Through a direct equity offering, a company’s management capitalizes its business by selling ownership in the company directly to groups of qualified investors for cash, services or something of value. The use of equity in financing emerging companies follows a predictable pattern, with money being raised from the same types of investors over and over again. The regulatory scheme contemplates that financings will start small and grow larger. A typical equity investment cycle for a start-up company might be: issuance of founders’ shares, sales to “friends, family and affinity group”, sales to a mixed bag of accredited and non-accredited investors, venture capital financing (VC) and initial public offering.
Early on, a business needs to keep its financing activities private in nature, whether they are between the business and investors or between a placement agent and investors. Following the market crash of 1929, Congress determined that to offer and sell securities to the public (a “distribution”) requires the filing with and review by the SEC of a registration statement containing financial and other information about the issuer and its securities as well as delivery to investors of a prospectus.
After balancing the need for business to raise money quickly and cheaply against the need for investor protection, Congress determined that a “public” versus a “private” offering was the appropriate place to draw the line and require SEC registration of the offering, which can be costly and time consuming.
In limited circumstances, exemptions are provided for privately negotiated sales that by definition must not involve any public solicitation or public advertising. In very general terms, exemptions are premised either on the small size of the offering, the private nature of the offering, or the extent to which purchases need the protections of the securities laws. In addition, since one attribute of a public offering is a large amount of capital raised over a short period of time, federal exemptions look at the total financing activity taking place within a 12-month window (six months before and six months after). Offerings that are not registered, and do not qualify for an available exemption, are illegal.
What Types of “Private” Equity Offerings May A Company Make?
The principal exemptions to registration used by companies to sell its securities for small or limited offerings are set forth in Regulation D of the Securities Act of 1933, as amended. Three separate but interrelated exemptions are contained in Regulation D as follows:
I. Rule 504 exempts certain offerings not exceeding $1 million within a 12-month period.
Rule 504 provides an exemption for the offer and sale of up to $1 million of securities in a 12-month period. A business may use this exemption so long as it is not a blank-check company and is not subject to Exchange Act reporting requirements. A Rule 504 offering may be either a public offering or a limited offering depending upon which path an issuer chooses. The path an issuer chooses will depend on securities laws of the state where the issuer wants to conduct the offering. These state laws may permit offerings to state residents accompanied by general solicitations and advertising and with the securities sold being unrestricted in subsequent resales under the following circumstances:
•A business registers the offering exclusively in one or more states that require a publicly filed registration statement and delivery of a substantive disclosure document to investors.
•A business registers and sells in a state that requires registration and disclosure delivery and also sells in a state without those requirements (only in New York and DC), so long as the business delivers the disclosure documents mandated by the state in which the business registered to all purchasers.
•A business sells exclusively according to state-law exemptions that permit general solicitation and advertising, so long as your business sells only to “accredited investors”, described in more detail below.
Even if a business makes a private sale where there are no specific disclosure-delivery requirements, the promoters of the offering, which are typically the business’s management, should take care to provide sufficient information to investors to avoid violating the antifraud provisions of the securities laws. That means that any information the offering’s promoters provide to investors must be free from false or misleading statements. Similarly, a business should not exclude any information if the omission makes the information that is provided to investors false or misleading.
II. Rule 505 exempts certain offerings not exceeding $5 million within a 12-month period to an unlimited number of accredited investors and to no more than 35 purchasers who
are not accredited investors.
Rule 505 provides an exemption for offers and sales of securities totaling up to $5 million in any 12-month period. Under this exemption, a business may sell to an unlimited number of “accredited investors” and up to 35 other persons who do not need to satisfy the sophistication or wealth standards associated with other exemptions. Purchasers must buy for investment only, and not for resale. The issued securities are “restricted”. Consequently, a business must inform investors that they may not sell for at least a year without registering the transaction. An issuing business may not use general solicitation or advertising to sell the securities.
An “accredited investor” is:
•a bank, insurance company, registered investment company, business development company, or small business investment company;
•an employee benefit plan, within the meaning of the Employee Retirement Income Security Act, if a bank, insurance company, or registered investment adviser makes the investment decisions, or the plan has total assets in excess of $5 million;
•a charitable organization, corporation or partnership with assets exceeding $5 million;
•a director, executive officer or general partner of the company selling the securities;
•a business in which all the equity owners are accredited investors;
•a natural person with a net worth of at least $1 million;
•a natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year; or a trust with assets of at least $5million, not formed to acquire the securities offered, and whose purchases are directed by a sophisticated person.
