Tuesday, March 23, 2010

Federal Exemptions Available for Private Placement of Securities – Part I

This posting is mostly geared towards securities attorneys who advise small and growing businesses on how to do a private placement.

This posting is a brief outline of requirements of federal private placement exemptions available to companies that would like to offer and sell their securities (I refer to them as the "issuers" of securities) to investors and should not be relied upon for choosing the exemption that is most appropriate for any given company and/or offering.

The following federal exemptions may be available:

• Section 4(2) of the Securities Act
• Rule 506 of Regulation D
• Section 4(6) of the Securities Act
• Rule 504 of Regulation D
• Rule 505 of Regulation D
• Rule 701
• Regulation A
• Section 3(a)(11)
• Rule 147

Part I discusses the first two exemptions: Section 4(2) and Rule 506 of Regulation D.

Section 4(2) private placement exemption

Courts look at the following factors in deciding whether this exemption is available, as discussed in the instrumental Ralson Purina case (Securities and Exchange Commission v. Ralson Purina Co., 346 U.S. 199 (1953):

1. All offers must comply with the exemption requirements. A single offer that does not qualify may invalidate the whole offering.
2. There should be a limited number of offerees (there is no exact limit, but it is clear that there is a limit depending on the circumstances).
3. Company issuing the securities cannot engage in general solicitation or advertising. For more information on this ban, see my earlier post “Rules relating to solicitation and advertising in Regulation D private placement of securities.”
4. The issuer has to restrict resales of securities by obtaining investment letters from investors, placing restrictive legends on stock certificates and issuing stop transfer instructions.
5. All offerees have to be financially sophisticated or have an advisor who has the required financial expertise. Wealth does not necessarily make investor financially sophisticated.
6. Offerees need to have access to the kind of information about the company and the offering that would be contained in a registration statement or actually receive such information. Certain offerees have access to this information because they are executive managers of the issuer, have family ties or special business/ economic bargaining power with the company that would allow them to have access to the required information.

In addition to satisfying all factors listed above, issuers also have to comply with state securities laws, as states may impose their own requirements for private offerings that are conducted under Section 4(2) of the Securities Act.

Rule 506 of Regulation D

Rule 506 was adopted by the Securities and Exchange Commission in 1982 as a “safe harbor” to the Section 4(2) exemption. This means that if the company issuing the securities complies with the requirements of Rule 506, such issuer has perfected the Section
4(2) private placement exemption. On the other hand, it is not necessary to comply with Rule 506 requirements in order to have a successful private placement.

Rule 506 contains the following requirements:

1. Rule 506 places no limit on the aggregate amount of the offering price.
2. Like in Section 4(2) private placements, no general solicitation or advertising is allowed. For more information on this ban, see my earlier post “Rules relating to solicitation and advertising in Regulation D private placement of securities.”
3. There may be only a maximum of 35 nonaccredited investors and an unlimited number of accredited investors (see more below).
4. Specified disclosure must be made to all nonaccredited investors.
5. The issuer must reasonably believe that nonaccredited investors (either alone or together with their investment representatives) have sufficient financial and business knowledge to allow them to evaluate the risks and merits of the investment.
6. The issuer has to restrict resales of securities by obtaining investment letters from investors, placing restrictive legends on stock certificates and issuing stop transfer instructions.
7. The issuer must provide disclosure to nonaccredited investors regarding limitations on resale.
8. The issuer must file Form D with the Securities and Exchange Commission within 15 days of the first sale of securities.

Accredited investors are defined to include those individuals whose net worth (or joint net worth) at the time of purchase exceeds $1 million and/or those who have over $200,000 income in the last two years (or $300,000 combined with a spouse) and reasonable expectation to have similar income in the present year. Accredited investors definition also includes directors, executive officers or general partners of the issuer, and certain institutional investors such as certain banks, insurance companies, employee benefit plan, charities, corporations, trusts and partnerships with assets in excess of $5 million.

The definition of accredited investors generally focuses on wealth, whereas the definition of sophisticated investors, used in Section
4(2) exemption, although not well defined, focuses primarily on whether such investors have sufficient experience in financial and business matters to be able to adequately evaluate the risks and merits of a proposed investment.

States are preempted from regulation of offerings made under Rule 506 but may set forth notice filing requirements and collect fees.

This posting will continue in Part II.

