both federal and state securities laws. Consequently, any transaction involving the shares or debt must be registered under such securities laws or be exempt from registration.

Typically, the offeror is an emerging growth company that has few capital alternatives, although more mature companies tend to be more successful in this process. Securities laws generally require that offers are made mainly to accredited investors.

There are two basic types of private placement offerings:

  • Private Placement Equity Offering?The company sells partial ownership via the sale of stock or a membership unit in order to raise capital. Equity offerings are preferred by early-stage companies, because there is no set repayment schedule with this offering.
  • Private Placement Debt Offering?The company raises debt financing by selling a note instrument to investors with a set annual rate of return and a maturity date that dictates when the funds will be paid back to investors in full. A debt offering is similar to a business loan, except the financing is provided by investors instead of an institution.

Although private placements are exempt from full SEC registration requirements, they still must comply with federal and state regulations. The most important private placement rules fall under Regulation D, promulgated by the SEC.

Regulation D: Private Placement Rules and Exemptions

Reg D is a series of six rules, Rules 501-506, establishing three transactional exemptions from the registration requirements of the 1933 Act. Rules 501-503 set forth definitions, terms and conditions that apply generally throughout the regulation. Specific exemptions are set out in Rules 504-506.

Rule 504

Rule 504 is the most popular of the Reg D rules. Raising capital for a small business can be expensive and time consuming, but a private placement under Rule 504 of Reg D can minimize costs and delays while giving the issuer access to debt or equity capital.

In a Rule 504 offering, a business can raise a maximum of $1 million in any year. Rule 504 has no prescribed disclosure requirements, no limit on the number of purchasers, and no investor sophistication standards. Offerings that are exempt under Rule 504 are relatively simple to prepare and can generally be undertaken by the offeror without substantial outside professional expenses. The JOBS Act of 2012 allows offerings to be made through any form of general solicitation or advertising..

Rule 504 does not mandate that specified disclosure be provided to purchasers. However, the offeror must provide enough information to meet the full disclosure obligations under the anti-fraud provisions of the securities laws.

Rule 505

A Rule 505 offering may not exceed $5 million in any given 12-month period. This exemption limits the number of non-accredited investors to 35, but has no investor sophistication standards and no limit on the number of accredited investors. Rule 505 was adopted by the SEC to provide small businesses more flexibility in raising capital than under Rule 504.

If only accredited investors are involved in the offering, there is no specific information the issuer must furnish to investors. However, if the offering involves one or more non-accredited persons, the issuer must furnish all purchasers with the same kind of information specified by Regulation D. As with a 504 offering, prior to the JOBS Act of 2012, this offering could not be made by means of general solicitation or general advertising.

For Rule 505 offerings over $2 million, financial statement conditions include the following:

  • Only financial statements for the most recent fiscal year need be certified by an independent public accountant.
  • If an issuer other than a limited partnership cannot obtain audited financial statements without unreasonable effort or expense, only the issuer’s balance sheet (to be dated within 120 days of the start of the offering) must be audited.
  • Limited partnerships unable to obtain required financial statements without unreasonable effort or expense may furnish financial statements prepared on the basis of federal income tax requirements and examined and reported on by an independent public or certified accountant in accordance with generally accepted auditing standards.
  • The issuer must also be available to answer questions by prospective purchasers about the issuer or the offering.

Rule 506

Rule 506 provides an exemption for limited offers and sales without regard to the dollar amount of the offering. There is no ceiling on the amount of money which may be raised. The JOBS Act of 2012 permits general solicitation and advertising. There is no limit to the number of accredited investors, but the number of non-accredited investors may not exceed 35. If only accredited investors are involved in the offering, the issuer is under no obligation to furnish specific information to investors. If the offering involves one or more non-accredited persons, however, the issuer must furnish all purchasers with the same information required by Reg D.

Rule 506 requires detailed disclosure of relevant information to potential investors; the extent of disclosure depends on the dollar size of the offering. For offerings over $2 million, the issuer must provide audited financial statements. Offerings under $2 million follow Reg A as a guide, with an additional requirement for a certified balance sheet.

