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What is a Safe Harbor Exemption?
Under both federal and state law certain “safe harbors” have been developed for use in private placements. These “safe harbors” are rules that, if strictly complied with, give you the assurance that you have not violated the securities laws. You must exercise great caution to comply with all of the requirements of the exemption. If you violate the rules, you will lose the private placement exemption.
There are several safe harbors providing exemption from registration but Rule 506 of Regulation D is probably the most widely used since it effectively preempts most state law registration or review.
What are the Differences between a Public Offering and a Private Offering?
The difference between a “private” and a “public” offering has been the subject of much debate, court rulings and regulations by the agencies that enforce securities laws. A public offering is designed so that the securities can be sold to a broad spectrum of potential buyers and the shares are typically free to be traded immediately after closing in open markets such as the stock exchanges, the OTCBB and the over the counter markets. Public offerings usually require painstakingly detailed prospectus disclosures that are reviewed in minute detail by securities regulators.
A private offering is limited in its scope, offered to a much smaller universe of potential buyers, and generally is not available for trading until eligible under Rule 144 or by a later registration.
To remain a private offering there can be no “general solicitation.” This is also a phrase that has been the subject of much debate. Clearly you cannot advertise in general media such as newspapers, TV, radio and so on. Information placed on websites that are available to the public also are disqualified. Broadcast mailings, mailing lists, and hiring telephone solicitation companies will be deemed public solicitation.
This applies even if the lists have been prequalified as “accredited investors.” In a “no action” interpretation to Agristar Global Networks the SEC was “unable to provide the requested no-action relief regarding the Company's proposal to establish a database of accredited investors.”
Also, the key is the “offerees” not the ultimate purchasers. For example, if you broadcast a request for “accredited investors” in a newspaper, that is a general solicitation that will forfeit the private offering exemption, even if only a few people actually respond and all of them are accredited.
It is critical that the securities “come to rest” with the original accredited purchasers and that no persons or entities are used as conduits to larger groups or to non-accredited investors. For example, a sale to a partnership of physicians who are also individually accredited is probably safe. But if the Partnership is then going to re-offer the interest to their employees, nurses, receptionists and so on, the private exemption will be lost.
What's in the PPM?
Federal securities laws generally require companies to give investors "full disclosure" of all "material facts." A material fact does not have to be so important that it would tip the scales, but it must be significant enough that a reasonable investor would have considered it in making an investment decision. In the public offering this is accomplished by requiring companies to file a registration statement with the SEC that includes extensive information for investors.
In a private offering this is accomplished through a private placement memorandum (PPM). The PPM tracks many of the categories required for offerings under Regulation A, SCOR and similar public offerings, but the level of disclosure is reduced and there is no review by regulators. In addition to the PPM, there are a number of ancillary documents that are required such as the Form D, the Sales Agent Questionnaire, the Accredited Investor Questionnaire, the Subscription Agreement, and so on.
There are no specific requirements for the information to be included in the PPM when the offering is limited to accredited investors only. When an offer is made to a non-accredited investor, the rules change and information roughly equivalent to that in a Reg A offering must be provided. If non-accredited investors are involved, you must then provide to the accredited investors the same information provided to the non-accredited investors.
Since the anti-fraud provisions continue to apply in a private offering, there is a serious risk to providing no written information. Most companies making private offerings prepare a PPM that contains essentially the same information whether limited to accredited investors or not. This accomplishes several purposes. It provides a written record so there can be no disputes as to the representations that were made. Since the PPM is drafted by the Company or its counsel, it can be written in a fashion best suited to protect the Company's interests. And the PPM can provide detailed information so investors can review at their leisure and gain a deeper understanding of the Company and its goals.
There is a tendency to think that the PPM should only contain negative statements. It can be misleading to provide this type of information as well as overly rosy information. The goal of the PPM is accuracy – to fully and fairly present the Company, the offering, and the information pertinent to making an investment decision. How are Private Placements Sold?
