A private placement (also known as unregistered offering) is a securities offering exempt from registration with the SEC. Startups, small and emerging companies, such as production companies and film funds, will engage in private placements to raise equity or debt financing from a small group of select investors instead of the public, usually from institutional investors and high net worth individuals. In general, investing in private placements is risky: private placement offerings are not registered with the SEC; most private placement securities are restricted securities and can tie up your investment for a year or more; and most private placements do not have the same investor protections as registered offerings, such as the comprehensive disclosure requirements that apply to publicly traded companies.
Disclosure Requirements
The disclosure requirements that apply to registered offerings mirror the disclosure requirements of Regulation A, or Part I of the SEC’s Form S-1 used for filing a prospectus as part of a registration statement for a publicly traded company. These requirements are extensive. They include descriptions of the company’s current business operations, past business performance, the use of proceeds, total number of units or shares being sold and price per share, information about the officers and managers, executive compensation, audited financial statements, risks, and tax and legal status of the business. Generally, private companies will try to avoid registration, because the preparation of disclosure documents, the public disclosure obligations, and the ongoing compliance obligations that flow from registration can be time-consuming and expensive, and the companies lose the ability to remain a private company. Private companies may avoid registration of the offer or sale of their securities by making use of any one of a number of private placement exemptions available under Regulation D (Reg D) of the Securities Act.
Regulation D
The entity selling the securities is commonly referred to as the issuer. Under Section 4(a)(2) of the Securities Act 1933, the obligation to register the offer and sale of securities does not apply to transactions by an issuer not involving a public offering. This Reg D exemption allows companies to raise capital while keeping their financial records private, instead of disclosing such information to the SEC, and the buying public, each quarter. All issuers relying on a Reg D exemption are required to file a document called a Form D no later than 15 days after they first sell the securities in the offering. The Form D will only include brief information about the issuer, its management and promoters, and the offering itself. Issuers often rely on Rules 504 and 506 of Reg D to sell securities in private placements.
Rule 504
Rule 504 provides an exemption from registration for securities offerings of less than $5 million within a 12-month period. A company may offer and sell these securities to an unlimited number of accredited and non-accredited investors. Under Rule 504, the issuer is not required to provide any specific information or disclosures to potential investors, so long as it does not violate the anti-fraud prohibitions of the federal securities laws. However, if an issuer provides information to accredited investors, it must provide such information to non-accredited investors as well. An “accredited investor” is an individual who:
• 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)). An accredited investor is also any director, executive officer, or general partner of the issuer, or an entity such as a bank, partnership, corporation, nonprofit or trust, when the entity satisfies certain financial criteria.
Rule 506
Under Rule 506(b), a company can raise an unlimited amount of money from an unlimited number of accredited investors, but from no more than 35 non-accredited investors. However, unlike Rule 504, the non-accredited investors must be financially sophisticated, that is, have sufficient knowledge and experience in financial and business matters to evaluate the investment. This sophistication requirement may be satisfied if the non-accredited makes the investor invests through a registered broker-dealer. Unlike Rule 504, Rule 506(b) requires a company to give non-accredited investors comprehensive disclosure documents. However, the company has discretion what information to give to accredited investors, in view of the anti-fraud prohibitions of the federal securities laws. In addition, if the issuer provides information to accredited investors, it must also provide this same information to non-accredited investors. Under Rule 506(b), a company cannot use general solicitation or advertising to market and sell securities. However, under Rule 506(c), the company may use general solicitation, marketing or advertising to market and sell securities to accredited investors only. The company must take reasonable steps to verify that the investors are accredited investors, which could include reviewing documentation, such as W-2s, tax returns, bank and brokerage statements, credit reports and the like.
