Private placements for small business. (small securities offerings)by Wilson, Peter S., Jr.
The offering and sale of securities are subject to substantial governmental regulation. In order to offer securities publicly, the issuer must usually file a registration statement with the SEC and with certain state securities regulators. This is a time-consuming and expensive process, and the economics of many smaller offerings make the cost prohibitive. Hence, many emerging businesses seek to offer and sell their securities in transactions exempt from such registration. Framework of Securities Regulation
The term "security" is broadly defined to include a wide variety of investment arrangements. Likewise, the terms "offer" and "sale" are very broadly defined under both federal and state law. As a result, the laws and regulations governing the issuance and sale of securities extend to a wide array of transactions. Generally, both the securities and the sellers must be appropriately registered unless an exemption from registration is available. Federal Securities Regulation
The numerous abuses during the 1920s involving the sale of securities, and the stock market crash of 1929 prompted Congress to adopt the Securities Act of 1933 (the "Securities Act") and the Securities and Exchange Act of 1934 (the "Exchange Act"). Sec. 5 of the Securities Act makes it illegal to use the instrumentalities of interstate commerce" to make offers and sales of unregistered securities. Since it would be difficult to consummate a securities sale without using a telephone or the mail, the prohibitions of Sec. 5 extend to most offers and sales of securities. However, recognizing that not all offers and sales should be registered with the SEC, Congress provided a number of exemptions.
One exemption used by emerging businesses comes under Sec. 4(2) of the Securities Act for "transactions by an issuer not involving any public offering." It is commonly known as the "private placement" exemption. The Supreme Court has ruled that this exemption is available only if: 1) no offeree needs the protection afforded by registration; and 2) each offeree has access to the information provided in a registration statement. Although there is no strict numeric standard for determining the availability of the private placement exemption, any increase in the number of offerees increases the risk that a particular offeree does not meet this two-part test. As a result, reliance on the statutory private placement exemption is appropriate only in very limited offerings where the universe of offerees can be strictly controlled.
In an attempt to better define the statutory private placement exemption, the SEC adopted Reg. D in 1982. Reg. D provides a safe harbor for offerings of securities using the private placement exemption of Sec. 4(2) or the small offering" exemption for offerings less than $5 million under Sec. 3(b) of the Securities Act. It should be noted that Reg. D is available only to the issuers of securities and is not available for resales. There cannot be a firm commitment" underwritten offering under Reg. D. Furthermore, Reg. D is an exemption from securities registration only; the issuer is still subject to the anti- fraud provisions of the Securities Act and the Exchange Act. There are three separate exemptions available under Rules 504, 505 and 506 of Reg. D.
Amount of Securities Offered. Under Rule 504, the aggregate amount of securities that generally can be offered during a 12-month period is $500,000, but this amount can be increased (with some restrictions) to $1 million if the securities are registered under state securities laws. Up to $5 million of securities generally can be sold under Rule 505 during a 12-month period, and there is no dollar limit on the amount of securities that can be sold in a Rule 506 offering. Except for Rule 504 offerings that have been registered under state securities laws, the issuer cannot use general solicitation, such as advertising, investment seminars or "news" stories concerning the offering to locate potential investors. This limits an issuer's ability to "self-sell" its securities to investors with whom it has a particular type of pre-existing relationship.
Number of Investors. There is no limit as to the number of investors and there are no specific information requirements for offerings under Rule 504. Under Rules 505 and 506, the issuer can sell its securities to an unlimited number of "accredited investors" and up to 35 non- accredited investors. There are specific information requirements (including audited financial statements) that apply if an issuer sells its securities to a non-accredited investor under Rules 505 or 506, and all non-accredited investors in a Rule 506 offering must either be financially sophisticated or be represented by a qualified purchaser representative. The term accredited investor" includes specifically defined categories of institutional investors and individuals having substantial net worth or annual income.
