[This article has been updated on 4/5/15 to reflect the new SEC rules on JOBS Act TitleIV offerings, aka “Regulation A+”]
A private offering or private placement is the sale of securities by a company to a small number of select investors. There are several different types of private offerings available. These private offerings are exempt from full registration with the Securities and Exchange Commission as would be required with an Initial Public Offering of stock; therefore, they are referred to as exemptions.
In many cases, detailed financial information is not disclosed and a the need for a prospectus is waived. Private offering exemptions are generally only available to issuers that are not reporting companies, and are subject to the equity securities-holder limits of the Exchange Act of 500 non-accredited investors or 2000 total investors in any particular class of equity securities, above which that class of securities must be registered pursuant to the provisions of the Exchange Act.
Many of the new investment crowdfunding portals that we cover on this site take advantage of these private placement exemptions to enable them to offer investments online through their platforms to investors.
This is a guide to the different private placement exemptions available for businesses to raise money from private investors, as well as the upcoming exemptions promulgated under the JOBS Act for businesses to raise money from public investors as well.
The Regulation D Offering Exemptions
Many in the startup and emerging company community are familiar with Regulation D Rule 506, the federal regulation that exempts many private securities offerings from the burdensome requirement under the securities laws to register the offering (i.e., a public offering). However, the federal securities laws and regulations provide several more options for exemption, depending on the size of the offering and the number and type of purchasers.
The Regulation D offerings include Rule 504, Rule 505 and Rule 506. Regulation D offerings only have a federal filing requirement of Form D, which should be filed within 15 days of the first sale. It is also important to note that only Rule 506 exempts the offering from any state registration requirement (although states can require a “notice” filing and filing fee) — Rule 504 and Rule 505 offerings must either register in the states where securities are offered or sold, or find an applicable exemption to state registration under that state’s laws.
Rule 504 is considered a “seed capital” exemption, and allows issuers to raise up to $1 million in any 12-month period. Rule 504 offerings are open to any type of investor, and generally do not have any disclosure requirements. However, Rule 504 offerings may not be generally solicited, and can only sell “restricted” securities (securities that may not be resold except pursuant to registration or exemption), unless the offering is registered under a state law that requires a offering/disclosure document to be provided to investors, or the offering is made under a state law exemption permitting general solicitation and sales are only made to accredited investors.
Rule 505 allows for sales up to $5 million in any 12-month period, to an unlimited number of accredited investors, and up to 35 non-accredited investors. However, if there are any non-accredited purchasers, they must be provided with disclosure documents that generally contain the same information as a registration statement for a registered offering.
Rule 506 is the most popular of the Regulation D exemptions, since it permits an unlimited amount of funds to be raised. Rule 506 comes in two varieties: Rule 506(b), or “old-style” Rule 506; and Rule 506(c), which allows for general solicitation. Rule 506(b) does not permit general solicitation, and allows for sales to an unlimited number of accredited investors and up to 35 non-accredited, “sophisticated” investors, which are investors who, either alone or with advisors, possess the necessary knowledge and experience to evaluate the merits and risks of the particular investment. Sophisticated investors must also receive disclosure documents with generally the same information as contained in a registration statement.
Rule 506(c), in exchange for allowing general solicitation, only permits sales to accredited investors; furthermore, unlike Rule 506(b) that allows accredited investors to “self-certify” their accredited status, Rule 506(c) requires issuers to take “reasonable steps” to verify that all their purchasers are accredited — there is no definition as to what reasonable steps must include, although the SEC does offer several “safe harbor” methods.
