Use of Private Placements to Raise Investment Funds

The life of a syndicator involves a lot of administrative tasks. Frequently I have to review the voluminous legal documents that make up the offering to investors (the investment documents). Sometimes I get a question from an investor or potential investor about private placements. I spent much of my day today pooling all my prior research and doing further research into the legal framework of private placements. 

So here is my assembled research. Note that I am not an attorney and you should consult one for interpretation and compliance before you attempt to do a private placement.

Generally a private placement is the vehicle syndicators use to raise investor funds. It is called a private placement because the syndicator raises money from friends, family and colleagues. In most cases, there can be no advertising of a specific offering or even touting past investment results (known as "priming the market"). 

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[EDIT: I apologize for the copy/paste style and poor formatting of the SEC regs below. Most of my formatting done in Microsoft Word was lost in the blog post and it is not easy material to read anyway. This is just the SUMMARY of the regulations but without an understanding of what you want to do, you can't easily decide which Rule you want to comply with. I will do a new post with some more actionable information soon. B.M. 1-20-16] The following comes primarily from the SEC Guide for Small Business plus snippets from other SEC.gov pages.
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SEC Legal Framework and Requirements

I. SEC Regulation: The Securities and Exchange Commission (‘SEC’) regulates the issuance and investment in securities. Information was taken from sec.gov and the SEC Guide for Small Business.

1. a.A “security”, for SEC purposes, is an undertaking that pools investor funds with the expectation of profit (and such investors are not all active managers of the undertaking)
2. b.Securities must be registered with the SEC [This a costly and time-consuming up-front process plus onerous ongoing reporting burden – Ed.] per the Securities Act of 1933 or the security may have an exemption from registration
3. c.Section 4(a)(2) of the Securities Act contains the “private placement” exemptions. To qualify the purchasers of the securities must:

i.either have enough knowledge and experience in finance and business matters to be “sophisticated investors” (able to evaluate the risks and merits of the investment), or be able to bear the investment's economic risk;

ii.have access to the type of information normally provided in a prospectus for a registered securities offering; and

iii.agree not to resell or distribute the securities to the public.

• d.Regulation D contains the Rules (504, 505 & 506) that establish exemptions from Securities Act registration. All require the filing of Form D within 15 days of the first issuance of securities. The main purpose of the Form D filing is to notify federal (and state) authorities of the amount and nature of the offering being undertaken in reliance upon Regulation D.
• e.Rule 504, sometimes referred to as the “seed capital” exemption, provides an exemption for the offer and sale of up to $1,000,000 of securities in a 12-month period. Your company may use this exemption so long as it is not a blank check company and is not subject to Exchange Act reporting requirements. In general, you may not use general solicitation or advertising to market the securities, and purchasers generally receive “restricted securities.” Purchasers of restricted securities may not sell them without SEC registration or using another exemption, which is further explained below under the heading “Resales of restricted securities.” Investors should be informed that they may not be able to sell securities of a non-reporting company for at least a year without the issuer registering the transaction with the SEC.
• i.Your company may, however, use the Rule 504 exemption for a public offering of its securities with general solicitation and advertising, and investors will receive non-restricted securities, under one of the following circumstances:

1.It sells in accordance with a state law that requires the public filing and delivery to investors of a substantive disclosure document; or

2.It sells in accordance with a state law that requires registration and disclosure document delivery and also sells in a state without those requirements, so long as your company delivers to all purchasers the disclosure documents mandated by a state in which it registered; or

3.It sells exclusively according to state law exemptions that permit general solicitation and advertising, so long as sales are made only to "accredited investors" (we describe the term “accredited investor” in more detail below in connection with our description of Rule 506 offerings).

