Contents Of A Private Placement

Now that you have made the decision to use a Private Placement Memorandum, what goes in it? The main concern of State and Federal securities laws are the protection of the investor. In this context, there is one cardinal rule – tell the truth, the whole truth and nothing but the truth. This means do not misrepresent material facts, and do not omit material facts where the inclusion of such facts would lead the prospective investor to a different conclusion.

Aside from being truthful and factual, your PPM should provide your prospective investor with all the information necessary to make an intelligent investment decision. It is common sense – put yourself in the investor’s shoes and think about what information you would like to have.

And, while the required disclosure will vary depending on various factors, such as size of the offering and whether there are non-accredited investors, I recommend erring on the side of caution. You may run afoul of securities laws by not having the right disclosure, but there is no harm if you “over-disclose”.

The following includes some of the sections that should be included in your Private Placement Memorandum:

• Notices to Investors: The Notice to Investors section includes federal and state disclosure legends, providing certain notices to prospective investors informing them that the securities described in the PPM are not registered. Additionally, some states have specific disclosure language they will require over and above the federal disclosures.

• Summary of Terms: The Summary of Terms provides a summary of the “deal”; i.e. purpose of the transaction, who the Issuer is, what type of security is being issued, specific terms of the security being issued (dividends or interest; current pay or accrued; warrants; collateral), affirmative and negative covenants, conditions precedent,  etc.

• Risk Factors: This section sets forth the risks specific to the Issuer and the risks of investing in the type of securities being issued. Some examples include reliance on customer concentration, cyclicality, inability to achieve projections, changes in regulations, etc.

• Conflicts of Interest: The conflict of interest section identifies and describes potential conflicts of interest of the Issuer, and its principals or affiliates. As an example, one of the principles may provide accounting services for the Issuer, or one of the principles may be a significant customer of the Issuer.

• Description of the Issuer, its Business and the Business Plan: Describes the business of the Issuer including its products, strategy, customers, sales and marketing, operations, industry and competitive analysis, and discussion of management.

• Transaction Description: The transaction section describes the transaction, including a schematic of the deal, sources and uses table and capitalization.

• Financial Information: This section includes presentation of historical financial performance as well as discussion and analysis of the results. The financial information section will also include management forecasts and relevant assumptions behind the forecast.

• Misc Sections: These sections will typically comprise of tax matters, and a description of the capital stock of the Issuer.

• Subscription Section: This section provides the prospective investor with the instructions on how to participate in the offering.

• Appendices: The appendices will vary from deal to deal, and should consist of supplemental information and documents that may be material to an investor’s investment decision. Items that may be part of the appendices include the letter of intent, audited financial statements, shareholder’s agreement, etc.

While all of this seems complicated, you can make it easy on yourself by using a Private Placement Memorandum template. Using a PPM template will ensure that you end up with a professional-looking offering memorandum, while easily saving thousands of dollars.

Regulation D Offering

Under the Securities Act of 1933, any offer to sell securities must either be registered with the SEC or meet an exemption. Regulation D (or Reg D) contains three rules providing exemptions from the registration requirements, allowing some smaller companies to offer and sell their securities without having to register the securities with the SEC. For more information about these exemptions, read our publications on Rules 504, 505, and 506 of Regulation D.

While companies using a Reg D exemption do not have to register their securities and usually do not have to file reports with the SEC, they must file what’s known as a “Form D” after they first sell their securities. Form D is a brief notice that includes the names and addresses of the company’s executive officers and stock promoters, but contains little other information about the company.

As an investor, if you are thinking about investing in a company that is issuing securities which have not been registered with the SEC, you should access EDGAR Company Search to determine whether the company has filed a Form D. If the company has filed a Form D, you can request a copy. If the company has not filed a Form D, this should alert you that the company might not be in compliance with federal securities laws.

You should always check with your state securities regulator to see if they have more information about the company and the people behind it. Be sure to ask whether your state regulator has cleared the offering for sale in your state. You can get the address and telephone number for your state securities regulator by calling the North American Securities Administrators Association at (202) 737-0900 or by visiting its website. You’ll also find this information in the state government section of your local phone book.

