Companies looking to raise funds through the issuance of equity securities can either seek capital in the public or private markets and, in the case of private markets, through private offerings. Public offerings require registration with the Securities and Exchange Commission (the “SEC”), which can be time-consuming and expensive. Raising capital through the private markets can be an effective way to fund a business without going through the registration process. The SEC has stated that all offers and sales of securities either need to be registered with the SEC or must be made pursuant to an exemption from registration.
What are the most common exemptions from registration used in private offerings?
The most common exemptions from registration used in private offerings are the following:
Section 4(a)(2);
Rule 504 under Regulation D;
Rule 506(b) under Regulation D;
Rule 506(c) under Regulation D;
Rule 701;
Regulation S;
Regulation A (Reg. A+); and
Regulation Crowdfunding.
What is the Section 4(a)(2) exemption used in private offerings?
Section 4(a)(2) of the Securities Act of 1933, as amended (the “Securities Act”), exempts from registration transactions by an issuer not involving any public offering; however, “public offering” is never defined. In SEC v. Ralston Purina Co., the Supreme Court provided some guidance regarding the Section 4(a)(2) exemption used in private offerings which is as follows:
The exemption focuses on “offerees” and not actual purchasers in the private offering;
The exemption does not depend upon a numerical test and number of offerees is insufficient, by itself, to establish loss of exemption in the private offering;
Whether the exemption is available in the private offering turns on whether the particular class of persons need the protection of the Securities Act and whether the offerees are shown to be able to fend for themselves; and
Where offerees in the private offering do not have access to the kind of information that a registration statement would disclose, the issuer is required to provide the same kind of information that otherwise generally would be available in a registration statement.
What are the benefits and downsides of using a Section 4(a)(2) exemption in a private offering?
The benefits to using a Section 4(a)(2) exemption in a private offering are as follows:
Unlimited private offering amount;
Unlimited amount of investors in the private offering;
Not limited to private issuers; SEC reporting issuers may also rely on exemption in private offering;
No reporting requirement following private offering (such as a Form D); and
Bad actor disqualification not applicable in private offerings.
The downsides to using a Section 4(a)(2) exemption in a private offering are as follows:
Only sophisticated investors who can fend for themselves can invest in the private offering;
General solicitation and general advertising of the private offering are not allowed and an issuer can only raise money in the private offering from investors with whom it has a substantive, pre-existing relationship;
The securities sold in the private offering will be restricted securities, which means they may not be resold, without registration with the SEC, for up to 12 months;
Issuer may be required to provide to investors in the private offering disclosure that would be provided in a registration statement (including audited financial statements); and
State exemptions still required for private offering.
What qualifies investors in private offerings as sophisticated and can fend for themselves?
Although there is no bright-line rule, courts have interpreted that an investor in a private offering is “sophisticated and can fend for themselves” when they have the financial ability to bear the risk of loss of their investment or extensive business experience and access to necessary disclosure.
The decision whether to commence a private offering, including the preparation of required disclosures and federal and state compliance, can be complicated and difficult. Business Legal Advisors, LLC has over seven years of experience assisting companies with private offerings from preparing for the private offering to the completion of a successful offering.