Anti-Fraud Protection
Securities laws are designed to ensure that investors fully understand what they are investing in and fully appreciate the risks before they invest. Therefore, even if a company is exempt from registration under securities law, it must provide potential investors with access to company records if they ask for them, be available to answer questions by potential investors, and must take care to provide sufficient information to investors so that they can make an informed decision. To avoid violating the antifraud provisions of the securities laws and liability for securities fraud, any disclosure (oral or written) to investors must be free from false or misleading statements, must include all material facts concerning the investment, and should not exclude any information if such omission makes what is provided to investors false or misleading. In practice, issuers often provide a document called a private placement memorandum or offering memorandum (PPM) that introduces the investment and discloses information about the securities offering and the issuer.
Private Placement Memorandum
A PPM is a legal disclosure document that provides full and transparent disclosure regarding the terms of the investment offering, information about the company, operations and management, the use of the proceeds, and describes the risks factors inherent in the business and industry. The PPM is not filed with the SEC. A PPM can be as much for a company’s protection from legal liability, as it is for potential investors to be fully informed before they buy the company’s stock. The SEC has even warned prospective investors that the absence of a PPM is a red flag to consider before investing. A carefully drafted PPM protects the issuer from claims by securities regulators or litigation by disgruntled investors, for improper disclosure. A PPM must contain accurate, truthful and current information. While many PPMs share some similarities, they are all completely customized and unique to each investment deal. For example, a well-prepared PPM will avoid using formulaic risk factors. Instead, they will detail the specific risks associated with the company’s industry, such as market trends, competitive analysis, or regulatory and tax issues. In addition, a well-prepared PPM will avoid sales/revenue projections, especially overinflated ones, that are not based on expected reality and that are the exception. Investors will likely expect you to achieve those financial targets, and the SEC will closely scrutinize such performance forecasts set out in the PPM. Whether a company needs to use a PPM or not, and the amount and type of information in the PPM, will, in general, depend on;
• which exemption from registration is being used,
• the type of issuer,
• the number of investors,
• the level of sophistication and type of investor,
• the amount of money being raised, and
• the complexity of the terms of the offering.
In investment finance, an offering memorandum is a kind of a detailed business plan that highlights information required by an investor to understand the business. It provides details on the terms of engagement, potential risks associated with the business, and a detailed description of the operations of the business. The document also often includes a subscription agreement that acts as a contract between the two parties, i.e., the investor and the issuing company. Investments formally follow these guidelines and are mostly required by securities regulators. A prospectus is similar to an offering memorandum, but the former is for publicly-traded issues while the latter is for private placements. Business growth requires an injection of capital that is obtained from investors. The offering memorandum is part of the investment process. For instance, a company may decide to increase the number of its offices, which will require a significant amount of funds. The process begins with the firm deciding how much they need for the expansion. Then, an investment banker drafts the offering memorandum, which must comply with existing procedures and securities laws and regulations. The company then chooses who to issue the document with, depending on their targeted investors. It is much like the process of doing an IPO, but an offering memorandum is aimed at a private placement investment rather than the company seeking funds going public.
Contents of the Offering Memorandum
An offering memorandum comprises key information on the company’s future growth strategy, upcoming opportunities in the market, strategy for achieving future projections, and details on competition in the marketplace. How the current management team plans on dealing with weaknesses, operations scalability, etc., are detailed in the document. The investment banker, financial advisors, and the like, should provide valuable information but the offering memorandum should also contain information directly from the company. Every clause should be scrutinized and vetted to ensure it’s free from errors or omissions. The document is meant to give the company an opportunity to convince targeted investors, and it should be flawless for this purpose.
Example Offering Memorandum Table of Contents:
• Summary of the Offering
• Business Summary
• Requirements for Purchasers
• Forward-Looking Information (Financial)
• Risk Factors
• Use of Proceeds
• Management
• Compensation
• Board of Directors
• Capitalization Table and Dilution
• Legal Information
The document should present data to show the company’s progress, and provide future projections, highlighting various strategies being implemented to cope with challenges. It should present a realistic picture of the industry the company operates in and show the investor clearly what the company’s prospects and goals are. False information is dangerous and can attract heavy fines if it is determined that investors have been deceived into making commitments. The details on the balance sheet should be presented to tell the investor what the business is worth in assets and liabilities, which also helps the investor determine if the share value is worth committing their investment. Ultimately, the presentation should portray the company as a valuable entity that anyone should feel fortunate to have the opportunity to invest in.
