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The following sections of the Venture Associates web site discusses private investor financing using Regulation D, private placement memorandums (PPMs), the terms, forms, procedures, and documents. Reg D Private placement offerings differ from public offerings in that when the fund raising is completed, the company's stock is not publicly traded on an exchange. HOWEVER, many of the steps and documents for properly raising private financing are similar to those of going public and Regulation D stock is tradeable.
This section includes discussions on the topics of:
The Preferred Investment Vehicles
Regardless of the source of your financing--family and friends, angels, or venture capital--you will need some vehicle, forms, or set of papers to make it all nice and legal. On the surface, it would seem that if you're going to sell stock, you could take the investors' check and give them a stock certificate. Or if it was to be a loan, just take the check and sign a note. Unfortunately, it's not quite that simple. And in fact, you don't want it to be.
Today's "sue the buzzards" mentality causes some real problems for entrepreneurs when it comes to raising money. The main problem is the entrepreneurs themselves. Considering their natural propensity and rightful enthusiasm for their project, they tend to oversell. This is okay if everything works out the way it is planned. But we all know that "Murphy" will enter the program and that not always what is well, ends well. In the worst cases, your company may not survive.
The problem then becomes that the friendly original investor is not the least bit happy about the fact that you did not perform up to expectations or lost all their money. Their fee-happy lawyer is more than pleased to take on the case of suing you because you said there wasn't any significant competition, that your engineer was a genius and couldn't miss on inventing the black box, that you had umpteen customers lined up, and the endless list goes on. What it comes down to is your word against theirs, and most likely they have more money (which is why you went to them in the first place) and they can afford the upfront legal fees that will be repaid when they sell your house.
There is a solution to this dilemma, various documents that have been blessed by our governmental bodies, which act like a sort of insurance policy for entrepreneurs to protect them against disgruntled investors, be they friend, family, angel, or venture capitalist. They are the subject of the next section.
The Selling of Securities
Simply stated, it's against the law to sell stock unless you are licensed to do so or can qualify for an exemption from the Securities and Exchange Commission (SEC) and the various states securities commissions' rules. The very worst that can happen is that you will have to pay penalties or you can be put in jail. The least that can happen is that you would be required to refund any monies you raised. This can be very difficult if you've already spent a sizable portion
before the legal problem arises.
For most entrepreneurs, the best vehicle to accomplish initial equity financing under an exemption is through the use of a Private Placement Memorandum (PPM) under Regulation D (Reg D), which is a limited offer and sale of their company's stock, or securities, without registration under the Federal Securities Act of 1933.
Some risks continue under Reg D, but compliance is significantly easier than before Reg D. A major, major point is that by complying with Reg D, it provides the company, its officers, and its directors with an insurance policy of sorts regarding disclosure.
There Are Six Basic Rules
Regulation D consists of six basic rules. The first three are concerned with definitions, conditions, and notification. Rule 501 covers the definitions of the various terms used in the rules. Rule 502 sets forth the conditions, limitations, and information requirements for the exemptions in Rules 504, 505, and 506. Rule 503 contains the SEC notification requirements.
The last three rules (504, 505, and 506) deal with the specifics of raising money under Reg D. Rule 504 generally pertains to securities sales up to $1 million. Rule 505 applies to offerings from $1 million to $5 million. Rule 506 is for securities offerings exceeding $5 million. (A complete review of all aspects of Reg D is contained in our book Going Public" - Everything You Need to Know to Take Your Company Public.)
This rule is considered by many as the perfect answer for the company just starting out OR one that needs to raise less than $1 million. Regulation D Rule 504 offers such companies:
- An exemption to raise up to $1 million
- No disclosure criteria
- Few general solicitation and resale restrictions
- No limit as to the number or type of investors
Actually, Congress's original intent in 1982 for Rule 504 was to "set aside a clear and workable exemption for small issuers to be regulated by state blue sky requirements, but by the same token, to be subjected to federal anti-fraud provisions and civil liability provisions." Rule 504 exemption is provided for almost any type of organization, including corporations, LLCs, partnerships, trusts, or other entities. However, it is not applicable to companies already reporting to the SEC (subject to the '34 Act) or investment companies.