It is up to the offering’s promoters to decide what information he or she gives to accredited investors, so long as the promoters do not violate the antifraud prohibitions. But a promoter must give nonaccredited investors disclosure documents that generally are the same as those used in registered offerings. If a promoter provides information to accredited investors, the promoter must make this information available to the nonaccredited investors as well. This is a frequent area of misstep for entrepreneurs. You must also be available to answer questions by prospective purchasers.
Here are some specifics about the financial-statement requirements applicable to this type of offering:
•Financial statements need to be certified by an independent public accountant.
•If a company other than a limited partnership cannot obtain audited financial statements without unreasonable effort or expense, only the company’s balance sheet, to be dated within 120 days of the start of the offering, must be audited.
•Limited partnerships unable to obtain required financial statements without unreasonable effort or expense may furnish audited financial statements prepared under the federal income tax laws.
III. Rule 506 exempts certain offerings without regard to dollar amount to an unlimited
number of accredited investors and to no more than 35 purchasers who either alone or with their purchaser representatives have (or who the issuer reasonably believes have), the knowledge and experience in financial and business matters that they are capable of evaluating the merits and risks of the prospective investment.
Rule 506 is a “safe harbor” for the private offering exemption. If the following standards are followed, an issuing business can be assured that it is within this exemption:
•a business can raise an unlimited amount of capital.
•a business cannot use general solicitation or advertising to market the securities.
•A business can sell securities to an unlimited number of accredited investors and up to 35 other purchasers. Unlike Rule 505, all nonaccredited investors, either alone or with a purchaser representative, must be sophisticated—that is, they must have sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment;
•It is up to the offering’s promoters to decide what information to give accredited investors, so long as he or she does not violate the antifraud prohibitions. But the promoters must give nonaccredited investors disclosure documents that generally are the same as those used in registered offerings. If a promoter provides information to accredited investors, a promoter must make this information available to the nonaccredited investors as well.
•An issuing business must be available to answer questions by prospective purchasers.
•Financial-statement requirements are the same as for Rule 505.
•Purchasers receive “restricted” securities. Consequently, purchasers may not
freely trade the securities in the secondary market after the offering.
Section 4(6) of the Securities Act exempts from registration offers and sales of securities to accredited investors when the total offering price is less than $5 million. The definition of accredited investors is the same as that used in Regulation D. Like the exemptions in Rule 505 and Rule 506, this exemption does not permit any form of advertising or public solicitation. There are no document-delivery requirements. Of course, all the transactions are subject to the antifraud provisions of the securities laws. Section 4 (6) also requires that a notice of sales on Form D be filed with the SEC.
Section 4(2) of the Securities Act of 1933, exempts from registration, offers and sales of securities “not involving any public offering.” In SEC v. Ralson Purina Company, 36 U.S. 119 (1953), a key case in the interpretation of Section 4(2), the U.S. Supreme Court stated that “[a]n offering to those who are shown to be able to fend for themselves is a transaction ‘not involving any public offering.” Although not considered by the Ralson Court, additional factors that other courts have indicated as important to establish a section 4(2) exemption include:
• The size of the offering (i.e. the number of securities offered and the aggregate offering price thereof); and
• The presence of a relationship between the offerees and the issuer.
Rule 701 is a particularly useful exemption. It exempts sales of securities if made to compensate employees according to a written plan of compensation. This exemption is available only to private companies that are not subject to Exchange Act reporting requirements. It is useful because it frequently will exempt stock awards to employees that are not otherwise qualified purchasers under Section 4(2). An issuing business can sell at least $1 million of securities under Rule 701, no matter how small the company is.
An issuing business can sell even more if it satisfies certain formulas based on its assets or on the number of its outstanding securities (for example, up to 15 percent of assets). If an issuing business sells more than $5 million in securities in a 12-month period, an issuing business needs to provide limited disclosure documents to his or her employees. Regardless of the amount of securities sold, each employee receiving a stock award must receive a copy of the written equity compensation plan. As with any exempt offering, employees receive “restricted securities” in these transactions and may not freely offer or sell them to the public.
When making a private sale of securities, in addition to complying with federal law, a company needs to comply with state law in the jurisdictions where it is offering and selling securities. These laws are commonly known as “Blue Sky” laws. In most cases, “Blue Sky” state exemptions from registration generally parallel federal exemptions. Maryland allows a local company to offer $150,000 in securities during any 12 month period to no more than 10 purchasers. This type of “intrastate” offering is exempt under federal law pursuant to Section 3(a)(ii) of the Securities Act. Maryland also permits other types of private offerings of securities to its residents, in connection with federal law.