Private offerings are generally made via documents specially prepared for that purpose. Private offerings tend to be made to relatively wealthy individuals and entities that are “Accredited investors” under Regulation D in one on one or small group settings. The offerings can be equity (ownership), debt (loans) or a combination. The money raised can be used for any legitimate corporate purpose within the scope of the disclosures given to the prospective investors.
The PPMs are usually printed and numbered. The Company usually keeps a log of each PPM and requires that it be returned if the investor does not invest. If a PPM is returned, the company should mark the return and send a letter to the prospect confirming the fact. Then the Company can reuse the PPM.
Securities laws essentially designate everything in writing as a potential prospectus. Therefore it is a mistake to offer other written materials such as company brochures, sales materials, business plans and so on to investors. Instead, it is common to use powerpoint, slide shows or chalk boards for presentations, leaving nothing with the prospect other than the PPM and the private offering documents.
The offerings are usually offered by Company employees. There are strict rules governing the sales by employees. Many states require a cover letter or a questionnaire giving information about the people who will be handling the actual sales. The Employee must not be compensated for the sales efforts unless they are also a licensed securities broker. The employee handling the sales must be otherwise employed in some meaningful capacity with the Company. The employee sales are subject to an exemption that can only be used once in a twelve month period.
Sales are usually made by a “subscription agreement” signed by the investor along with a check for the purchase. The subscription agreement confirms that the investor received and reviewed the PPM, had an opportunity to review the information with the Company, is accredited under Regulation D and so on. This document also provides some assurance to the Company that various claims that could possibly be made have been waived or eliminated.
One of the classic problems with the private offering is the relative lack of liquidity in the securities purchased by the private placement purchaser. Generally the purchaser must certify that the securities are being held for investment purposes and without any intent to resale. Holding periods under Rule 144 usually prevent resale sooner than one year, although the newest proposals will reduce that to 6 months for certain reporting companies.
To provide more liquidity, many private offerings come with a promise to register the shares in a subsequent public offering or to otherwise take the company public so that the shares can be resold in securities markets after the holding periods and other limitations have expired.
The Power to Print Money
With a liquid trading market, whether the stock is $50 or 50 cents, securities can be issued instead of cash. Capital can be raised, employees compensated, and acquisitions completed with the stock and securities of the company.
We can show you how to structure your private offering to maximize your chances for success on either of these routes -
The primary benefit of being public is the greater liquidity from freely tradable securities. With liquidity, the company can:
1. Issue securities to raise capital
2. Use securities to make acquisitions
3. Reward employees with securities instead of cash
4. Provide an exit strategy for entrepreneurs and their family
The Power of the P/E
The day after losing the governor's race, a gentlemen learned that he had incurred $1 Million in campaign debt. He and his brother sat in their law office and called their stockbroker to sell their holdings. He noticed the discussion about the P/E of each company. He asked what that meant and was told that public companies typically trade at a multiple of earnings.
He asked about the P/E of their law practice and was patiently told that a private company did not have a P/E. He thought about this and then asked:
“So if we make $1 Million in our private company, we're worth $1 M, but if we make $1 Million in a public company, we could be worth $10, $12, or $20 Million.” He said he knew that was the end of his law practice.
One year later, he was worth $100 Million.
Doesn't a 506 Private Placement Permit Some Non-Accredited Investors?
Regulation D is a multi-part regulation and Rule 506 is just one of the rules. It is technically true that a 506 Private Placement can allow up to 35 non-accredited investors, but it gets tricky from there. You must refer to the other parts of Regulation D and wind your way through to determine the requirements. With accredited investors there are no specific disclosure requirements so long as the disclosures are not misleading. As soon as even one non-accredited investor becomes an offeree, that convenience flies out the window. Regulation D prescribes financial and other disclosure requirements that are far too technical for non-experts. If you offer to non-accredited investors and make an error in the requirements, the private placement exemption is lost.
We can prepare a custom offer that includes up to 35 non-accredited investors but these offerings are considerably more expensive. |
