If you’re a private company, how can you sell your securities to VCs or angel investors without going public or registering your securities with the SEC?  Private companies, whether startups or more established companies, can offer and sell their securities through a private placement.  Companies can use one of the registration exemptions under Regulation D of the Securities Act of 1933 to undertake a private placement.

Regulation D’s three exemptions are found in Rules 504, 505, and 506.

The Rule 504 Exemption

Rule 504 applies to transactions consisting of no more than $1 million of securities sales in any twelve-month period.  Rule 504 does not limit the number of investors and allows commissions to be paid.  The exemption does not permit issuers to broadly solicit or advertise their securities to the public.  Purchasers may not resell these “restricted” securities without registering them or using an exemption.  Under certain circumstances, securities that are not restricted may be resold.  Because of these scant federal rules, securities transactions of this size fall under the purview of state Blue Sky laws.

The Rule 505 Exemption And Accredited Investors (Rule 501)

Rule 505 provides a registration exemption for securities sales that meet the following four conditions:

1. The company may sell no more than $5 million of its securities in any twelve-month period.
2. The company may sell to as many “accredited investors” as it wants to and up to 35 other persons who do not meet the sophistication or asset and income standards.
3. The company must tell purchasers that the securities are “restricted,” and cannot be resold for six months without registering the securities.
4. The company cannot sell the securities through general solicitation or advertising to the public.

The company must provide non-accredited investors with disclosure documents that are similar to those given in a registered offering.  Particularly noteworthy is the requirement that an independent public auditor must certify the financial statements.  Further, any information given to accredited investors must also be given to non-accredited investors.

Under Rule 501, an accredited investor is a natural person:

• whose net worth, or net worth with the person’s spouse, is greater than $1 million at the time of purchase (where net worth includes value of primary residence)
• with income exceeding $200,000 in each of the past two years, or joint income with the person’s spouse greater than $300,000 for the past two years and a reasonable expectation of having the same income level in the current year; or
• a trust with assets greater than $5 million, which was not established to obtain the securities offered, whose purchases a sophisticated person makes.

Examples of other accredited investors include banks, insurance companies, and employee benefit plans.

The Rule 506 Exemption

Rule 506 does not impose a dollar limit on the offering.  Again, the company cannot solicit or advertise to the offering to the public.  The financial statement requirements mirror those of Rule 505.  As with Rule 505, the company must give accredited and non-accredited investors the same information.  The purchasers receive “restricted” securities.  This Section 4(2) safe harbor is satisfied if the following additional criteria are met:

• The company can sell the securities to an unlimited number of accredited investors and up to 35 other purchasers.  In contrast to Rule 505, the other investors must all be sophisticated — that is, possess sufficient knowledge and background to make a competent investment decision.
• The company must be available to answer questions from potential investors.

Further Requirements

The sale of securities under a Regulation D exemption are subject to a few additional requirements.  First, the antifraud provisions of the securities laws apply to private placements.  The company must disclose relevant information to potential investors.  Second, Rule 503 provides that the issuer must file Form D within 15 days after the first sale of securities.  Form D is a notice requirement with no other substantive reporting requirement.

Conclusion

To summarize, Regulation D poses considerable requirements upon exempt offerings.  Yet, a private company that does not want to go public or register its securities has a strong incentive to satisfy the standards for a private placement under Regulation D.

If you are contemplating a Regulation D private placement offering, you should be aware that the Dodd-Frank Wall Street Reform and Consumer Protection Act will affect such offerings.  A future post will cover the implications of Dodd-Frank for Regulation D offerings.

Douglas Y. Park

Twitter: @DougYPark

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