private placement

What Is A Private Placement?

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A Private Placement is a capital transaction between an issuer, the entity seeking to raise capital, and an investor, or group of investors. When discussing a private placement, its usually in the context of a private company raising capital; however, public companies will also seek to raise capital using a private placement. In the latter case, this type of transaction is known as a “PIPE,” which stands for private investment in a private entity.

Private placements fall under what is know as Regulation D, or Reg D of the Securities Act of 1933. Private placements are also sometimes called Reg D offering. Reg D is what provides for the registration exemption under the Securities Act requirement that any offer to sell securities must either: 1) be registered with the SEC, or 2) meet an exemption. The exemptions provided under Reg D are known as Rule 504, Rule 505 and Rule 506.

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Private Placement Market Opens Up With The JOBS Act

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Issuing a Private Placement might get a little easier for small businesses seeking to raise debt or equity using a Private Placement. One of the big changes is the proposed elimination of the prohibition on advertising and general solicitation.

Are you ready?

The JOBS Act Opens The Private Placement Market

The President recently signed the Jumpstart Our Business Startups Act (known as the “JOBS Act“) with broad bipartisan support. The JOBS Act removes restrictions on solicitation and advertising for companies seeking to raise …

Investment Funds – Structure and Mechanics Part II

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In the last video we ended with a slide that showed the tremendous leverage that is available on the General Partner’s capital.

Before we dig into the economic mechanics of an investment partnership, we need to understand a few concepts:

  • Carried Interest
  • Preferred Return
  • Waterfall

Carried Interest is defined as a share of any profits as long as i) all capital is returned to the investors; and ii) the investors receive their Preferred Return.

Preferred Return is the return on invested capital before the General Partner receives its carried interest.

The Waterfall defines the priority of the distribution of invested capital of an investment fund in general, and from the exit of each discrete investment in particular. The Waterfall is not just for an investment fund, or blind pool; its also applicable if you are raising money for a single asset transaction – such as a single real estate investment.

So, what does a waterfall look like, in other words, what does the priority of distribution look like?

Below is the “Executive Summary” version of a waterfall from one of our offering memorandum templates:

i.     return of 100% of invested capital;
ii.    the Preferred Return;
iii.  100% to the G.P. as a catch-up until the G.P. has received 20% of distributed profits; and
iv.  thereafter, 80% to the partners and 20% to the G.P.

Traditionally, the carried interest on investment funds is 20%

Also, note that the Partners do not receive their Preferred Return AND an 80% allocation of the profits; they receive 80% of the profits. The Preferred Return is the hurdle rate for the G.P.

For example, if the G.P. has been receiving its Carried Interest in the early years of the partnership, but the the partnership sustains some losses so that the Partners’ return is less than the Preferred Return, then the Partners can “Claw Back” some of the Carried Interest received by the G.P. until the Preferred Return is met.

Towards the end of the video in this post I walk through an example of a fund and show how the dollars flow. I also present the IRR for the fund, the Limited Partners, and the General Partners.

Get Professional With A Private Placement Memorandum Template

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Private placements are not just for multi-million dollar deals. Even if you are seeking raise $100,000 to acquire a franchise or a piece of investment real estate, you are still required to present prospective investors with a private placement memorandum, or PPM. The challenge is that PPMs can be expensive to have drafted. A good attorney will cost you $20,000 or more. A PPM consultant will cost $5,000 to $15,000 (and you should still have an attorney to review it). Unfortunately, these costs are either i) out of reach for many businesses and entrepreneurs, or ii) recognized as sunk money if their deal doesn’t close.

A great alternative for many business owners and entrepreneurs is to purchase a Private Placement Memorandum Template. A well-formulated private placement template will help guide the issuer through the process from the term sheet through the business description. Specifically, the template should help the issuer craft the memorandum so that the prospective investor can make an intelligent Go / No-Go decision. Of course the template can only go so far; the issuer must be totally transparent in presenting the business and opportunity – warts and all. There should be no commission of false statements or omission of facts that, had they been presented, would lead the reader to a different conclusion.

Aside from being required to be legally compliant with securities laws, a well-written PPM will present you and your company in a professional manner. Your private placement template should include the same things you would want to see if you were sitting in the seat of the prospective investor. Some of these sections include investor disclosures, a term sheet, risk section, business description, transaction description, capitalization, sources and uses of funds, financial presentation (including discussion and analysis), description of the securities being issued and a tax discussion.

