While Cutting Edge is best known for community capital raising strategies such as direct public offerings, we help many of our clients utilize private placement strategies instead of or in addition to other types of capital raises. The term “private placement” refers to the process of raising capital in an offering that is not registered with securities regulators and is not offered broadly to the public.
Private placements include offering types ranging from friends and family investments in a new retail establishment, to angel investments in a social enterprise, to institutional and venture capital investment in a growth company. Any kind of security can be offered in a private placement, including notes, stock (common or preferred), revenue share securities, convertible notes, SAFEs (security agreement for future equity) or others; 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.
Below is an overview of options and a brief discussion of key factors.
Accredited Investor Definition. To understand the options, we need to start with understanding what is an accredited investor. 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 expect an income in excess of $200,000 in 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.
Statutory exemption, Section 4(a)(2): Non-public Offering. This is the broad private placement exemption of the of the Securities Act of 1933 and it exempts from registration “transactions by an issuer not involving any public offering.” There is no limit on the number of investors 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 or the safe harbour of Rule 506. The securities issued under this exemption are restricted securities and may not be transferred or sold without registration or use of another exemption.
Regulation D, Rule 504: Small offering ($5 million limit) exemption. Rule 504 provides an exemption for the sale of up to $5,000,000 of securities in a 12-month period and may include sales to accredited or non-accredited investors. There is no requirement to provide specific information to potential investors as in Rule 506 offerings. In general, you may not use general solicitation or advertising to market the securities using this rule unless you have registered the sale at the state level. As with previous exemption, an issuer must comply with state law requirements for any potential state level private placement exemption. Purchasers generally receive “restricted securities” and may not sell them without SEC registration or using another exemption.
Regulation D, Rule 506(b): Unlimited raise allowing 35 non-accredited Investors. Rule 506(b) is a “safe harbor” for the non-public offering exemption in Section 4(a)(2) of the Securities Act, which means it provides specific requirements that, if followed, establish that the offering falls within the Section 4(a)(2) exemption. Rule 506 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 (but all non-accredited investors, either alone or with a purchaser representative, must 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; and provide the same financial statement information as required under Rule 505. Rule 506 offerings, pursuant to Section 18 of the Securities Act, 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): Accredited investors only, advertising permitted. Rule 506(c) is also a safe harbour to the exemption under Section 4(a)(2). There is no raise limit under this Rule. This exemption permits advertising and general solicitation of investors but then limits investors to only those who are accredited. The issuer must take reasonable steps to verify that the purchasers are accredited investors before the purchase. Purchasers receive “restricted securities.” As explained above under Rule 506(b), offerings under Rule 506 preempt states from imposing registration and review requirements but states may still impose notice filings and fees.
How to choose? The preceding is merely an overview to help map out possible strategies. 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 as unique as the business and its potential network of investors. And, we haven’t touched how the security can be structured. We can help you map out a strategy that works for your business. Contact us for a free strategy call.