With private exempt offerings of securities, a company must be careful to comply with all of the applicable federal and state requirements for the offering. Failure to meet one requirement could void the availability of the exemption. In that event, an unhappy investor may be able to demand its money back from the company’s principals if the investment goes sour. Often there is a requirement to pay a filing fee, supply state securities regulators with a copy of the offering document, and file a Form D with states in which securities are offered or sold. Such is the case, for example, with offerings under Rule 701 in Maryland. For Rule 701 employee stock awards, you file a copy of the Equity Compensation Plan. Form D filings as well as other securities filings, can be done electronically with the SEC and many State regulators.
In addition to private exempt offerings of securities, a company, through its principals can make direct public offerings of its securities.
What is a Direct Public Offering?
A direct public offering is a mechanism by which a company’s management sells equity ownership in the company directly to the public, free from having to qualify investors before making an offer and free from restrictions on general solicitation and advertising. Generally, these offerings raise less than $20,000,000 for companies. These offerings are an alternative to the traditional underwritten public offerings, where securities are sold by brokers to their customers. The price of the stock sold, the rights that attach to the stock sold, and the amount of stock sold is determined by the company’s management. In this way, management controls the valuation placed on its company and price of participating in the equity of the company.
Regulation A Offerings. Section 3(b) of the Securities Act authorizes the SEC to exempt from registration requirements securities offerings based purely on their small size. Regulation A was created under Section 3(b) to exempt public offerings not exceeding $5 million in any 12-month period. If an issuing business relies on this exemption, it must file an offering statement (called a “Form 1-A”) with the SEC for review. The offering statement consists of a notification, offering circular and exhibits.
Regulation A offerings share many characteristics or requirements with full registered offerings. For example, an issuer must provide purchasers with an offering circular that is similar in content to a prospectus. Like registered offerings, the securities can be offered publicly and are not “restricted”, meaning they are freely tradable in the secondary market after the offering. The principal advantages of Regulation A offerings, as opposed to full registration, are:
•The financial statements are simpler and do not need to be audited.
•There are no Exchange Act reporting obligations after the offering (unless the company has more than $10 million in total assets and more than 500 shareholders).
•Companies may choose among three formats to prepare the offering circular, one of which is a simplified question-and-answer document.
•An issuer may “test the waters” (make limited general solicitations) to determine if there is adequate interest in its securities before going through the expense of filing and review with the SEC.
All types of companies that do not report under the Exchange Act may use Regulation A, except “blank Check” companies, those with an unspecified business, and investment companies registered or required to be registered under the Investment Company Act of 1940. In most cases, shareholders may use Regulation A to resell up to $1.5 million of securities.
If an issuer “tests the waters”, it can use general solicitation and advertising prior to filing an offering statement with the SEC. This allows an issuer the advantage of determining whether there is enough market interest in its securities before running up significant legal, accounting and other costs associated with filing an offering statement. An issuer may not, however, solicit or accept money until the SEC staff completes its review of the filed offering statement and the issuer delivers prescribed offering materials to investors.
Regulation A offerings historically have not been popular with investors, probably because there are other exemptions that are easier to use. However, because general solicitations are permitted in a Regulation A offering and are not permitted under other exemptions, Regulation A offerings have become slightly more popular as a means to offer securities over the Internet.
The Small Company Offering Registration (“SCOR”) offers an optional method of registration that utilizes a question and answer disclosure document and enables corporations and limited liability companies (“LLC”s) to raise up to $1 million during a period of up to 12 months through the sale of securities to the public.
SCOR offerings are designed to be exempt from registration under federal securities laws by virtue of Securities and Exchange Commission (“SEC”) Rules and Securities Statutes. Issuing companies may use commissioned selling agents or sell the securities to the public themselves through classified ads or other means of mass solicitation, such as the internet. Investors are not limited as to number or type, not is there any restriction on the amount that may be sold to any one person.
The core of the SCOR registration is the Form SCOR Disclosure Document (Form U-7), which is presented in a question and answer format. The questions presented in the form are designed to elicit specific types of information of special relevance to small businesses including the background of persons operating the company (including compensation paid, percentage of ownership in the company and any transactions between the individuals and the company), intended uses of the proceeds of the offering, the terms of the offering and the type of security being offered, the assets, liabilities and cash flow of the company, and risks associated with investing in the company. Because a registration is involved, examiners from the State Regulatory Agencies will comment on the disclosure provided and request different or more detailed disclosure if the answers are not sufficiently responsive.