The securities sold are “restricted” under the same stipulations in Rules 504 and 505. A company is required to file a notice of the offering on Form D at SEC headquarters within 15 days after the first sale in the offering. There is no requirement to file the offering memorandum with the SEC.

From an investor’s perspective, here are some important compliance features of Regulation D:

  • No offerings are exempt from the anti-fraud and civil liability provisions of the various federal securities laws.
  • Issuers are not relieved of their obligation to provide investors with information needed to make any required disclosures not misleading.
  • Regulation D provides transactional exemptions to issuers only. An investor whose purchase was exempt from registration cannot resell their interest without establishing an independent basis of exemption.

Table 1: Summary of Private Placements Characteristics, Per Reg D

Reg D Type Offering Limit/Year Non-accredited Investors Accredited Investors Financial Stmt Audit Required?
504 $1 million No limit No limit No
505 $5 million Up to 35 Yes
506 No ceiling Up to 35 Yes

Documents to Support a Private Placement

The following documents are needed to raise private financing from investors.

Private Placement Memorandum

A Private Placement Memorandum (PPM) provides critical details about the offering. This differs from a business plan, which does not provide information about the technical structure of an offering. A PPM is used to raise capital from a number of investors instead of trying to find one with the entire amount of required capital.

The PPM outlines information such as:

  • Purchase price per note
  • Number of shares or notes being sold
  • Maturity date
  • Rate of return
  • Risk factors

Additional Private Placement Documents

  • Subscription Agreement sets forth the terms and conditions of the investment. This is the document that the investor executes, and to which he or she attaches a check.
  • Promissory Note Agreement (for debt only) is the actual loan agreement between the investor and the company.
  • Form D SEC Filing is the notification filing that is sent to the SEC in Washington, DC. It notifies the SEC that the issuer is using the Regulation D program and provides basic information on the company and the offering. It is not an approval document. It is merely a filing that notifies the SEC that the offeror has a Reg D offering in place.

Types of Private Placement Offerings

Regulation D Equity Offering

An equity offering lists the securities authorized and offered by the issuer, as well as the use of proceeds. Purchasers of these securities are almost always minority investors. This alone creates a liquidity risk and minority rights issues that should be strongly considered. Offerees should seek legal assistance before making such an investment.

Regulation D Debt Offering

A debt offering involves the sale of a promissory note to investors. The note sets forth the terms and conditions of the loan arrangement between the company and the investor. For instance, the interest rate, payment periods, and maturity date are described in the note.

Notes are sold in fractional amounts providing flexibility for accommodating investors. For example, in a typical debt offering the company raises $1,000,000, which might involve the sale of 20 notes at $50,000 per note.

Red Flags and Expectations for Investors

When private placements fail, it is usually because either (a) the offeror does not present the market with a security that promises enough return for the risk, or (b) the investors cannot ascertain the risk of the investment.

Most of these offerors are very small companies with business models that are unproven. With this as a backdrop, it is reasonable for investors to expect at least 25 to 35 percent effective returns on their investments. Individual investors are typically not in a position to measure the risk of most private placements. Protecting individual investors from themselves explains why the blue-sky laws exist to begin with.

Here are some questions to ask the offerors before you consider investing in a private placement:

  • Does the product or service solve a problem or need?
  • How many competitors are already in the marketplace?
  • Who are potential customers and how will they be reached?
  • Is the management capable of delivering the business plan?
  • What does the investor get for his or her investment?

Final Caveat for Investors

Offerers should treat all investors at arm’s length, even if the offering is targeted mainly at family and friends. There should be no special deal offered to some investors that isn’t offered to all others.

[Editor’s Note: Check out these related webinars, which can be taken for Continuing Legal Education (CLE) credit, or simply for practical and entertaining education for business owners, Accredited Investors, and their legal and financial advisors: Private Offering Exemptions and Private Placements, Private Offering Exemptions and Private Placements 2, Securities Law, An Overview 2019. This is an updated version of an article that first appeared February 2013.]

Read more: In Trump Administration, Private Placement Insurance Has a Rising Role

About Robert T. Slee

President of Robertson & Foley, and author of Private Capital Markets, 2nd Ed.

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