|Rule 504||Rule 505||Rule 506(b)||Rule 506(c)|
|Max. # of Investors?*||Unlimited||Unlimited accredited investors, plus max of 35 non-accredited investors||Unlimited accredited investors, plus max of 35 non-accredited, “sophisticated” investors||Unlimited|
|Types of Eligible Investors?||Anyone||Anyone||Accredited and non-accredited, “sophisticated” investors||Accredited only; issuer must take “reasonable steps” to verify all purchasers are accredited|
|General Solicitation Permitted?||No, unless offering registered under state law requiring disclosure documents, or exempted under state law permitting general solicitation and all sales made to accredited investors||No||No||Yes|
|Max. Aggregate Investment Limit?||$1 million in 12-month period||$5 million in 12-month period||Unlimited||Unlimited|
|Disclosure Requirements?||None||None for accredited investors; disclosures for non-accredited investors outlined in Rule 502(b)(disclosures provided to any investor should be provided to all investors)||None for accredited investors; disclosures for non-accredited investors outlined in Rule 502(b)(disclosures provided to any investor should be provided to all investors)||None|
|Federal Filing Requirements?||Form D||Form D||Form D||Form D|
|Broker or Intermediary Required?||No||No||No||No|
|State Registration Pre-empted?||No||No||Yes||Yes|
|Restricted Securities?||Yes, unless registered under state law requiring disclosure document, or only sold to accredited investors under state law exemption permitting general solicitation||Yes||Yes||Yes|
|“Bad Actor” and other disqualification provisions?||No||Yes||Yes||Yes|
|Able to Be Integrated?||Yes||Yes||Yes||Yes|
Crowdfunding: The Regulation A and JOBS Act Title III Exemptions
Regulation A was conceived as a “mini public offering” as one of the SEC’s registration exemptions. However, Reg A fell in to relative disuse due to the fact that Reg A offerings were still subject to state registration. With the passage of the JOBS Act, Congress, in Title IV of the Act, directed the SEC to adopt rules reforming Reg A to make them more useful for capital formation for smaller companies. The resulting rules, colloquially referred to as “Reg A+”, reformed the Reg A exemption by splitting Reg A into two tiers. Tier I permits companies to raise up to $20 million in any 12-month period; companies must file an offering statement for review by the SEC, and the offering is also subject to state registration/qualification requirements. Tier II permits companies to raise up to $50 million, and most importantly, preempts state registration/qualification; however, in exchange for state preemption, Tier II issuers have ongoing reporting requirements with the SEC in the form of annual, semi-annual, and “current event” reports.
Title III of the JOBS Act amended the Securities Act to provide for an exemption to what is popularly known as “equity crowdfunding”. Title III and the proposed SEC regulations that go along with it permit companies to “crowdfund” by selling up to $1 million in securities to all types of purchasers — however, the law places limits on how much an investor can invest in all equity crowdfunded offerings in any 12-month period, based on the investor’s net worth or annual income. The crowdfunding exemption will likely come with a required filing form, as well as some significant disclosure requirements, including information about the business, its operation, finances, and business plan and plans for raised funds, and as an offering reaches the $1 million threshold, CPA-reviewed or audited financial records
|“Reg A+”||JOBS Act Title III/ §4(a)(6) Equity Crowdfunding|
|Legal Yet?||Yes (60 days after publishing in Federal Register)||No|
|Max. # of Investors?*||Unlimited||Unlimited|
|Types of Eligible Investors?||Anyone; cannot purchase more than greater of 10% of annual income or net worth in Tier II||Anyone; in any 12-month period, investors with annual income or net worth less than $100,000 may not invest greater of $2000 or 5% of net worth or annual income, and investors with annual income or net worth greater than $100,000 may not invest greater of 10% of annual income or net worth to max of $100,000|
|General Solicitation Permitted?||Yes, may “test the waters” with general solicitation before filing offering statement with SEC||No, except may publicly advertise link to offering profile on funding portal|
|Max. Aggregate Investment Limit?||Tier I: $20 million in 12-month period; Tier II: $50 million in 12-month period||$1 million in 12-month period|
|Disclosure Requirements?||Offering statement outlined in Regulation A; plus audited financial statement in Tier II (also in Tier I if company already has audited financials). Ongoing disclosure requirements in Tier II.||Offering statement with information about the business, including business plan, financial condition, company’s equity structure, and intended use of funds raised|
|Federal Filing Requirements?||Form 1-A, consisting of offering statement and exhibits; also, any general solicitation materials; Form 1-Z exit filing in Tier I; ongoing Form 1-K annual, Form 1-SA semiannual, and Form 1-U “current event” filing/disclosure requirements in Tier II||Form C (proposed)|
|Broker or Intermediary Required?||No||Yes, must use regulated “funding portal”|
|State Registration Pre-empted?||No in Tier I; Yes in Tier II||Yes|
|Restricted Securities?||No||One-year restriction, with the exception of transfers to the issuer, to a family member of the purchaser, or to an accredited investor|
|“Bad Actor” and other disqualification provisions?||Yes||Yes|
|Able to Be Integrated?||No, subject to conditions||Unclear at this point, but likely not|
There are also other federal exemptions available. First is the Section 4(a)(5) accredited investor exemption, which permits aggregate sales of up to $5 million to accredited investors. The exemption also requires a Form D filing, and has no disclosure requirement, although general solicitation is also prohibited.
