Raising Capital through Private Placements: The Basics of SEC Regulation D

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One of the more common conversation topics brought to light by my business clients is raising capital for expansion. There are many ways to raise money for a company with which clients may already be familiar. These include debt financing, equity financing, and private contracts to ensure percentages of top-line revenue in return for non-ownership investments. However, the aspect of funding and financing that most clients do not ordinarily consider is how to raise money while remaining in compliance with both SEC regulations and Florida Blue Sky Laws regarding the sale of securities.

Fortunately, both the SEC and the State of Florida have implemented regulations that benefit private companies by allowing them to offer and sell their securities through private placements. More specifically, private companies can use Regulation D of the Securities Act of 1933 to sell securities to private investors, venture capitalists, angel investors, and institutional investors without first going public or registering securities with the Securities and Exchange Commission. Regulation D is a registration exemption implemented by the SEC for this exact purpose. Contained in Regulation D are three separate exemptions – Rules 504, 505, and 506. This article will explain and outline the differences between these three registration exemptions.

The Rule 504 exemption – Raising up to $1 million

Rule 504 applies only when a company wants to raise no more than $1 million by means of security sales in any given 12 month period. Unlike 505 and 506, 504 does not limit the number of investors who wish to contribute capital to the capital raise. It also allows for commissions to be paid to those who assist in selling the securities as a consultant. The ability to hire a consultant helps companies trying to raise a relatively small amount of capital under 504 to reach a broad base of investors. In terms of advertising, although 504, 505, and 506 do not permit companies to broadly advertise or otherwise solicit the securities to the general public, provisions in the JOBS Act recently signed by President Obama could change this and allow crowd-funded capital raising efforts to be advertised via the Internet, social media, and other channels. One last major issue which comes up under 504 is the resale of securities by investors. In some cases, securities that are not “restricted” may be sold to third parties after initially being purchased by investors, but generally purchasers cannot resell 504 securities without first registering them with the SEC or using an exemption.

The Rule 505 exemption – Raising up to $5 million

The first major difference in exemption Rule 505, as compared to 504, is that companies can raise up to $5 million in securities in any 12 month period. However, with this increased allowance of capital raising ability comes increased restrictions. Unlike 504, the company issuing securities under 505 may only sell securities to up to 35 “unsophisticated” persons who do not meet certain asset and income standards. Additionally, companies may sell to as many “accredited investors” as they want to. Another restriction unique to 505 is that the company must let purchasers know the securities are “restricted”. In the present context, “restricted” means that the securities cannot be resold for at least six months without the company registering the securities.

Finally, under 505 (as well as 504 and 506), the company must provide unaccredited investors with disclosure documents such as a Private Placement Memorandum (PPM.) PPMs contain similar information to that contained in a standard registered offering of securities (as in an IPO.) It is standard procedure for a company’s legal counsel to prepare and issue a PPM for 504, 505, and 506 capital raises. The reader should note that along with the issuance of a PPM, there must be a certification by an independent public auditor that the financial statements included therein are accurate.

Before moving on to our final Regulation D exemption, let’s spell out exactly the SEC considers to be an “accredited investor.” An accredited investor is:

  • A natural person;
  • Whose net worth, or combined net worth with a spouse, is greater than $1 million at the time of security securities at the time of the purchase of securities; (This net worth used to include the value of a primary residence; it now excludes this value according to the recently-enacted Dodd-Frank Wall Street Reform and Consumer Protection Act) AND
  • With income that exceeds $200,000 in each of the past two years, or joint income with a 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 which holds assets greater than $5 million, which was not established specifically to purchase the securities offered, and whose purchases are made by a sophisticated party.

Accredited investors can also include banks, employee benefit plans, and insurance companies.

The Rule 506 exemption – Raising unlimited capital

Rule 506, in large part, is identical to rule 505 except that it has no limitation on raising capital and requires that unaccredited investors be “sophisticated.” According to the SEC, a sophisticated investor is one who possesses sufficient knowledge and background to make a competent investment decision. In short, in a 506 issuance of securities, a company owner’s unaccredited Grandpa can invest if he is a financial planner. Grandpa (still unaccredited) cannot invest if he has no investment knowledge, but is a casual poker player with “a keen eye for a good bet.” Regardless, Grandpa can always invest if he meets the definition of an accredited investor (outlined above.)

In addition to the 506 requirements listed above, the company must also be available to answer questions from potential investors if they choose to issue a 506 PPM and offering.

Further requirements of all exemption Rules

Despite their differences, 504, 505, and 506 under Regulation D are all subject to some general requirements. First, it is important to note that the antifraud provisions of the SEC securities laws apply to private placements the same as they apply to other securities; accordingly, the company must disclose relevant information to potential investors. Second, Rule 503 provides that any company which sells securities must file an informational form titled Form D with the SEC within 15 days after selling the first security. Form D is a notice requirement which provides the SEC with information about the company offering the securities.

Conclusion

In summary, Regulation D imposes numerous, but reasonable, requirements on exempt offerings of private placement securities. A private company that does not want to go public, or does not have the financial wherewithal to complete a full SEC registration, has a strong, suitable option in Regulation D. Satisfying the standards for private placement under the exemption is certainly worthwhile when weighed against the exemption’s benefits

If you are contemplating a Regulation D private placement offering, be sure to consult with a qualified attorney to make sure that your offering is in compliance with both the Securities Act of 1933 and any relevant state Blue Sky Laws. Be aware that the Dodd-Frank Act and the new JOBS Act will both affect such offerings. The Donaldson Law Firm provides a full range of services for both corporations and LLCs looking to raise private funding including preparation of Private Placement Memorandums (PPMs) and the preparation and filing of Form D with the SEC through the EDGAR filing system.

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Jordan Donaldson
Jordan Donaldson
Jordan L. Donaldson is the founding attorney at Donaldson Law. He is known for delivering expert, objective advice and is committed to client-focused representation.