So if you want to save some money and mitigate your risk of ending up with huge busted deal expenses, consider using a private placement memorandum template. Just make sure that its flexible enough to accommodate your transaction and that the template itself is set up to guide you through each section. Finally, regardless of where you purchase your PPM template, make sure that after you get your PPM drafted, have your attorney review it and provide comments.

Raising Capital For Your Business

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Whether your business is a start-up or a mature business, one of the most critical activities you’ll face is raising capital. One of the best, and often the most overlooked sources of capital are private investors. And while often times money is raised through friends and family, my view is to stick with accredited investors that are in the deal business each and every day. If you do tap friends and family for capital, make sure that the relationship  can handle a total loss scenario.

An intergal part of the capital raising process is your “prospectus,” which is different depending on where you go for your capital needs. If you are going to a bank, or a non-bank lender (such as an SBIC), you’ll want to have a crisp executive summary that provides the lender with information about your business and the use of funds. Some points that the executive summary should cover include a short history of the business, overview of the transaction (working capital, purchase new equipment, refinance existing debt, buyout of a partner), what products you sell, who your customers are (if applicable, think top ten customers and the last three years of sales for these customers), who your suppliers are (top five or ten suppliers and amounts purchased over the past three years), manufacturing process (as applicable), industry and competition (a SWOT analysis), sources and uses of funds, capital structured (pre and post financing), and summary of financial performance with applicable discussion and analysis.

If, on the other hand you are seeking to raise some type of junior capital, such as equity or subordinated debt, from private investors, you will need to have a private placement memorandum.

Think of the private placement memorandum as the executive summary on steroids. The private placement memorandum, or PPM, provides your prospective investors with the information that is needed to assess the trade-off between risk and return. You will need to articulate what the “deal” is; i.e. what type of security you are issuing, the terms, restrictions and covenants of the security. The PPM should also articulate the risks of the transaction, which includes risks inherent in the business, industry, potential conflicts of interest, risks specific to the security being issued, and corporate structure. The key to this risk section is to not sugar coat it and to not try to mitigate the risks in this section. Put yourself in the shoes of you prospective investor – what information would you wan to know?

Raising capital is not easy, but can be rewarding, aside from actually raising the money. Going through this process will require to think about and talk about your business in ways that you might not have had to in the past. And while you may think you have the best business or business idea (in the case of a start-up) in the world, when exposed to the the light of seeking capital, you will begin to see and think about your business in news ways.

Raising capital, particularly private capital, can take a long time. Depending on what type of relationships you have and how much initial work you do, expect to take six months or more to complete your offering. Even closing on a simple bank financing can take six to eight weeks from start to finish.

Raising capital can also be expensive. In the case of a traditional bank financing, your costs can often be rolled into your financing. Likewise with private placements, except for any placement fees you may pay, your costs can be paid or recouped out of the proceeds of your closing. The biggest risk, however, is the risk of bused deal expenses – your upfront expenses that get paid regardless of whether your transaction closes or not. As an example, your private placement memorandum can cost as much as $20,000 when prepared by an attorney, and bank financing expenses can include commitment fees, appraisal fees, and environmental assessment fees.

At the end of the day, raising capital is something that can be done. Like a lot of things in life, it takes know-how, persistence, and a little luck.

Accredited Investor

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Are you pitching your private placement to Accredited Investors? Under the Securities Act of 1933, a company that offers or sells its securities must register the securities with the SEC or find an exemption from the registration requirements. The Act provides companies with a number of exemptions. For some of the exemptions, such as rules 505 and 506 of Regulation D, a company may sell its securities to what are known as “accredited investors.”

The federal securities laws define the term accredited investor in Rule 501 of Regulation D as:

1. A bank, insurance company, registered investment company, business development company, or small business investment company;

2. 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 if the plan has total assets in excess of $5 million;

3. A charitable organization, corporation, or partnership with assets exceeding $5 million;

4. A director, executive officer, or general partner of the company selling the securities;

5. A business in which all the equity owners are accredited investors;

6. A natural person who has individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase;

7. 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

8. A trust with assets in excess of $5 million, not formed to acquire the securities offered, whose purchases a sophisticated person makes.

Using Warrants In Your Private Offering

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If you’re in the market raising junior capital through a private offering, you will need to understand how warrants are used in structuring your offering. If you are floating a Private Placement of preferred stock or subordinated debt, your investors will expect to have warrants attached to their security.

What is a warrant?