SCOR offerings must be registered in the State where they are conducted by qualification. Registration by qualification requires the filing of the SCOR form and other documents with State Securities Regulators. The State Securities Regulators review the SCOR form for adequacy of disclosure and compliance with certain substantive criteria.
Past regulatory problems by potential selling agents in the offering, the selling agents’ management, or 10% or greater owners may result in the disqualification of the selling agents. Selling agents must sell only on behalf of the company and not on their own behalf. Accordingly, firmly underwritten offerings are prohibited.
A selling agent or finder engaged in the business of selling securities must be registered as a Broker-Dealer with the State Securities Regulator. Individuals receiving commissions or other compensation for selling securities in the offering must be registered as securities salespersons and have passed appropriate examinations. If the corporation is selling the securities directly without paying commissions, officers and directors of the company may sell the offering without being registered.
Proceeds of the offering must be placed in an impound with an independent bank or similar institution until the minimum amount necessary for the company to achieve its stated objectives is raised. The company may raise additional funds so long as their anticipated use is clearly disclosed.
Financial statements for the company’s last fiscal year must be attached to SCOR Disclosure Document. Financial statements must be prepared in accordance with generally accepted accounting principles (GAAP), complete with appropriate footnote disclosure. They may need to be reviewed or audited by an accountant.
Coordinated Review-SCOR (CR-SCOR) is a coordinated review program available for companies that intend to conduct a SCOR offering in more than one state. This program streamlines the review process for the company, since the review of the offering is coordinated amongst the states in which the company desires to register. A lead review state is appointed to coordinate the review and a single comment letter is generated for all the states participating in the review. The company must work with only one state to resolve any registration issues, rather than having to deal with each individual state in which the issuer desires to register.
Small Business (SB) Registered Offerings
Other than SCOR and Regulation A offerings, the SEC has adopted simplified registration forms (Forms SB-1 and SB-2) for use by small business issuers. A small business issuer is a United States or Canadian issuer that had less than $25 million in revenues in its last fiscal year, provided that the value of its outstanding securities in the hands of the public is no more that $25 million.
These formats are alternatives to Form S-1. Form SB-1 for small business issuers offering up to $10 million worth of securities in a fiscal year, permits the use of disclosure similar to that required in a Regulation A offering, including the use of the question and answer format. It requires, however, audited financial statements.
Form SB-2 permits the offering of an unlimited dollar amount of securities by any small business issuer. The form may be used again and again as long as the issuer meets the definition of small business issuer. Form SB-2 offers certain advantages, including the location of all disclosure requirements in a central repository, Regulation S-B.
Form SB-2 also permits the issuer to:
• Provide audited financial statements, prepared in accordance with generally accepted accounting principles, for two fiscal years (Form S-1 requires the issuer to provide audited financial statements, prepared in accordance with more detailed SEC regulations, for three fiscal years);
• Include less extensive narrative disclosure, particularly in the areas of the description of business, and executive compensation, than that required by Form S-1; and
• File its initial public offering with either the SEC Regional Office nearest to where the company conducts its principal business operations (the Atlanta District Office for issuers in the Southeast Region) or with the SEC Division of Corporation Finance in Washington, DC. The primary advantage of regional filing is that regional office personnel may be more familiar with local economic conditions, the business community, the financial environment, and, in some cases, the background and history of the company.
Registration statements are examined for compliance with disclosure requirements. If a statement appears to be materially incomplete or inaccurate, the registrant usually is informed by letter and given an opportunity to file correcting or clarifying amendments. The Commission can refuse or suspend the effectiveness of any registration statement if it finds that material representations are misleading, inaccurate, or incomplete.
What Is The Process For A Direct Public Offering?
A company should generally plan on a commitment of a significant amount of time and resources over a six-month period to successfully conduct a direct public offering.
The company management will first need to determine the amount of stock it will offer and the pricing on the offered stock. This will necessarily implicate a valuation of the company prior
to the offering and a thorough review of the company’s business plan, financial statements and financial projections.
The company will also need to determine the type of securities regulation filing it will make and where it will conduct its offering. This will implicate the type of financial statements it will need to prepare and the States where it will register its securities for sale. As indicated above, the most commonly used registration forms for DPOs are (1) the Rule 504 Small Corporate Offering Registration (SCOR) statement for offerings of $1,000,000 or less; (2) a Regulation A Offering Circular for offerings of $5,000,000 or less; (3) a SB-1 registration statement for offerings of $10,000,000 or less; and (4) a SB-2 registration statement for offerings in unlimited amounts.
