As the Great Recession comes to a close, entrepreneurs, investors and even speculators are seeing business opportunities for the first time in many years. Getting financing for such opportunities is more difficult than ever, and certain types of businesses have virtually no access to capital.
Whether seeking to finance expansion of manufacturing facilities, acquisition of a business or technology, or the purchase of REO property from a bank, businesses find that obtaining traditional debt financing is often impossible.
Since valuations have come down dramatically in certain segments of our economy, equity financing is becoming more attractive. Businesses with cash in hand have a strong negotiating position and may be able to take advantage of deals that are unavailable to those seeking traditional financing.
That’s why it may be practical to raise funds by issuing securities. Even small companies or opportunities are frequently financed through the issuance of securities.
Sometimes that is done by simply forming an LLC with a family member, friends or acquaintances. Understand, an LLC issuance probably is a regulated securities offering, even if it involves just a few friends or acquaintances.
To protect the person raising the funds, anyone forming an LLC must consult a lawyer familiar with securities regulations. The consequences for violating the securities laws include substantial fines and even jail sentences.
One of the most common offenses is failing to obtain an exemption from registration of your securities offering from the Securities and Exchange Commission and the state Department of Finance. Fortunately, most business opportunities worth pursuing have sufficient upside so that the hiring of a lawyer is not cost prohibitive.
The lawyer’s work will help insulate from liability the promoters of the investment opportunity. While the work of the lawyer in this instance may strike a neophyte as pessimistic and negative marketing, most sophisticated investors are familiar with the typical format of a private securities offering circular known as a Private Placement Memorandum or PPM.
A PPM informs potential investors of the risks associated with the investment so that they can make an informed decision. The liability of the promoter is significantly reduced if proper disclosures are made in a timely fashion.
The sophisticated investors you are trying to attract will probably be less inclined to invest if the PPM is nothing but a flowery marketing piece promising substantial economic returns with little or no risk.
Frankly, such a PPM would signal to many people that the promoters have not adequately done their homework. Such a PPM is far more likely to attract investors for whom the investment is completely unsuitable, such as those not financially able to absorb a loss if any undisclosed risk factors cause losses.
Companies seeking to raise capital should carefully consider other methods of issuing securities. Under the Securities Act of 1933, any offer to sell securities must either be registered with the SEC or meet an exemption.
For example, the Securities Act exempts from registration and prospectus delivery requirements “transactions . . . not involving any public offering.” Such transactions are commonly referred to as “private placements.”
Congress has never defined “public offering.” Since 1933, ambiguous and sometimes inconsistent judicial and administrative interpretations of “public offering” have hindered effective use of the statutory exemption. The SEC has attempted to provide more certainty in the area by adopting a series of rules known as Regulation D, which provides objective standards for determining the availability of the statutory exemption and creates a safe harbor for offerings made in compliance with the rule.
Rule 504 and 505 of Regulation D provide for two types of exemptions from the registration provisions of the Securities Act, both of which do not contain restrictions concerning the nature or sophistication of the purchasers.
Rule 504 provides for an exemption for offerings of up to $1 million to an unlimited number of purchasers; Rule 505 provides an exemption for offerings of up to $5 million to a limited number of purchasers.
Rule 506 of Regulation D also provides for two additional exemptions which are in the nature of private offerings: (1) a private offering made only to accredited investors, which means those having a pre-determined net worth or annual income; and (2) a private offering to a limited number of sophisticated purchasers, that is, those who may not be accredited, but have experience in business and financial matters and who are able to evaluate the risks of an investment.
While Regulation D relates to transactions exempted from the registration provisions of the Securities Act, such transactions are not exempt from the antifraud, civil liability, or other provisions of the federal securities laws. Attempted compliance with any rule in Regulation D does not act as an exclusive election; the issuer can also claim the availability of any other applicable exemption.
This article was co-written by T.J. Angstman and Brian Webb. Angstman is managing member of Angstman Johnson law firm and advises clients on business-related matters. Webb, also an attorney at Angstman Johnson, represents clients in business-related matters, including private offerings of securities and criminal and civil securities litigation.