• f.Rule 505. Rule 505 provides an exemption for offers and sales of securities totaling up to $5 million in any 12-month period. Under this exemption, your company may sell to an unlimited number of “accredited investors” and up to 35 persons that are not accredited investors. Purchasers must buy for investment purposes only, and not for the purpose of reselling the securities. The issued securities are “restricted securities,” meaning purchasers may not resell them without registration or an applicable exemption, as explained below under the heading “Resales of restricted securities.” If your company is not an SEC reporting company, investors should be informed that they may not be able to sell securities for at least a year without the company registering the transaction with the SEC. Your company may not use general solicitation or advertising to sell the securities.
• i.Under Rule 505, if your offering involves any purchasers that are not accredited investors, you must give these purchasers disclosure documents that generally contain the same information as those included in a registration statement for a registered offering. There are also financial statement requirements that apply to Rule 505 offerings involving purchasers that are not accredited investors. For instance, if financial statements are required, they must be audited by a certified public accountant. You must also be available to answer questions from prospective purchasers who are not accredited investors.
• ii.You may decide what information to give to accredited investors, so long as it does not violate the antifraud prohibitions of the federal securities laws. If your company provides information to accredited investors, it must make this information available to the non-accredited investors as well.
• g.Rule 506. Rule 506 provides two different ways of conducting a securities offering that is exempt from registration: Rule 506(b) and Rule 506(c). Rule 506(b) is a long-standing rule. Rule 506(c) was added in 2013 to implement a statutory mandate under the JOBS Act.
• i.Rule 506(b). As discussed earlier, Rule 506(b) is a "safe harbor" for the non-public offering exemption in Section 4(a)(2) of the Securities Act, which means it provides specific requirements that, if followed, establish that your transaction falls within the Section 4(a)(2) exemption. Rule 506 does not limit the amount of money your company can raise or the number of accredited investors it can sell securities to, but to qualify for the safe harbor, your company must:

1.not use general solicitation or advertising to market the securities;

2.not sell securities to more than 35 non-accredited investors (unlike Rule 505, all non-accredited investors, either alone or with a purchaser representative, must be “sophisticated”, a legal standard of having sufficient knowledge and experience in financial and business matters to be capable of evaluating the merits and risks of the prospective investment);

3.give non-accredited investors specified disclosure documents that generally contain the same information as provided in registered offerings (the company is not required to provide specified disclosure documents to accredited investors, but, if it does provide information to accredited investors, it must also make this information available to the non-accredited investors as well);

4.be available to answer questions from prospective purchasers who are non-accredited investors; and

5.provide the same financial statement information as required under Rule 505.

• ii.Rule 506(c). To implement Section 201(a) of the JOBS Act, the SEC promulgated Rule 506(c) to eliminate the prohibition on using general solicitation under Rule 506 where all purchasers of the securities are accredited investors and the issuer takes reasonable steps to verify that the purchasers are accredited investors.
• 1.Under Rule 506(c), issuers may offer securities through means of general solicitation, provided that:

a.all purchasers in the offering are accredited investors,

b.the issuer takes reasonable steps to verify their accredited investor status, and

c.certain other conditions in Regulation D are satisfied.

• iii.Purchasers receive “restricted securities” in a Rule 506 offering. Therefore, they may not freely trade the securities after the offering, as explained below under the heading “Resales of restricted securities.”
• iv.Section 18 of the Securities Act provides a federal preemption or exemption from state registration and review of private offerings that are exempt under Rule 506. The states still have authority, however, to investigate and bring enforcement actions for fraud, impose state notice filing requirements and collect state fees.
• h.An "accredited investor" is:

i.a bank, insurance company, registered investment company, business development company, or small business investment company;

ii.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;

iii.a tax exempt charitable organization, corporation or partnership with assets in excess of $5 million;

iv.a director, executive officer, or general partner of the company selling the securities;

v.an enterprise in which all the equity owners are accredited investors;

vi.an individual with a net worth of at least $1 million, not including the value of his or her primary residence;

vii.an individual with income exceeding $200,000 in each of the two most recent calendar years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year; or

viii.a trust with assets of at least $5 million, not formed only to acquire the securities offered, and whose purchases are directed by a person who meets the legal standard of having sufficient knowledge and experience in financial and business matters to be capable of evaluating the merits and risks of the prospective investment.