Rule 504

Rule 504 of Regulation D provides an exemption from the registration requirements of the federal securities laws for some companies when they offer and sell up to $1,000,000 of their securities in any 12-month period.

A company can use this exemption so long as it is not a blank check company and does not have to file reports under the Securities Exchange Act of 1934. Also, the exemption generally does not allow companies to solicit or advertise their securities to the public, and purchasers receive “restricted” securities, meaning that they may not sell the securities without registration or an applicable exemption.

Rule 504 does allow companies to sell securities that are not restricted, if one of the following circumstances is met:

  • The company 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 company registers and sells the offering in a state that requires registration and disclosure delivery and also sells in a state without those requirements, so long as the company delivers the disclosure documents required by the state where the company registered the offering to all purchasers (including those in the state that has no such requirements); or
  • The company sells exclusively according to state law exemptions that permit general solicitation and advertising, so long as the company sells only to “accredited investors.”

Even if a company makes a private sale where there are no specific disclosure delivery requirements, a company should take care to provide sufficient information to investors to avoid violating the anti fraud provisions of the securities laws. This means that any information a company provides to investors must be free from false or misleading statements. Similarly, a company should not exclude any information if the omission makes what is provided to investors false or misleading.

While companies using the Rule 504 exemption do not have to register their securities and usually do not have to file reports with the SEC, they must file what is known as a “Form D” after they first sell their securities. Form D is a brief notice that includes the names and addresses of the company’s owners and stock promoters, but contains little other information about the company.

Rule 505

Rule 505 of Regulation D allows some companies offering their securities to have those securities exempted from the registration requirements of the federal securities laws.

To qualify for this exemption, a company:

  • Can only offer and sell up to $5 million of its securities in any 12-month period;
  • 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;
  • Must inform purchasers that they receive “restricted” securities, meaning that the securities cannot be sold for at least a year without registering them; and
  • Cannot use general solicitation or advertising to sell the securities.

Rule 505 allows companies to decide what information to give to accredited investors, so long as it does not violate the antifraud prohibitions of the federal securities laws. But companies must give non-accredited investors disclosure documents that generally are the same as those used in registered offerings. If a company provides information to accredited investors, it must make this information available to non-accredited investors as well. The company 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; and
  • 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.

While companies using the Rule 505 exemption do not have to register their securities and usually do not have to file reports with the SEC, they must file what is known as a “Form D” after they first sell their securities. Form D is a brief notice that includes the names and addresses of the company’s owners and stock promoters, but contains little other information about the company.

Rule 506

Rule 506 of Regulation D is considered a “safe harbor” for the private offering exemption of Section 4(2) of the Securities Act. Companies using the Rule 506 exemption can raise an unlimited amount of money.

A company can be assured it is within the Section 4(2) exemption by satisfying the following standards:

  • The company cannot use general solicitation or advertising to market the securities;
  • The company may sell its securities to an unlimited number of “accredited investors” and up to 35 other purchases. Unlike Rule 505, all non-accredited 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;
  • Companies must decide what information to give to accredited investors, so long as it does not violate the antifraud prohibitions of the federal securities laws. But companies must give non-accredited investors disclosure documents that are generally the same as those used in registered offerings. If a company provides information to accredited investors, it must make this information available to non-accredited investors as well;
  • The company must be available to answer questions by prospective purchasers;
  • Financial statement requirements are the same as for Rule 505; and
  • Purchasers receive “restricted” securities, meaning that the securities cannot be sold for at least a year without registering them.

While companies using the Rule 506 exemption do not have to register their securities and usually do not have to file reports with the SEC, they must file what is known as a “Form D” after they first sell their securities. Form D is a brief notice that includes the names and addresses of the company’s owners and stock promoters, but contains little other information about the company.