Tuesday, March 16, 2010

Access to Capital for Small Businesses - Debt Financing

On March 12, 2010 I attended the seminar "Access to Capital" sponsored by the Education Committee of the Manhattan Chamber of Commerce. The focus of the program was to provide small business owners with ideas of how and where they can obtain necessary funding for their businesses.

There are two sources of outside financing: equity and debt. I found that this seminar focused primarily on the debt financing options available to small businesses.

The first panel consisted of a representative of M&T Bank, a commercial bank that lends to small businesses, a representative of Yellowstone Capital, an alternative lending company that provides merchant cash advances by purchasing credit card receivables, and a representative of ACCION USA, a microlending institution that lends to small businesses.

I learned the following information:

Receiving a loan from M&T Bank takes about one week. There is no application fee, althrough at times they charge a small commitment fee. Small businesses can get loans or a line of credit or a combination of the two. The Bank usually wants the loan to be collateralized with business assets such as receivables. An ideal candidate is a business that has been in operations for some time, has a positive cash flow and good credit. The Bank will ask to see a business plan and two-year projections if the loan is for over $200,000. The interest rates are approximately 1 1/3% over prime. M&A Bank also provides loans that are guaranteed by SBA (Small Business Administration).

Accion USA is all about providing capital for small businesses. They take about 5-10 business days to underwrite a loan. They will lend to businesses that are home-based (no need to have a separate office in order to obtain a loan), in all industries except for real estate. Accion USA may provide loans of up to $50,000 to businesses that have been denied loans from a traditional bank/lending institution. If Accion USA denies a loan, they will help with financial advice and solutions on how to restructure the business. Their rates are typically 8-15%, although they have special initiatives with lower rates. They also do not charge an application fee.

Yellowstate Capital provides alternative financing for businesses that have many receivables (like restaurants, shops).

The second panel was comprised of a representative of NYC Business Solutions, SBA of NY, and two entrepreneurs/small business owners. NYC Business Solutions is a part of the New York City Department of Small Business Services. The organization runs a number of centers throughout New York City that provide no-cost services to startups and small businesses, including financing assistance, legal review of contracts and leases and free classes on how to run and market your business. At NYC Business Solutions they work with businesses to make them "loan ready" (i.e., help develop a business plan, understand financing needs) and then act as a no-cost loan broker in connecting the businesses with loan partners, such as Accion USA, M&T Bank or other institutions. I think this is a great resource available to entrepreneurs and small business owners.

SBA stands for U.S. Small Business Administration, a federal agency created to assist small businesses and entrepreneurs. SBA can guarantee up to 90% of the loan. SBA has several different programs (504 program is a real estate program and 7A is for all other businesses) and can guarantee loans for up to $2 million.

I am enthusiastic to see so many debt financing options available to entrepreneurs and small businesses, as external capital is necessary for business growth. There is also an option of obtaining private debt from investors (promissory notes) that can either be straight debt or be convertible into equity at preferred conversion rates. Of course, startups can also use credit cards to cover their working capital needs, but interest rates charged by credit cards are high.

The main advantages of debt financing are (1) obtaining debt financing typically takes less time than obtaining equity financing; (2) it costs less to document it (rather than equity financing, where a private placement memorandum may be required - see my previous post); and (3) equity ownership is not diluted (unless debt is convertible). The main disadvantages of obtaining debt financing include (1) debt has to be paid back; (2) paying interest on debt can be difficult for some businesses; (3) debt agreements typically contain some restrictions on various transactions or may require lender consent; (4) debt will be carried as a liability on the balance sheet; and (5) business owners may have to personally guarantee it.

Sunday, March 14, 2010

To have or not to have a PPM in private placements

PPMs are private placement memorandums. These disclosure documents are customarily used in connection with private placements of securities to qualified investors. PPMs describe, among other things, the terms of the offering, the company issuing the securities (its business strategy, employees, senior management, properties, financial statements), industry, market, competition, how the company will use the proceeds from the offering and risk factors relating to the industry, the company and the offering.

A PPM is viewed to be the central document of the transaction, and yet, thousands of private placements are conducted without one. So, what are the pros and cons of preparing a PPM in connection with a private offering of securities by a private issuer?


1. To qualify for certain exemptions from registration of the offering under the securities laws, state or federal laws require that companies provide certain disclosure to a certain type of investors, therefore a PPM is needed to establish the claim for exemption from registration and to comply with applicable laws.
2. PPM is a written proof of what was presented to the investors in connection with the offering, therefore a PPM can help avoid liability for material misstatements or omissions under the antifraud provisions of state or federal law.


