Private Placements: A Primer
A private equity offering or "private placement" of securities is the process of offering and selling securities to prospective investors without first registering the securities with the U.S. Securities and Exchange Commission (the "SEC"). In a private placement, a business or entrepreneur raises capital by selling equity to select investors (family and friends, key employees, institutional investors, angels, venture capital companies, etc.) who meet certain qualifications. Private placements allow a startup to raise capital with less time and expense than registered offerings and allow a company to customize an equity offering for certain select, targeted investors while keeping the company’s information private.
As we previously discussed here, which includes a discussion of "general solicitation" in the context of private placements, Section 5 of the Securities Act of 1933, as amended (the "Securities Act"), provides that all offers and sales of securities must be registered with the SEC, or else be exempt from registration. Regulation D includes three SEC rules—Rules 504, 505 and 506—that a company may rely on to sell securities in unregistered offerings.
Regulation D
Rule 504. Rule 504 provides an exemption for the offer and sale of up to $1 million of securities in any 12-month period. These securities may be sold to any number and type of investor, and the company is not subject to any specific disclosure requirements. Generally, securities issued under Rule 504 will be restricted securities, meaning that they may not be sold without registration or an applicable exemption, unless the offering meets certain additional requirements.
Rule 505. Under Rule 505, a company may offer and sell up to $5 million of its securities in any 12-month period, but there are limits on the types of investors who may purchase the securities. Rule 505 allows a company to offer and sell securities to an unlimited number of accredited investors, but to no more than 35 non-accredited investors. An individual will be considered an accredited investor if he or she:
- earned income that exceeded $200,000 (or $300,000 together with a spouse) in each of the prior two years, and reasonably expects the same for the current year; or
- has a net worth over $1 million, either alone or together with a spouse (excluding the value of the person’s primary residence and any loans secured by the residence (up to the value of the residence)).
Any company offering or selling securities to non-accredited investors must be aware, however, that if the company sells its securities to non-accredited investors, it must disclose certain information about itself, including its financial statements. If sales are made only to accredited investors, the company has discretion as to what to disclose to its investors. Any information provided to accredited investors must be provided to non-accredited investors.
Rule 506. As explained in greater detail here and here, an unlimited amount of money may be raised in offerings relying on one of two possible Rule 506 exemptions. As with Rule 505, a company relying on Rule 506(b) may sell to an unlimited number of accredited investors, but to no more than 35 non-accredited investors. However, unlike Rule 505, the non-accredited investors in the offering must be financially sophisticated—that is, they must have sufficient knowledge and experience in financial and business matters to evaluate the investment. Similarly to a Rule 505 offering, if non-accredited investors are involved, the company must disclose certain information about itself, including its financial statements, but if selling only to accredited investors, the company has discretion as to what to disclose to investors.
Form D
All issuers of securities relying on a Regulation D exemption are required to file a document called a Form D no later than fifteen days after they first sell the securities in the offering. The Form D will include brief information about the issuer, its management and promoters, and the offering itself.
Other Considerations
Integration Regulation D has a concept called "integration" that requires that all offers and sales that are part of the same offering must meet the requirements, else the issuer risk losing the exemption for the entire offering. There is a 6 month bright line test in Regulation D that insulates different offerings if no securities of the same class or series are offered or sold in that period. For instance, if a company did a Rule 504 offering of Series A preferred to non-accredited investors and followed up by selling more Series A in what purported to be a Rule 506 offering a few months later, in all likelihood, the offerings would be integrated and unlikely to fit squarely within either exemption.
Antifraud Even though private placements are not subject to the same disclosure obligations as registered offerings, private placements remain subject to the antifraud provisions of the federal securities laws. Therefore, any information provided must be true and may not omit any material facts necessary to prevent the statements made from being misleading.
State Blue Sky Law In addition, even though a private placement offering may be exempt from SEC registration, the offering may have to separately comply with state securities laws, including state registration requirements or a state exemption from registration. For instance, offerings under Rule 506 are "covered securities" that are exempt from state registration under the Securities Act (hence Rule 506’s preeminence in startup private placements), while offerings under Rules 504 and 505 are not, and thus must either be registered or issued under a valid exemption in each state in which offers and sales are made.