Warrants

A Warrant, also called a Stock Warrant, is a certificate that entitles the holder (the person to whom the Warrant is issued) to purchase a certain number of shares of common stock, at a stated price, for a specified period of time. Warrants are the equity kicker which investors require to target their expected return Without the warrant, the return would be equal to the interest rate or dividend.

The amount of Warrants offered represents how much equity dilution you are taking, or how much equity you are giving up. The amount of equity you give up is a function of the investor’s expected return, which takes into account the dividend or interest rate, whether the dividend or interest is paid currently or accrued, and the value of the common equity at the end of the investment horizon.

Exercise Price

The exercise price of a warrant is the price at which the warrant holder pays for the common stock. In a private transaction, the exercise price warrant can be set at any price, and is typically set at $0.01 per share. A higher exercise price just means that the investor will require more shares to achieve the targeted return.

Cashless Exercise

A cashless exercise feature is a way to convert the warrant shares into common equity without writing a check. For example, if you have 5,000 penny warrants and the market value of the common equity is $5.00 per share. You would use 10 shares as currency to purchase your 5,000 shares at $0.01 per share, or $50.00. Your net proceeds would then be $24,950, or (5,000 – 10) x $5.00.

Put/Call Feature

Warrants will typically come with a Put/Call feature. The Put feature allows the warrant holder to monetize his investment by forcing the issuer to redeem the warrant. The Call feature allows the issuer to buy the warrant shares away from the warrant holder, which can be useful if the issuer believes that the value of the equity will be greater than it is at the time the Call is exercised.

The right to Put the warrant shares back to the issuer typically becomes available to the warrant holder any time after five years. The Call rights of the issuer will typically become available 12 months later, or after year six in this example if the Call is available after year five.

The Put or Call of a warrant is completed at the market price, which is tricky to say the least for a private company where the common equity is not traded. The Warrant Agreement should have language that either 1) predefines a formula to determine the value of the equity, or 2) provides for a process to determine the value of the equity.

Predefining the value of the warrant is straight forward, the simplest is assigning a multiple to the then-current EBITDA to arrive at an enterprise value. From the enterprise value subtract all debt and preferred stock, and add unrestricted cash to arrive at the equity value. The “exit multiple” is usually the “going-in multiple”. The downside of this methodology is that someone is potentially leaving money on the table; i.e. the company may be worth more or less than the value suggested by the formula.

Providing for a process to value the equity comes down to the hiring of a valuation firm to determine the value of the equity. In the event one of the parties disagrees with the value determined by the valuation firm, the warrant agreement should provide for a resolution that will usually allow for the dissenting party to hire a second valuation firm. If there is still disagreement, then the two valuation firms will hire a third firm with a final value determined by taking the average of all three valuations.

C-Corp

Sole proprietorships and partnerships are not separate legal entities and are considered to be the same as the owner(s). Corporations are separate legal entities that are owned by shareholders. The C corporation is a standard corporation, and is a very common business structure. In order to form a corporation, certain documents must be filed with the state and the state filing fees be paid. These documents are usually called the articles of incorporation or a certificate of incorporation.

The primary advantage of incorporating a business is the limited liability the corporate entity affords its shareholders. Typically, shareholders are not personally liable for the debts and obligations of the corporation; thus, creditors will not come knocking at the door of a shareholder to pay debts owed by the corporation, unless the shareholder(s) has guaranteed the debt. In a partnership or sole proprietorship the owner’s personal assets may be used to pay debts of the business.

Other advantages of incorporating a business include:

  • Incorporating may establish credibility for a new business with potential customers, employees, vendors, and partners;
  • The ownership of a corporation is easily transferable through the sale of stock;
  • Corporations have unlimited life extending beyond the illness or death of owners;
  • Certain expenses, such as insurance, travel, and qualified retirement plans are typically tax-deductible; and
  • Additional capital can be easily raised through the sale of stock (shares) in a corporation.

