Section 4(2) is the most General Exemption:
It exempts from federal registration any transaction by an issuer not involving a public offering. This is the traditional exemption for private offerings. Companies use Section 4(2) for offerings that are obviously private, for example, a private placement of securities with institutions or the promotion of a business venture by a few closely related persons.
Section 4(2) is not available for offerings of speculative ventures to unrelated and uninformed persons.
Whether Section 4(2) applies depends on the circumstances of the offering, including the issuer’s relationship with the investors, and the nature, size and manner of the offering.
So it’s a crap shoot. If you are in in doubt about any of these factors, do not use Section 4(2). .
Regulation D
Most issuers rely on Regulation D when conducting their private offerings of securities. Within Regulation D, some issuers use the Rule 504 exemption for offerings up to $1 million, and the Rule 506 exemption for all other offerings.
Read on for the pitfalls of 504.
All Regulation D offerings are private offerings, meaning that the issuer may not sell securities by any general solicitation or advertisement. A large scale offering under Regulation D also might require the delivery of a disclosure documents (also called a private placement memorandum, or an offering circular) to unaccredited investors. Remember, all securities issued through Regulation D are “restricted” securities, meaning that the investor is restricted in its resale of the securities.
Forget the Intrastate Offering
Section 3(a)(11) of the Securities Act exempts from registration any offering made solely to persons residing in a single state or territory, where the issuer is incorporated and doing business in the same state. The rationale is that a wholly intrastate transaction is adequately policed by the laws of the state.
Under Rule 147, an issuer does business in a state if (1) at least 80% of its gross revenues (including subsidiaries) is derived from operations or assets in-state; (2) at least 80% of its assets (including subsidiaries) is located in-state; (3) at least 80% of the offering's net proceeds is used in-state; and (4) its principal office is in-state. During the offering period and for nine months from the last sale by the issuer, purchasers may only resell their stock to other persons living in-state.
An offer to even one out-of-state resident will blow the exemption. And the risk is higher because the doctrine of integration applies – the intrastate exemption can be integrated with prior and future offerings thereby causing an almost certain loss of the intrastate exemption. The state exemption qualification procedures may be more onerous than a 506 offering.
Reg D
Regulation D consists of Rules 501 through 508. Rules 501 and 502 give definitions and general terms and conditions, including some of the definitions, i.e. accredited investors, disclosure requirements, limitations on advertising and solicitation, and integration. Rule 503 requires the filing of a notice on Form D. Rules 504, 505 and 506 contain the specific exemptions that issuers actually use under Regulation D. Rule 507 enforces the Form D filing requirement. Rule 508 relates to defective offerings.
Rule 504 – Offerings up to $1 Million.
Rule 504 combined with the SCOR (Small Corporate Offering Registration) exemption that most states have adopted permits an issuer (other than an investment company or an Exchange Act reporting company) to sell up to $1 million of its securities during a 12-month period. Rule 504 does not restrict the number of investors, nor does it require a disclosure document. Rule 504 does prohibit general advertising and solicitation, however. Most states have agreed to regional coordination. The country is divided into five regions; a single state is designated as the reviewer for all participating states in that region. Form U-7 must be used and approval for the offering must be given in advance. On the other hand, there can be an unlimited number of investors, there are no suitability requirements for investors and full public advertising is allowed.
Not all states participate in the SCOR program. You need State approval which can take time to obtain. The forms are onerous and most startup companies will not qualify because they have not been active long enough. And worst of all you will end up with investors who you ultimately will not want in a second round.
Rule 505 – Offerings up to $5 Million.
Rule 505 permits an issuer to sell up to $5 million in securities during a 12-month period.
Rule 505 permits sales to an unlimited number of accredited investors and to 35 unaccredited investors. In most other respects, Rule 505 is similar to Rule 506 (next).
Rule 506 – Offerings Beyond $5 Million.
Rule 506 permits an unlimited dollar amount of sales to an unlimited number of accredited investors and to 35 unaccredited investors.
Rule 506 requires that the issuer deliver statutory disclosure documents to unaccredited investors, but not accredited investors. Bottom line is that your Offering Memorandum is pretty much whatever you want it to be keeping in mind disclosure is the best policy to avoid disputes later.
Accredited Investors.
Rules 505 and 506 distinguish between accredited and unaccredited investors – the issuer may sell to an unlimited number of accredited investors but only up to 35 unaccredited investors. The definition of accredited investor is given in Rule 501(a). Accredited investors include directors, executive officers and general partners of the issuer, a natural person whose net worth is at least $1 million exclusive of his personal residence
(this requirement recently added), and a natural person with income over $200,000 in each of the last two years or joint income with that person’s spouse over $300,000 in each of those years and who reasonably expects to reach the same income level in the current year.
Disclosure Requirements.
Rules 505 and 506 (not 504) require the issuer to make statutory disclosures to unaccredited investors. The law contains detailed requirements for the content and format of the disclosures. The disclosures include financial and non-financial information. The scope of disclosure is dependent on the nature of the issuer and the amount of the offering.
The disclosure requirement can be very costly to issuers, both in terms of the issuer’s time and resources, and the costs of lawyers and accountants in preparing the disclosures.
For this reason alone, issuers should consider selling only to accredited investors to avoid the statutory disclosure requirement. Other reasons are that non-accredited investors are more risk adverse and disliked as a group by second round angel investors who only want to deal with sophisticated investors.
No General Advertisements.
All of Rules 504, 505 and 506 prohibit the issuer from selling securities through any general solicitation or advertising. It is for this reason that these offerings are “private placements” or “private offerings.”
The SEC requires that the issuer have a substantive relationship with each investor before offering securities to the investor. The issuer must know each investor well enough to ensure that the investment is suitable to the investor. The issuer may not use any advertisement, article, notice or other communication in any newspaper, TV or similar media, or any seminar where attendees have been invited by any general solicitation or advertising. This is because in all these cases, the issuer solicits the public-at-large.
This does not mean that if you play by the rules you cannot get the word out.