1. There is no particular requirement to provide any specific quantum of information to accredited investors (so if the offering is made only to accredited investors, technically speaking, a PPM is not necessary).
2. The preparation of the document is expensive. Typically, a PPM is a joint effort of senior management, placement agents, lawyers and accountants and requires hours and hours to prepare. A successful PPM is a fine balance between creating a selling document that would appeal to potential investors and a document that is in compliance with applicable laws and regulations. A mistake in the preparation of the PPM can subject the company to civil and even criminal sanctions, result in lawsuits by investors and unravel the offering.
3. The Ralson Purina decision (the Securities and Exchange Commission v. Ralson Purina Co., 346 U.S. 199 (1953)), widely used for factors defining a private placement, requires only access to the type of information that a registration statement would disclose, not that the actual information be handed to the investors.
4. PPMs have to be consistent with future offering documents of the company; if not, questions may be raised as to whether the company was being truthful in its representations made in the PPM.

Overall, thousands of private offerings are conducted with little or no disclosure documents, and consequently, lower offering costs. On the other hand, PPMs, if prepared correctly, can serve as written testimony of what was and was not represented by the company in connection with the offering, thus saving the company thousands of dollars in potential legal disputes.

Perhaps, if a company conducts a smaller offering to accredited investors only, it may be sufficient to use a combination of an expanded business plan, coupled with risk factors, access to company records and a seminar for potential investors affording them an opportunity to ask the senior management questions relating to the offering.

Friday, March 12, 2010

Rules relating to solicitation and advertising in Regulation D private placement of securities

At some point in the early stages of growth, many start-up companies need external capital. One way to obtain such capital is by conducting a private offering of securities (either equity or debt) to angel investors or venture capital firms. Below I am discussing some aspects of federal law that every small business owner should be aware of when he or she is contemplating a private placement of securities.

Under the Securities Act of 1933, any offer to sell securities must either be registered with the Securities and Exchange Commission (the “SEC”) or meet an exemption. One of the widely used private placement exemptions under the Securities Act is Regulation D, which includes rules 505 and 506, each of which prohibit general solicitation or advertising to sell the securities.

In particular, Regulation D prohibits “any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio” and “any seminar or meeting whose attendees have been invited by any general solicitation or general advertising.” This means that businesses cannot advertise their offers or solicit offers in the newspaper, TV, radio, or use mail to do so. If they advertise in violation of this restriction, this may turn the private offering into a public one, which then defeats the exemption and may require registration and/or return of investors’ money.

So, how can businesses find individuals or firms willing to invest in them?

The answer to this question is derived from multiple responses published by the SEC, called no-action letters, as well as various court decisions. In summary, no-action letters indicate that there is no general solicitation when the business owners, employees or agents send offering materials or describe the offer to potential investors with whom they have a substantial preexisting relationship (such relationship should be of substance and duration, and should enable the company to evaluate investor’s wealth, experience and financial sophistication). The numbers of potential investors that are contacted are not important, what matters is whether the potential investors have the substantial relationship prior to the solicitation.

Therefore, only those potential investors should be contacted with whom someone on the issuer side of the offering (founders, officers, directors, placement agents, lawyers, accountants) has a preexisting relationship. This list may include friends, business acquaintances or prior investors in the business. Placement agents (typically banks or investment firms hired by the company to facilitate the offering) may establish preexisting relationships by sending out generic questionnaires to potential investors well in advance of the offering asking individuals to share their financial information in order to establish whether they are “sophisticated” or “accredited” investors. (More on “accredited” investors in future blog posts). Placement agents can then use their list of pre-screened potential investors to send out offering materials. The SEC Staff has also said that there was no general solicitation by the company that required potential investors to (1) complete a questionnaire designed to allow the company to determine whether such investor was an accredited investor, (2) pay a subscription fee, and (3) wait for at least 30 days prior to accessing the password-protected website containing offering materials,. (See Lamp Technologies, Inc., SEC No Action Letter May 29, 1997).

It is important to keep records of all contacts made in connection with the offering.

In conclusion, business owners should be careful not to solicit offers from the general public or advertise a contemplated offering of securities and should seek advice of competent legal counsel well in advance of the offering.

Please note: nothing in this blog post constitutes legal advice.

Arina Shulga.