April 2007

Venturing Into Private Offerings

Every growing business runs into a need for more equity funding at some point in its life. Even the most innovative and promising business plan will not attract and secure the necessary capital without careful (and realistic) strategic planning. All capital raising efforts are subject to federal and state securities laws that require compliance with the complex registration and regulatory rubric of a public offering -- unless the company carefully structures its offering to qualify for an exemption from registration. The most common exemption is for “private offerings.” Unfortunately, the applicable statutes provide little guidance as to what qualifies as a private offering, essentially defining a “private offering” as an offering that is not a “public offering.” Broadly speaking, a private offering is the offering of securities to a limited number of identified investors without any general solicitations, advertising or the like. Failure to carefully structure a capital raise not only reduces the likelihood of success of the effort, but also increases the entrepreneur’s exposure to personal liability for violating the rules applicable to public offerings. This Legal Update summarizes some of the key securities law concepts applicable to raising equity capital through a private offering and offers tips for increasing the likelihood of success in the process.

What qualifies as a “public offering” is a subjective concept governed by principles set forth in a long line of case law developed over the past 70 years. In order to provide clarity for issuers, the U.S. Securities and Exchange Commission (the “SEC”) adopted “safe harbor” rules contained in what is commonly known as “Regulation D.” Regulation D identifies three separate categories of offerings deemed by the SEC to be private offerings, and therefore, exempt from registration.

The first of the Regulation D categories is the Rule 504 exemption for transactions in which the issuer sells no more than $1,000,000 of securities in any 12-month period. Aside from the general prohibition on the use of any form of “general solicitation” or “general advertising” (which applies to all three of the Regulation D exemption categories), there are very few other requirements to qualify for the Rule 504 exemption.

The second of the Regulation D categories is the Rule 505 exemption for transactions in which the issuer sells no more than $5,000,000 of securities in any 12-month period. To qualify for the Rule 505 exemption, the issuer may sell the securities to no more than 35 “non-accredited” investors, but may sell to an unlimited number of “accredited investors.” “Accredited Investor” is defined very specifically in Rule 501(a) and generally includes officers and directors of the issuer, certain high-net worth and high-income individuals, and certain institutional investors. The issuer must follow specific disclosure requirements and provide information regarding the issuer and its securities to each purchaser in the offering. Moreover, the disclosure requirements for sales to non-accredited investors under Rule 505 (as well as 506) are more burdensome than those involved in offerings that are limited to accredited investors only, generally requiring a full private placement memorandum, complete with detailed exhibits, to be provided to those offered the opportunity to invest.

The final Regulation D category is the Rule 506 exemption, which contains no limitation on the size of the offering. Instead, Rule 506 imposes on the issuer all of the other limitations applicable under Rules 504 and 505, plus the additional burden of establishing that all of the non-accredited investors purchasing securities in the offering have sufficient knowledge and experience in financial and business matters to evaluate the merits and risks of the investment.

Qualifying for a Regulation D exemption does not exempt the issuer from compliance with the so-called “blue-sky” laws of the various states. These laws can vary widely from state to state and can be more onerous than the requirements at the federal level. Issuers must consult with counsel regarding the blue-sky laws in each state where the issuer plans to offer its securities (each of the states of residence of the prospective investors in the offering).

If you or a company with which you are involved seeks to raise equity through private offerings, we suggest you observe the following general guidelines to help ensure a successful private offering:

1. Prepare a business plan that includes your company’s pre-offering structure, explains your growth strategy and clearly identifies how the proceeds of the offering will be used to execute that strategy.
2. Obtain legal counsel early in the process, before you select the sources and structure to fulfill your capital needs. Understand the applicable rules for the type of offering you plan. Be sure to let your legal counsel promptly know each time you accept funds from an investor.
3. Work with counsel to develop an administrative plan and check-list for record-keeping and compliance. It is not sufficient to satisfy the applicable rules if you cannot prove you did so.
4. Furnish potential investors with properly written, professional, informative documents that not only satisfy applicable legal compliance requirements, but also help investors understand and appreciate the investment opportunity you are offering. Do it right the first time because, as the old adage goes, “you never get a second chance to make a first impression.”

FVLD publishes updates on legal issues and summaries of legal topics for its clients and friends.  They are merely informational and do not constitute legal advice. We welcome comments or questions.  FVLD has prepared antitrust compliance policies and conducts antitrust compliance seminars for managers and employees. If we can be of assistance, please call or write Glenn Rice 312.701.6895 grice@fvldlaw.com, Wilson Funkhouser 312.701.6810 wfunkhouser@fvldlaw.com, or Damon Dunn 312.701.6825 ddunn@fvldlaw.com, or your regular FVLD contact.