You Cannot Exceed $1 Million. The total offering amount under Regulation D Rule 504 can be up to $1 million in a 12-month period, less the aggregate offering of all securities sold within 12 months before the start of a 504 offering. So, if a company has raised $100,000 in private money in the previous 12 months, it can still raise up to $900,000 without being accused of breaking the rules, or "integration."
Generally speaking, there are no specific disclosure requirements under Rule 504 (disclosing what the company is about, what it intends to do, or who is connected with it). This means that, theoretically, an issuer can have a purchaser sign a subscription agreement and purchase stock without any information about the company being disclosed. However, the rule is dependent on the blue-sky laws of each state in which the securities are offered. This means that if a state's blue-sky rules require disclosure, it must be provided regardless of Rule 504.
A word of caution to the entrepreneur--regardless of the amount of disclosure the issuer is willing to provide, Rule 504 does not dismiss the issuer from the federal requirements, nor is there an exemption from the fraud provisions, including the areas of material omissions or misstatements. The penalties for noncompliance are severe, including monetary fines and mandatory jail sentences.
Number of Investors. With its limited disclosure requirements, Rule 504 also allows an issuer to sell securities to an unlimited number of investors. Theoretically, a company could raise $1 million by selling its stock at a penny a share to 100 million different investors. Obviously, the administrative economics are not too attractive, but there's no rule that stops an issuer from selling $500 blocks of stock to 2000 investors. Rule 504 is the only rule under Reg D that permits an unlimited number of investors.
A final note on Rule 504 is that the exemption provides for sales of securities of either debt or equity. This opens the door for combinations of both via convertible debentures. By way of explanation, convertible debentures are a debt issue (debenture) that is convertible to a preferred or, most commonly, common stock at some future date.
Rule 505: Offerings of $5 million or less
Rule 505 is used for offerings of $5 million or less in any 12-month period and is restricted to 35 purchasers other than "accredited investors."
There are a number of required disclosures if the sale of securities includes investors who are not accredited investors: advertising and a general solicitation are prohibited, one must inform purchasers that they receive "restricted" securities (meaning that the securities cannot be sold for a time period without registering them), your must not violate the anti fraud prohibitions of the Federal Security Laws, financial statements need to be certified by an independent public accountant or at a minimum, the balance sheet needs to be audited.
Companies must give non-accredited investors disclosure documents that are the same as those used in registered offerings. If a company provides information to accredited investors, it must make this information available to non-accredited investors as well. The company must also be available to answer questions by prospective purchasers. The Issuer must comply with the securities laws of each state in which a person who buys the security is a resident, and must usually file a notice with that state's commissioner of corporations or similar official.
Rule 506: Offerings with no dollar limit
Under SEC Rule 506; an issuer may issue an unlimited amount of securities, with no dollar limit, to 35 unsophisticated investors plus any number of "accredited investors." There are required disclosures, if a sale of securities includes purchasers who are not accredited investors. All non-accredited investors must be sophisticated and must sign an Investor Questionnaire acknowledging same. Advertising and a general solicitation are prohibited. The securities are "restricted securities" which may not be readily resold. There is a major advantage to 506, in that it supersedes and preempts the securities laws of all the states. This saves a lot of time, effort, and expense if the issuer is obtaining money from investors in multiple states. Form D must be filed with the SEC within 15 days after the first sale of securities and also with the Secretary of State of each state in which a purchaser is a resident.
Under Rule 506(c)
Just like 506(b). there is no limit on the dollar size and a company can broadly solicit and generally advertise the offering if:
- The investors in the offering are all accredited investors; and
- The company has taken reasonable steps to verify that its investors are accredited investors, which could include reviewing documentation, such as W-2s, tax returns, bank and brokerage statements, credit reports and the like
- SEC mandated legend
Visit our FAQ page on Private Offerings for additional information
There are several other rules and exemptions besides the Reg D exemption's discussed above. They are worth looking into and are discussed below under the headings of Regulation A and the Small Corporate Offering Registration (SCOR).
As pointed out in the last section, the principal advantage of an exemption from registration is that the buy-and-sell transactions can take place as soon as the parties decide to proceed. It eliminates the necessity of preparing and filing a prospectus with the SEC, and it saves legal costs, plus accounting and registration fees.