• i.Resales of restricted securities
• i.“Restricted securities” are previously-issued securities held by security holders that are not freely tradable because the sale transaction from the issuer to the security holders was a private transaction. After such a private transaction, the security holders can only resell the securities into the market by using an “effective” registration statement under the Securities Act or a valid exemption from the registration requirements of the Securities Act for the resale, such as Rule 144 under the Securities Act.
• ii.If holders of restricted securities want to resell using an effective registration statement, the issuing company can provide a registration statement for them to make sales in a public offering by following the process discussed above for registering a public offering of securities.
• iii.Alternatively, a holder of restricted securities can resell using an exemption. For example, Securities Act Rule 144 provides an exemption that permits the resale of restricted securities if a number of conditions are met, including holding the securities for six months or one year, depending on whether the issuer has been filing reports under the Exchange Act. Rule 144 may limit the amount of securities that can be sold at one time and may restrict the manner of sale, depending on whether the security holder is an affiliate. An affiliate of a company is a person that, directly, or indirectly through one or more intermediaries controls, or is controlled by, or is under common control with, the company.
• j.Other exemptions from registration
• i.Accredited investor exemption—Section 4(a)(5)
• 1.Section 4(a)(5) of the Securities Act exempts from registration offers and sales of securities to accredited investors when the total offering price is less than $5 million.
• 2.The definition of accredited investor is the same as that used in Regulation D, which is summarized above. Like the exemptions in Rule 505 and 506, this exemption does not permit any form of general solicitation or advertising. There are no document delivery requirements, but all transactions are subject to the antifraud provisions of the securities laws.
• ii.Intrastate offering exemption
• 1.Section 3(a)(11) of the Securities Act is generally known as the "intrastate offering exemption." This exemption facilitates the financing of local business operations. To qualify for the intrastate offering exemption, your company must:
• a.be organized in the state where it is offering the securities;
  
• b.carry out a significant amount of its business in that state; and
  
• c.make offers and sales only to residents of that state.
• 2.The intrastate offering exemption does not limit the size of the offering or the number of purchasers. Your company must determine the residence of each offeree and purchaser. If any of the securities are offered or sold to even one out-of-state person, the exemption may be lost. Without the exemption, the company could be in violation of the Securities Act.
• 3.If a purchaser resells any of the securities to a person who resides outside the state within a short period of time after the company's offering is complete (the usual test is nine months), the entire transaction, including the original sales made within the required state, might violate the Securities Act.
• 4.Your company may have difficulty relying on the intrastate exemption unless you know the persons to whom the securities are offered and the actual purchasers, and the sale is directly negotiated with them. If your company holds some of its assets outside the state, or derives a substantial portion of its revenues outside the state where it proposes to offer its securities, it may also have difficulty qualifying for the exemption.
• 5.You may follow Rule 147, a "safe harbor" rule, to ensure that you meet the requirements for the intrastate offering exemption. It is possible, however, that transactions not meeting all the requirements of Rule 147 may still qualify for the exemption.
• iii.Reporting Requirements. Rule 502(b) has the following information requirements
• 1.502(b)(1) When information must be furnished. If the issuer sells securities under Rule 505 or 506(b) to any purchaser that is not an accredited investor, the issuer shall furnish the information specified in paragraph (b)(2) of this section to such purchaser a reasonable time prior to sale. The issuer is not required to furnish the specified information to purchasers when it sells securities under Rule 504, or to any accredited investor. Note: When an issuer provides information to investors pursuant to paragraph (b)(1), it should consider providing such information to accredited investors as well, in view of the anti-fraud provisions of the federal securities laws.
• 2.502(b)(2) At a reasonable time prior to the sale of securities the issuer shall furnish to the purchaser, to the extent material to an understanding of the issuer, its business and the securities being offered:

issuer is eligible to use Regulation A (§ 230.251-263), the same kind of information as would be required in Part II of Form 1-A (§ 239.90 of this chapter). If the issuer is not eligible to use Regulation A, the same kind of information as required in Part I of a registration statement filed under the Securities Act on the form that the issuer would be entitled to use.

(B) Financial statement information—(1) Offerings up to $2,000,000. The information required in Article 8 of Regulation S-X (§ 210.8 of this chapter), except that only the issuer's balance sheet, which shall be dated within 120 days of the start of the offering, must be audited.

• 3.Offerings up to $7,500,000. The financial statement information required in Form S-1 (§ 239.10of this chapter) for smaller reporting companies. If an issuer, other than a limited partnership, cannot obtain audited financial statements without unreasonable effort or expense, then only the issuer's balance sheet, which shall be dated within 120 days of the start of the offering, must be audited. If the issuer is a limited partnership and cannot obtain the required financial statements without unreasonable effort or expense, it may furnish financial statements that have been prepared on the basis of Federal income tax requirements and examined and reported on in accordance with generally accepted auditing standards by an independent public or certified accountant.