The company will need to plan the manner by which it will market and sell its offering. It will need to develop a marketing plan for offering to prospective investors and determine how best to reach them. It will need to determine the best media to reach investors.
The company will also need to plan and think through the aftermarket for its stock. All investors will be concerned with liquidity; at some point, they will want to liquidate their investment. For this reason, the company will need to address this issue up front in the offering. Not all offerings require a public trading market in the traditional sense. It is possible to structure order matching services that match potential buyers and sellers of the company’s stock. Alternatively, if the company qualifies, it can obtain a listing on one of the exchanges or be cleared for quotation on the electronic bulletin board. The company will need to address this issue in the offering and how it plans to deal with it in both the short term and the long term.
Prior to conducting the offering, the company will need to review its own structure and tie up any loose ends that may compromise the offering. For example it should review its corporate structure and make any changes to its corporate charter that may assist it when it has additional shareholders. It should examine its board of directors, management structure and corporate organizational chart. The company should review its contracts, documenting where necessary, and its employment and intellectual property arrangements.
Finally, the company will need to determine the group of inside and outside professionals that will assist with the offering. The company may need professionals to help them address the following areas: finance and accounting, public relations/investor relations, legal/regulatory requirements, graphic and printing and internet/electronic commerce. In planning any offering, the company will need to develop a budget, timeline and list of assignments among the team.
What Will A Direct Public Offering Cost
Generally, a company should plan on a direct public offering costing about 3-5% of the amount raised. The majority of the costs of this offering will come from professionals and employees and the costs of the communications media for the offering.
Some of the costs of the offering will need to be paid up front, and some of the costs of the offering can be deferred to closing on the offering. Below is an estimated itemization of the costs that will need to be paid prior to closing:
a. SEC filing fee: $0 (Regulation A is zero, SB-2 is based on a dollar amount per million of an offering)
b. State filing fee $1,000 (average, per state where registered, runs from $0 to $2,500)
c. Audit $5000 (average, required by many states and very desirable)
d. Printing/EDGAR $7,000 (average for 1,000 copies. Note: offerings on the Internet can lessen this charge and save postage as well.) Plus misc. copying, $500.
e. Preparing the Offering $10,000 – 15,000
What Are The Benefits/Disadvantages Of A Direct Public Offering?
There are advantages and disadvantages to direct public offerings. The reasons for choosing to do a public offering usually include accessing capital that does not have to be paid back and does not require any interest and dividend payments; getting capital without giving up control over the business decisions management can make; creating a liquid trading market for shares that the company’s founders, management and major owners may use to begin cashing in on their investments; and having a security to use, instead of cash for compensating key employees and acquiring other businesses. The disadvantages to a public offering include operating the company so that its former owners/managers are now stewards of money entrusted to them by strangers; filing regular reports with regulatory agencies and issuing new releases to keep shareholders informed; monitoring the trading activity and price of the stock; and having to disclose information to the company, such as salaries, transactions with insiders and material contracts.
By being freely advertised, a DPO can educate the public about a company’s products and services and may develop business and markets for the company. As well, it might be marketed to potential strategic partners, vendors and customers. Oftentimes, these same groups provide investment, which, in turn, can serve to strengthen important business relationships.
Can the Internet Be Used For Private or Small Direct Public Offerings?
The SEC and most state securities regulators allow electronic delivery of disclosure documents. The issue for using the internet to deliver disclosure documents is whether the issuer, or its placement agent, has a pre-existing relationship with the offeree. If there is no pre-existing relationship, then the issuer might be accused of a general solicitation or a public offering. This would void the exemption for the private offerings discussed above. Even for the small direct public offerings discussed above, if the offering is not registered in all fifty (50) states, then using the internet might subject the issuer to a claim that the issuer is making an illegal offering in a state where its offering is not registered. Therefore, if an issuer is going to use the internet in making an offering, it needs to use special care in how it structures that use. The internet can be an important tool to facilitate offerings.
Raising capital is one of the most important activities that emerging companies engage in. To be successful, it requires planning, good counseling and common sense. As you can see, many of the legal requirements are complex and interrelated. However, there are things a business can do to benefit itself now to move the process along. A business can begin by writing a good business plan and keeping corporate records and documents in good order for review.
About Jiranek Company, P.A.
We help companies raise capital through direct sales of its securities. We have helped companies formulate and implement equity offerings, complying with the complex and myriad of legal requirements associated with these offerings. We assist companies in identifying and implementing the types of permissible sales and marketing techniques that are likely to be successful with these offerings. We have established relationships with professionals, lenders and investors that can assist the company with successfully capitalizing their business.