The main disadvantage to forming a C corporation is often considered to be the potential for double taxation. C corporations are considered separately taxable entities by the Internal Revenue Service (IRS), and taxes must be paid on the profits of the corporation. If a corporation then distributes its profits to shareholders in the form of dividends, the dividend income is also taxed as regular income to the shareholders. In this case, the corporation’s profits are taxed twice, first as income to the corporation and second as dividend income to the shareholder, creating the “double-tax.”

However, not all income a shareholder receives from a C corporation is subject to the double tax. For example, if the shareholder is also an employee of the corporation, that shareholder will most likely receive a salary payment from the corporation. As long as the salary paid to the shareholder is considered by the IRS to be reasonable (or similar to the market salary rates for that position), it is treated as a business expense and is deductible to the corporation. This helps reduce the amount of taxable income the corporation has.

In order to eliminate the possibility of double taxation, C corporations can elect to be taxed as an S corporation with the IRS. With S corporations, the profits and losses of the corporation are reported on the individual tax returns of the shareholders, and any necessary tax is paid at the individual level. This taxation method is called “pass-through” taxation, since the profit or loss of the corporation is passed through to the shareholders.

Other aspects of C corporations that can be considered disadvantages include:

  • Corporations are more expensive to form than sole proprietorships and partnerships.
  • There are more corporate formalities, such as annual paperwork, and more state and federal rules and regulations, than with sole proprietorships and general partnerships.

When evaluating whether the corporate structure is right for your particular business, it is advisable to first determine the goals of your business, and then to assess the advantages and potential disadvantages of the different business structures in relation to those goals. You may also wish to seek the advice of an attorney or accountant.

Forming a corporation is inexpensive and easy. Get an instant quote to incorporate your business.

LLC

The limited liability company (LLC) is a distinct business entity that combines the corporate advantage of limited liability protection with “pass-through” taxation, the method of taxation afforded to both general partnerships and S corporations.

Like corporations, LLCs come into existence after making a filing with the appropriate state body, typically the Secretary of State, and paying the necessary state filing fees. There are several online services that will manage the process for you at very reasonable prices.

In terms of taxation, the LLC’s income is not taxed at the entity level as is that of a C corporation. While the LLC does complete a tax return, the income or loss of the LLC as shown on this return is passed through the LLC and is reported on the owners’ individual tax returns. The LLC’s owners then pay taxes on the LLC’s profits at the individual tax level. LLCs can elect with the Internal Revenue Service (IRS) to be taxed like a C corporation, but this is not overly common.

Other advantages of LLCs include:

  • Members are typically not held personally responsible for the debts and liabilities of the company.
  • Forming an LLC can help establish credibility for a new business with potential customers, employees, vendors, and partners.
  • There are generally no restrictions on the number of members allowed.
  • LLCs have flexibility in structuring the management of the company.
  • LLCs do not require as much annual paperwork or have as many formalities as corporations and S corporations.

Some disadvantages of LLCs include:

  • LLCs are more expensive to form than sole proprietorships and general partnerships.
  • LLCs face more ongoing requirements, such as state annual report filings, than sole proprietorships and general partnerships.
  • Ownership is typically harder to transfer than with a corporation.
  • Because the LLC is a newer business structure, there is not as much case law to rely on for determining precedent.

Regarding the ownership of an LLC, the owners are called members. Members are analogous to shareholders in a corporation or partners in a partnership, depending on how the LLC is structured. Members will more closely resemble shareholders if the LLC utilizes a manager or managers because the members will not directly participate in the management of the LLC. If the LLC does not utilize managers, then the members will more closely resemble partners because they will have a direct say in the decision-making of the company. An LLC must specify at the time of formation whether it will be managed by members or managers.

A member’s ownership of an LLC is represented by “membership interest,” just like a partner’s interest in a partnership or a shareholder’s shares of stock in a corporation.

When evaluating whether the LLC is the right business structure for your particular business, it is advisable to first determine the goals of your business, and then to assess the advantages and potential disadvantages of the different business structures in relation to those goals. You may also wish to seek the advice of an attorney or accountant.