Transferability of Securities. Securities sold under Reg. D are deemed "restricted securities" and are not freely transferable by the investors. The transferability of securities sold in a state-registered Rule 504 offering is not restricted by federal law, although there may be state restrictions. The issuer must make a filing with the SEC within 15 days following the first sale of securities under Reg. D. Finally, offers and sales made within six months of a Reg. D offering may be integrated with the offering depending on a variety of factors, such as the type of securities offered and the use of proceeds. This integration must be taken into consideration in determining whether the limitations on the dollar amount of securities offered and on the number of non- accredited investors are met. States' Securities Regulation
States' securities regulation predated the adoption of the Securities Act by more than 20 years. While the focus of the Securities Act is on the disclosure of information material to the investor, the focus of many state securities or "blue sky" laws is on the fairness of the terms of the securities offered. This merit regulation of offerings and the inconsistency in application of securities regulation between states increases the complexity of compliance in a multi-state offering.
To streamline the state regulation of securities, the Uniform Securities Act (the "Uniform Act") was adopted by The National Conference of Commissioners on Uniform State Laws in 1956, and was revised in 1985. In response to the adoption of Reg. D in 1982, the North American Securities Administrators Association adopted the Uniform Limited Offering Exemption ("ULOE"), designed to coordinate with the exemptions under Rules 505 and 506. The Uniform Act and ULOE have each been adopted in some fashion in about 36 states. However, certain state legislatures and state securities administrators have modified their versions of the Uniform Act or ULOE. The resulting regulatory web is a substantial challenge in any multi-state private placement of securities. Furthermore, the provisions of the Uniform Act and of ULOE are in many respects more restrictive than Reg. D, so compliance with state securities laws can be the overriding issue in many private placements. Broker-Dealer Registration
The Exchange Act requires, with certain exceptions, that all broker- dealers be registered with the SEC. The SEC has taken the position that an issuer that offers and sells its own securities is not subject to broker-dealer registration if its officers and employees who handle the sales of securities are not paid commissions and have significant other duties in their employment by the issuer. The Uniform Act also exempts issuers from broker-dealer registration and exempts the officers and employees of the issuer from registration as "agents" in certain exempt transactions. However, some states do require the issuer to register as a broker-dealer in connection with certain securities offerings.
The importance of compliance with the broker-dealer registration requirements in the context of a private placement of securities cannot be overstated. Failure to comply can result in a loss of the securities registration exemption under ULOE or theoretically could be construed as "aiding and abetting" a nonregistered dealer. Therefore, issuers generally should avoid paying commissions to financial planners, consultants or finders" who are not appropriately registered as broker- dealers. The Accountant's Role
Many issuers of securities in Reg. D offerings are emerging businesses that rely on their CPAs for more than basic accounting and auditing services. As a business advisor, the accountant is in a position to assist a client in planning and structuring many aspects of a Reg. D offering.
An important task to be performed prior to structuring an offering is the objective assessment of the "project team." Occasionally, an issuer will select its counsel and financial advisors based on established relationships and friendships, without regard to their experience with private placements. This can increase both the cost and risk of failure of an offering. All members of the project team should have knowledge and experience in securities offerings. The investment banker should be registered as a broker-dealer with the SEC and in each state where the securities will be offered. If the issuer's regular counsel has little or no experience in private securities offerings, the issuer should consider engaging special counsel. A knowledgeable and experienced team will help the issuer avoid many pitfalls that can be encountered on the path toward a successful private offering.
An issuer must be willing to commit substantial time and effort to the offering process. Occasionally, the issuer's management personnel expect that the accountant, the attorneys and the investment bankers will somehow magically produce a successful offering with minimal input and effort. Without significant input from issuer's management, the offering may not be appropriately structured and may be difficult to sell. If the offering is not worth management's time, then it may not be worth the accountant's time. Structuring and Pricing of an Offering
The first step in a successful Reg. D offering is a careful analysis of the issuer's business plan and how the offering fits into the plan. The accountant should focus on areas such as the proposed use of proceeds and plans for future business growth. This analysis is necessary to structure the offering properly and will provide much of the information necessary for the private placement memorandum. If the business plan is poorly written or is nonexistent, the accountant should work with the issuer to prepare a suitable one.
