ABC's and 1-2-3's (or Regulation D & 501-506) of Private Placements

Cash for operations, expansion, and development in a young business is a scarce resource. If only we were all a Google and could have an Initial Public Offering (IPO) that nets several hundred dollars per share. To most, the idea of offering securities to raise capital is solely the domain of big corporations. Moreover, commercial bank loans are often directed to mature businesses with demonstrated profitability.

What if a small younger operation could raise capital through "securities" without the tremendous burden and expense of an IPO? The answer is the Private Placement or Private Offering.

What is a Private Placement?

Private Placements are vehicles, usually the form of stocks, units, bonds, and in certain cases notes, for investment in your company by private investors. Hence, a Private Placement is generally an offer or sale of a security outside of a public offering or the IPO. Such offerings are not registered with the SEC under the 1933 Act, since they are authorized as an exemption to the Act's registration requirements under Sections 3(b) or 4(2).

Private Placements are controlled by SEC Regulation D. Regulation D sets outs the compliance guidelines for this exemption. A private placement must conform to Regulation D's requirements, Sections 3(b) or 4(2) of the 1933 Act, and SEC interpretation and court decisions of those provisions. It is the offeror's burden to demonstrate that these requirements were met.
Regulation D

Overview

Regulation D is comprised of six numbered rules, Rules 501-506. Rules 504, 505, and 506 provide three detailed exemption categories. Rules 501-503 set forth definitions, terms and conditions.

Rule 504

Rule 504 governs offerings of no more than $1,000,000 in securities within any consecutive twelve-month period. The least restrictive rule, Rule 504 can permit (only when certain conditions are met, such as offering solely in state(s) that require a publicly filed registration statement and delivery of a substantive disclosure document to investors) commission payments to third parties, resale of securities, unrestricted manner of offering, and an unlimited number of investors. Importantly, unlike the other rules Rule 504 does not impose specific disclosures requirements. While federal securities requirements under Rule 504 offerings is limited, state "Blue Sky" laws often impose more detailed requirements on these very small offerings and they are governed by federal anti-fraud provisions and civil liability provisions of the Exchange Act.

Rule 505

Rule 505 governs offerings of no more than $5,000,000 of securities within any consecutive twelve-month period. Unlike offerings under rule 504, Rule 505 imposes a limitation of sales to only thirty-five "non-accredited" investors while allowing sales to an unlimited number of accredited investors. Under Rule 505 general solicitation or general advertising (e.g. taking a newspaper ad out inviting people to invest) is not permitted and such securities are not allowed to be resold.

Rule 506

While the other two rules control offerings within certain ranges, Rule 506 has no dollar limitation. Again, unlike offerings under rule 504, Rule 506 imposes a limitation of sales to only thirty-five "non-accredited" investors while allowing sales to an unlimited number of accredited investors. Rule 506 goes a step further than Rule 505 however, and imposes a requirement upon the offeror to assure that at the time of purchase each non-accredited purchaser meets a certain sophistication standard (this is not a legally defined term, but generally means that the purchaser has reasonable investment experience and knowledge in light of their purchase.) Rule 506 also prohibits any form of general solicitation or advertising.

Accredited Investor

Typically if one has the option, one should limit solicitations strictly to Accredited Investors. So who is an "Accredited Investor"? Rule 501(a) sets forth the technical definition. There are four main categories of accredited investors:

1) Directors, executive officers (this is a term further defined), and general partners of the offeror, including general partners of general partners;

2) A purchaser with a net worth either as an individual or jointly with his spouse equal to or greater than $1,000,000. (Regulation D offers no real definition of "net worth." As a result, non liquid assets, such as the house and car, are often counted in the net worth calculation.);

3) A Natural person (meaning not an entity) purchasers can also qualify based on "income." Such income must have been greater than $200,000 in both of the two previous years to the offering and the person must reasonably expect an income greater than $200,000 in the current year (the purchaser can rely on joint income with his spouse to satisfy the definition if such joint income is greater than $300,000); and

4) In certain instances, a business entity can be treated as a single accredited investor. However if that entity was organized specifically for acquiring the offered securities, each owner will be counted separately for purposes of the offering.