Exemptions under the Securities Act of 1933 ('33 Act) are listed as exempted securities and exempted transactions. They can save both time and money. The only drawback is they can take a legal genius to interpret them. They're full of loopholes, and the courts have shown no qualms about ruling against the entrepreneur in their interpretations. Regardless, the end results should make them worth pursuing. But since the whole area of exemptions is so complex, the entrepreneur should not proceed without first seeking the advice of qualified counsel to determine the best form of exemption.
Regulation A has a long history as an exemption for raising capital. It has been revised quite often, and it allows a company to publicly offer its securities without registration under the 1933 Act. Instead, an offering statement (Form 1-A) is filed and "qualified" with the SEC. A principal attraction of Reg A is that only two years of financial statements are required and they may be unaudited if audited information is not readily available. Additionally, the completion of a Reg A offering does not automatically subject the issuer to 1934 reporting.
Reg A has been revised into Two Tiers - Tier I allows offerings up to $20 Million and requires Blue Sky filing with all states. Tier II is for offerings from $20 to $50 million which are Blue Sky exempt but must have a registered Transfer Agent. Filing time for qualification ranges from 90 to 120 days.
The rules allow an issuer to "test the waters" before filing the offering statement. This means you can solicit indications of interest through the distribution or publications of preliminary materials. The materials are limited to factual information and must include a brief description of the company's business, the experience of the chief executive officer, and a statement that no money is being solicited or accepted. These solicitations of interest must be filed with the SEC on the date first used. Oral indications can be solicited but the solicitation materials must be discontinued when an offering statement is filed. Also, 20 days must expire between the use of the solicitation statement and the first sale of any securities.
The Form U-7, which is the basic registration/information form used in the SCOR (in some states, this is called Uniform Limited Offering Registration or ULOR) was adopted by the Securities and Exchange Commission in 1992. It allows a company to raise up to $1 million by selling securities. The disclosure statement (Form U-7) is considerably less complicated than standard disclosure forms and it is constructed in a question and answer format. Some states even offer it as a download.
The SCOR/ULOR process is touted as the simplest paper-work process used to complete an exempted offering. Still, it's an area that requires you to engage legal and accounting advice, although not to the extent of the other offering processes. Consequently, you can save some money in expensive professional fees, although we suggest that you should feel highly qualified in writing legalese. SCOR/ULOR offerings commonly receive a lot of scrutiny from state security commission offices.
Direct Public Offerings, or commonly known as Internet Offerings are a development of the Internet and World Wide Web. Similar to SCOR offerings in the type of paperwork required, they remain an unknown as far as acceptance by the securities industry. Their primary setback at this time is that there are no acknowledged trading markets (like NASDAQ, NYSE, AMEX). Direct Public Offerings are being conducted over the Internet with a high degree of skepticism. Both federal and state regulatory bodies can't quite figure out what to do with them in their relentless pursuit of fraudulent practices. Experience indicates that the offerer should have a very large (100,000 plus) database of prospective subscribers to have any opportunity to make a DPO offering successful.
A Final Exemption Note
Please note that many states' securities commissions are rejecting the federal rules and are choosing to adopt state blue-sky laws that are more restrictive than the federal rules and regulations. Entrepreneurs are strongly advised to check with qualified counsel on the fine points and the most up-to-date rules and regulations as they may pertain to their particular project. You are assured that some form of exempted investment vehicle is available for your money raising efforts.
A Final Financing Note
The secret to successful entrepreneurial financing is that it takes COMBINATIONS ! Combinations of debt and equity and at different time periods in the ongoing life of any enterprise. And the secret to successfully operating an entrepreneurial company is to pay constant, unrelenting attention to:
Visit our FAQ page on Private Placement Offerings for additional information
- Cash flow
- Accounts Receivable
- Accounts Payable
- Inventory Control
For additional, more detailed information on the preceding entrepreneurial financing methods, click "Books".
For information on "Taking Your Company Public," click "Going Public".
For information on "Internet Direct Public Offerings," click "DPOs".
For information on taking a company public via a reverse merger," click "Reverse Mergers".
To choose,buy and download 50 different types of Business Forms" click "Business Forms".
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VENTURE ASSOCIATES CONSULTING
We are specialists in the consulting, preparation, writing and financing of Regulation D Private Placement Memorandums.
The principals of Venture Associates have a great deal of experience in developing, writing and producing documents and in obtaining entrepreneurial financing. If you would like to discuss the availability and costs for services, please make contact via the following information:
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