When analyzing a business plan, the accountant must be objective and, when necessary, critical. It is important to identify potential problem areas in the issuer's management and business plan and to suggest changes to address the problems. Potential investors have a variety of investment alternatives available and they are likely to be critical and demanding. By addressing problem areas early in the process, the chances of a successful private offering will be increased.
When structuring the offering, several factors must be evaluated. These factors are not dissimilar from those that would be considered in a registered public offering of securities, and might include:
Control. How willing is the issuer's management to share control with the investors? An offering of voting common stock makes little sense for the entrepreneur who does not want to share control with minority shareholders.
Cash Flow. After giving effect to the projected use of proceeds, will the issuer's cash flow be sufficient to support debt service or dividends? If the issuer wishes to reinvest future earnings to maximize growth, an offering of common equity is more appropriate than an offering of debt.
Tax Factors. Are there tax benefits that can be passed through to investors, thereby enhancing the potential return? Even though the passive activity loss limitations have reduced the attraction of the partnership or S Corporation structure, some businesses (such as real estate or R&D) can use the partnership form to avoid double taxation upon the anticipated liquidation of the issuer. An issuer that intends to spend the net proceeds of the offering over an extended period may incur personal holding company tax liability on the interest earned on the invested proceeds.
Offerings by subsidiary corporations can prevent the subsidiary from consolidating its tax returns with its parent corporation, and an equity offering may also disqualify a corporate issuer from S Corporation eligibility if the securities are purchased by an ineligible shareholder or by too many purchasers.
Liquidity. Certain businesses, such as real estate or equipment leasing, have a limited life: assets are purchased, leased and eventually sold. Other businesses can have almost perpetual duration. In the latter case, the issuer must consider the means through which an investor in equity securities can eventually gain liquidity, such as registration rights or put options. This is especially important if there are no plans to pay dividends.
Capital Requirements. How much capital is required to implement the issuer's business plan and how much is to be provided by the offering? It is crucial that realistic estimates of capital requirements be employed so that the issuer does not discover later that the offering was too small. On the other hand, it is equally important to avoid the temptation to raise more money than the issuer could hope to use, since this can depress the rate of return.
Accounting Effects. The issuer should consider the proper accounting treatment for the securities being offered and whether the offering could result in violations of financial covenants in loan or other agreements. An offering of convertible preferred stock would be more appropriate than a convertible debt offering in the situation where the issuer may have difficulty in maintaining debt-equity or debt service coverage ratios in its inventory financing agreements.
After considering these and other relevant factors, the issuer and its advisors will be able to fashion an appropriate structure for the offering.
Once the issuer has settled on the structure of the offering, it is necessary to price the securities to be offered. Pricing is clearly more of an art than a science, since there are numerous variables; such as liquidity, voting control, projected growth and business risks, that must be subjectively considered. However, there are a variety of objective criteria that can be utilized in pricing, and the accountant can provide some assistance in the development and evaluation of the relevant financial criteria. Finally, it is critical that pricing decisions be made with due consideration to the returns available on competing investments.
An investor is not likely to purchase securities in a private placement by an emerging business unless the potential returns reflect the increased risk and decreased liquidity inherent in such an offering.
Although the inclusion of projections in a private placement memorandum may be infrequent because of concerns with securities law liability, projections of future income and cash flow are often developed to assist in pricing. The accountant may play an important role in offering an independent assessment as to the reasonableness of the projections and the underlying assumptions. This independent evaluation helps to temper the issuer's natural tendency to overvalue business opportunities and understate risks and to enhance the potential that the offering will be successfully completed. Presentation of Audited Financial Statements
There are no specific disclosure requirements for offerings under Rule 504 or when sales are made only to accredited investors under Rules 505 or 506. If sales are made to non-accredited investors under Rules 505 or 506, then certain information, to the extent material, must be provided to all purchasers during the offering.
