Exploring Private Raise Strategies
While we are best known for designing public capital raising strategies for our clients using methods like Regulation Crowdfunding, Regulation A+ and other direct public offerings that allow community investors, we also help many of our clients utilize private offering strategies instead of or in addition to public capital raises. A private placement or private offering refers to the process of raising capital in an offering that is exempt from federal registration and is not usually (historically) offered broadly to the public.
Private placements include offerings like friends and family, angel investor, foundation, and venture capital investments. Any type of security can be offered in a private placement, including notes, stock (common or preferred), revenue share securities, convertible notes, and SAFEs (simple agreement for future equity). And, the attributes of each one of these can vary quite a bit (differing rates of return, exit options, valuation, etc.). As clients look at options and assess their potential investor network, we often get questions about whether private placements can include non-accredited investors, whether a private placement can be advertised and what the regulatory or disclosure requirements are for this type of offering.
Below is an overview of options and a brief discussion of key terms and concepts.
Let’s start with the definition of an “accredited investor.” Most strategies for private placements are limited to high net worth or high income investors, known as accredited investors. An accredited investor is an individual whose net worth either individually or jointly with their spouse equals or exceeds $1 million (excluding primary residence). Or, an accredited investor has “income” in excess of $200,000 in each of the two most recent years and who reasonably expects an income in excess of $200,000 in the current year (or $300,000, jointly with their spouse). Businesses can be accredited investors too if they have $5 million in assets. There are a few other types of accredited investors. A full description can be found here.
Here are the private raise approaches:
Federal statutory exemption strategy: Non-public Offering. This is the broad private placement exemption of the Securities Act of 1933 (Section 4(a)(2)) and it exempts from registration “transactions by an issuer not involving any public offering.” There is no limit on the number of investors, accredited or nonaccredited, but state law may provide limits such as on the number of nonaccredited investors and may require a notice filing to offer or sell securities to residents of the state. Investors must either have enough knowledge and experience in finance and business matters to be “sophisticated investors” (able to evaluate the risks and merits of the investment) or be able to bear the investment’s economic risk as well as have open access to necessary information. There is no bright line test for sophistication or financial ability to bear the risks. Therefore, there are significantly higher risks to use this exemption rather than one of the other exemptions under the safe harbor of Rule 506.
Regulation D, Rule 506(b): A Rule 506(b) private raise allows 35 non-accredited Investors. Rule 506(b) is a “safe harbor” for the statutory exemption discussed above. A safe harbor provides specific requirements that, if followed, establish a presumption that the offering falls within the federal private raise exemption. Rule 506(b) does not limit the amount of money your company can raise or the number of accredited investors, but to qualify for the safe harbor, your company must: (1) not use general solicitation or advertising to market the securities; (2) not sell securities to more than 35 non-accredited investors unless they meet the legal standard of having sufficient knowledge and experience in financial and business matters to be capable of evaluating the merits and risks of the prospective investment; (3) give non-accredited investors specified disclosure documents that generally contain the same information as provided in registered offerings; (4) be available to answer questions from prospective purchasers who are non-accredited investors, among other requirements. The disclosure requirement for nonaccredited investors in item (3) above requires that an issuer include onerous and expensive disclosures and because of that, nonaccredited investors are rarely included in 506(b) offerings. Rule 506 offerings are exempt from state registration and review. The states still have authority to require a notice filing (and related fees) and may also investigate and bring enforcement actions for fraud.
Regulation D, Rule 506(c): This subsection of Rule 506 is limited to accredited investors only but permits advertising. Rule 506(c) is also a safe harbor to the statutory exemption. There is no raise limit under this rule. This exemption permits advertising and general solicitation of investors but, if advertised, this exemption is limited to investors who are accredited. In addition, the issuer must take reasonable steps to verify that the purchasers are accredited investors before the purchase which usually takes the form of a third party verifying that an investor’s income or assets meet the accredited thresholds. As explained above, any offering under Rule 506 preempts states from imposing registration and review requirements but states may still impose notice filings and fees. Given that this exemption strategy can be advertised, this capital raise approach can be run concurrently with other public exemption strategies without running into integration issues. For example, an issuer using Regulation CF can run a concurrent 506(c) which may help the issuer raise funds above the Reg CF caps by placing accredited investors in the 506(c) offering. Likewise, a revenue driven charity using the federal charitable offering exemption to raise capital in states where there is a state specific charitable exemption, may use the 506(c) exemption in states where no charitable exemption exists (although the offering in these states would be limited to accredited investors).
Disclosures. No specific disclosures are required for private offerings (unless offering to nonaccredited investors under 506(b)). However, we recommend appropriate disclosure materials that will vary depending on the type of investors, the regulatory pathway chosen, and the risk tolerance of the issuer. At a minimum, a term sheet should be provided and an investor agreement describing the terms. In other cases, it is prudent to provide an offering memorandum with risk disclosures.
Limitations on Resale. Because private placement securities are not registered, they are considered “restricted” securities and cannot be resold without registration or compliance with an exemption from registration, which makes them very difficult to transfer.
Need more information? Some guidance on how to choose a strategy? We are happy to discuss any of these options with you and go over the risks, pros, and cons of each. Each raise can be structured to best fit the business and its potential network of investors. We can help you map out a strategy that works for your business. Contact us for a free strategy call.