The Section 4(a)(2) exemption is a limited private offering exemption. Although Rule 506 — now Rule 506(b) — was promulgated as a safe harbor for Section 4(a)(2), it is possible to rely on the statute alone. The exemption requires no filing; instead, an issuer must prove that the issuance qualifies for the exemption if challenged by the SEC or by lawsuit. There is a myriad of case law that provides guidance on the contours of the exemption, and cases can be all over the place on certain requirements. As a result, the statute is rarely relied upon by itself to provide an exemption, since it is impossible to know for sure when making an offering whether it qualifies for the exemption.
An exemption from the federal securities laws is provided in Section 3(a)(11) (and its safe harbor Rule 147) for offerings that occur solely within the issuer’s home state. All offers must occur, and all of the purchasers are required to reside, in the same state as the issuer, and the issuer must conduct a substantial amount of its business within that state. The offering must comply with the securities laws in that state. However, sales made under this intrastate exemption may not be resold outside the state within a short period after the completion of the offering (usually 9 months).
|Max. # of Investors?*||No official max, but should be very limited||Unlimited||Subject to state law|
|Types of Eligible Investors?||Accredited or sophisticated investors, or investors able to bear loss of investment; investors should have close, preexisting relationship with issuer||Accredited only||Subject to state law; however, all investors must reside in the same state, which must be the same state where the issuer is located and conducts a substantial amount of its business|
|General Solicitation Permitted?||No||No||Subject to state law; Rule 147 safe harbor prohibits offers to non-residents of the state|
|Max. Aggregate Investment Limit?||Unclear, but probably limited||$5 million||Subject to state law|
|Disclosure Requirements?||“Prospectus-like disclosures”||None||Subject to state law|
|Federal Filing Requirements?||None||Form D||None|
|Broker or Intermediary Required?||No||No||Subject to state law|
|State Registration Pre-empted?||No||No||No|
|Restricted Securities?||Yes||Yes||Subject to state law; however, purchasers may not resell securities outside state within certain period after offering (usually 9 months)|
|“Bad Actor” and other disqualification provisions?||No||No||No|
|Able to Be Integrated?||Unclear||Unclear, but possibly||Yes, under Rule 147|
Offer Integration and Blue Sky Requirements
When conducting offerings, it is important to be mindful of a couple of concepts. The first is the “integration” doctrine. Under integration, if an issuer conducts multiple certain kinds of private offerings, the offerings are considered to be one single offering. The effect of integration is that if a prior offering is conducted under one exemption, and then the issuer tries to conduct another offering under another exemption that has different or more liberal requirements than the other exception, the second offering may lose the benefit of the exception. For example, if an issuer conducts a Rule 506(c) offering (which only permits sales to accredited investors), then a month later conducts an offering relying on Rule 504 to sell to non-accredited investors, the purported Rule 504 offering may be considered “integrated” into the Rule 506(c) offering, and the sales to non-accredited investors would cause the issuer to lose the benefit of the Rule 506(c) exemption.
Not all private offering exemptions are eligible to be integrated. One of the primary factors in determining whether offerings should be integrated is the length of time between offerings — the longer between offerings, the less likely it is that the offerings will be deemed integrated. Six months between offerings is generally a safe harbor for offerings to not be integrated, although depending on the types of offerings and the facts and circumstances, two offerings with a shorter period in between them may not be considered integrated.
Finally, the private offering exemptions discussed herein only apply to the federal securities laws. Each state has its own set of securities laws (commonly known as “blue sky laws”) that apply to any sales of securities that occur within a state’s borders. With limited exception, even if an offering is federally exempted, state registration requirements will still apply, so issuers must either register their offering in each state they make sales in or find an applicable exemption to registration under state law.
Even where a state’s registration requirement is preempted by the federal exemption, federal law usually permits a state to require that an issuer relying on an exemption that preempts state registration make a “notice filing” to the state (which typically comes with a filing fee).
About the Author
James M. Johnson is a Massachusetts attorney. His practice focuses on corporate and commercial matters for early-stage startups and small businesses.
Disclaimer: This article is for educational purposes only, and is not intended to create an attorney-client relationship or to be relied upon for legal advice. If you require legal advice applicable to your circumstances, please contact an attorney.