The information to be provided includes financial statements for the issuer, and perhaps its predecessors or recently acquired entities.
Before discussing the specific financial statement requirements, it is appropriate to consider the concept of materiality under Reg. D. The determination of what is material in the context of securities law disclosure is a matter of professional judgment. Courts have held that information is material if a reasonable investor would consider it material in evaluating the securities offered. With respect to financial statements, the SEC staff takes the position that audited statements are always required, even with a start-up company, since the issue of loss contingencies and proper footnote disclosure will be addressed by the independent auditor. To some issuers, the determination of the importance of audited financial statements seems to hinge upon the cost of an audit. If audited statements have been prepared in the past, it would be expected that they would be included in the disclosure document.
Assuming it has been decided that financial statement presentation is necessary, Reg. D generally requires that the issuer provide the financial statements that would have been included in the appropriate registration statement had the securities been publicly offered. For offerings up to $2 million, the issuer must present an audited balance sheet dated within 120 days of the start of the offering, together with two fiscal years of unaudited income statements and statements of changes in financial position or cash flows. For offerings up to $7.5 million, the issuer generally must present an audited balance sheet and two fiscal years of audited income statements and statements of changes in financial position or cash flows. For offerings over $7.5 million, the issuer must present audited balance sheets as of the end of its two most recent fiscal years, together with audited statements of income and changes in financial position or cash flows for the three most recent fiscal years. For all offerings over $2 million, if the latest audited financial statements are over 135 days old, then unaudited interim financial statements must be presented. There are certain provisions for easing these requirements if a corporate issuer cannot obtain audited financials without unreasonable effort or expense. Limited partnerships may pre- sent financial statements on the basis of federal income tax accounting.
When assessing the presentation of audited financial statements for a Reg. D offering, the issuer should consider the likelihood of a public offering in the foreseeable future. The issuer that intends to "go public" will need to obtain audited financials, so it may be appropriate to perform an audit at the present time. Preparation and Use of Projections
The SEC officially encourages the use of projections in public offerings of securities, and has so stated in Reg S-K, but did not establish detailed instructions for their preparation and presentation. The lack of specific criteria at times weakens the issuer's defense in an action for securities fraud based on "misstatements" in the projections, which by their nature are based on estimates and assumptions, notwithstanding the safe harbor provisions adopted by the SEC in Rule 175 under the Securities Act. Consequently, the spectre of securities law liability generally discourages their use in public offerings, as well as in private placements under Reg. D. However, private placements may sometimes offer more opportunities for their use.
Generally, projections are included in a private placement memorandum when there are objective bases for the underlying assumptions, such as a real estate limited partnership where the mortgage financing and lease terms are already known. Projections may also be used when the offering is limited to sophisticated investors accustomed to reviewing projections. Finally, projections may be used when historical financial information is not relevant to future operations, as in the case of a start-up company, and if it is unlikely that an investor could evaluate the offering and the issuer without the aid of such projections.
While the SEC does not have detailed instructions for the preparation and presentation of projected financial information, some states do impose specific requirements for their use. Therefore, knowing where the securities are to be offered will be important in the preparation of projections. In any event, the use of projections should always be accompanied by an explanation of the significant underlying assumptions, which of course should be reasonable. The CPA's degree of association with the projections should be clearly indicated and the CPA must follow the professional guidance in this area. (See article in this issue of The CPA journal, "Accountant Services on Prospective Financial Information.") Conclusion
The offering and sale of securities in a transaction exempt from securities registration requirements is subject to a number of conditions imposed both at the federal and state levels. This framework of regulation and the inconsistency of application of regulatory principles between jurisdictions increases the complexity of the offering process. An understanding of the basic provisions of Reg. D, the Uniform Act and ULOE will allow the accountant to cooperate and to coordinate with the issuer, its counsel and its investment banker to achieve a successful private placement of securities.
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