Importance of Issuing an Offering Memorandum
The document is legally binding, and its importance goes beyond being a necessary document in the process of investment for both sellers and investors. The document protocol helps the investor understand the opportunities being presented in the investment, imminent risks, potential returns, the operations involved, and the general capital structure. The offering memorandum also provides protection for the investor and for issuers of securities. The issuer is required to follow to the letter all regulations outlined by the SEC (Securities and Exchange Commission). The SEC promotes fairness in the investment industry by shielding investors in the securities industry from falsified information and by aiding the investor in making informed decisions in the process of committing huge amounts of funds. The offering memorandum also presents a professional touch to the seller. Investors cannot commit their money to businesses that don’t look organized or professional in their area of operation. Presenting a memorandum shows seriousness and professionalism in the business.
A prospectus is used for public markets while an offering memorandum is used for private markets. The offering memorandum document can also be referred to as an “offering circular” if it requires registration with the stock exchange commission. The offering memorandum and the prospectus share many attributes, ranging from the types of disclosures and amounts required to terms and conditions. Both documents describe the terms of the offer, such as the minimum amount to invest and the qualifications of an investor. The investor is also briefed on imminent risks such as tax issues, vulnerabilities, transferability issues, and potential returns. Both documents are basically a detailed business plan, with in-depth information on management structure, strengths and weaknesses, capital structure, asset values, share values, amount of shares available, and financial projections. When a publicly-traded company issues a private placement, existing shareholders often sustain at least a short-term loss from the resulting dilution of their shares. However, stockholders may see long-term gains if the company can effectively invest the extra capital obtained and ultimately increase its revenues and profitability.
Private Placement and Share Price
If the entity conducting a private placement is a private company, the private placement offering has no effect on share price because there are no pre-existing shares. With a publicly-traded company, the percentage of equity ownership that existing shareholders have prior to the private placement is diluted by the secondary issuance of additional stock, since this increases the total number of shares outstanding. The extent of the dilution is proportionate to the size of the private placement offering. For example, if there were 1 million shares of a company’s stock outstanding prior to a private placement offering of 100,000 shares, then the private placement would result in existing shareholders having 10 percent less of an equity interest in the company. However, if the company offered an additional 1 million shares through the private placement, that would reduce the ownership percentage of existing shareholders by 50 percent.
Motivation for Private Placement
The dilution of shares commonly leads to a corresponding decline in share price—at least in the near-term. The effect of a private placement offering on share price is similar to the effect of a company doing a stock split. The long-term effect on share price is much less certain and depends on how effectively the company employs the additional capital raised from the private placement. An important factor in determining the long-term share price is the company’s reason for the private placement. If the company was on the verge of insolvency and did the private placement as a means of avoiding bankruptcy, it would not bode well for the company’s shareholders. However, if the motivation for the private placement was a circumstance in which the company saw an outstanding opportunity for rapid growth that simply required additional financing, then the eventual extra profits realized from the company’s expansion may push its stock price substantially higher. Another possible motivation for doing a private placement could be that the company cannot attract large numbers of institutional or retail investors. This might be the case if the company’s market sector is currently considered unattractive, or there are only a few analysts covering the company.
Private Placement Lawyer Free Consultation
When you need legal help with a Private Placement in Utah, please call Ascent Law LLC for your free consultation (801) 676-5506. We want to help you.
8833 S. Redwood Road, Suite C
West Jordan, Utah
84088 United States
Telephone: (801) 676-5506
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