A warrant is a security that gives the warrant holder the right to purchase equity at a specific price, within a certain time frame. Without the warrants, the investor or lender would only receive the dividend yield or interest rate on his shares or loan, hardly compensating him for the risk of making the investment. This equity-kicker is what gets investors excited.

Warrants are usually expressed as a percentage of the “fully-diluted” common stock of the company, which then equates to a certain number of common equity shares.

Fully-diluted refers to the total number of shares that would be outstanding if all conversions take place; e.g. convertible securities, employee stock options, and warrants, including the warrants which are part of your offering.

Warrants will usually have a “nominal” exercise price, also known as “penny warrants”. In the context of a buyout where the majority of the equity capital is in the form of preferred, the common equity will only have a nominal value. In other situations, the common equity may be valued at a higher number in which case i) the warrants will have an exercise price at the market value of the common equity, or ii) the warrants will have a nominal price, but the number warrant shares will be less.

As you structure your transaction and write your Private Placement Memorandum, you should become familiar with some terms that you’ll need to include in your term sheet:

Anti-dilution rights protect the warrant holder from equity dilution from a subsequent issuance of shares at a price lower than what the investor originally paid.

A simple example – suppose an investor received warrants for 20% of the equity for a preferred investment $1 million. If the Issuer subsequently issued another $1 million of preferred with warrants for 30% of the equity, the first investor would be diluted from 20% equity to 14% equity if there were not any anti-dilution protection language.

There are a number of ways to address anti-dilution, but that discussion is beyond the scope of this article.

Demand and piggyback registration rights refer to the right of the warrant holder to register his warrant shares for public issuance. The difference between the two types of registration rights is that Demand registration allows the holder to initiate the registration of warrant shares for public issuance. Demand registration is usually reserved for majority warrant holders, or warrant holders who have a significant ownership. Piggyback registration means that the warrant holder may have his warrant shares registered along with another holder or the company if there is a registering of the company’s shares. Piggyback rights are for the benefit of minority investors, as only the majority investors will have Demand registration rights.

Tag-along rights give a shareholder the right to join in a transaction to sell his shares if another shareholder is selling his stake.

Preemptive rights give shareholders the right to purchase new securities being issued by the company prior to them being issued to new, outside investors. In the dilution example above, a preemptive right would have given the first investor the right to purchase a proportional amount of the new issuance to preserve their equity ownership.

Note: since there would be an anti-dilution provision in the shareholders agreement, the anti-dilution provision would require waiver by the shareholders to proceed with the new issuance.

A Put Option allows the warrant holder to “put” the warrant back to the company. When the warrant is put to the company, the company has an obligation to purchase the warrant back from the investor. It is a way for the investor to monetize the value of his equity stake. The price that the company pays for the warrant is the product of the equity value of the company and the percent of the fully-diluted equity represented by the warrant shares.

A Call Option is a way for the company to “call” in the claims on its common equity. A company may call its equity back from investors if it anticipates an increase in the value of its equity down the road. It is also a way for the company to consolidate ownership back to, say the sponsors of the transaction.

I had a situation once where an investor requested that we eliminate the Call Option. His rationale was that he wanted to ride the value and did not the equity value get called away from him.

There are no rules for the number of years for the investor to have its Put right, or the Issuer to have its Call right, except that typically the advantage is to the investor with the Put right occurring before the Call right. My experience is that Put/Call rights will usually occur in years 4/5 or 5/6.

The issue you will face will be determining the value of the equity if and when the Put or Call gets exercised (except if there is a sale of the company to an unrelated third party).

I have been in transactions where the equity value for the purposes of the warrant was negotiated upfront as the greater of i) a liquidity event (such as a sale) or ii) a formula.

For example, if the original transaction was valued at 5x EBITDA, then the valuation for the Put/Call was also 5x EBITDA. Keep in mind that the product of a multiple and EBITDA gets you to an Enterprise Value, which is not the same thing as the equity value. To get to equity value, you’ll need to subtract debt and add cash (unrestricted cash).

My experience is that if there is no predetermined formula, the value of the warrant is usually negotiated. The “fair market value as determined by a …” language is for when you can’t agree; however, you should always have this language even if you have a formula.

As the Issuer you may find that the formula is based on the just-ended fiscal year, but by the time the audit gets completed, there might have been a material adverse change in the business such that the agree-upon formula overstates the value of the equity. Conversely, if you are the investor, events subsequent to the audit may point to a significantly higher equity value than what would be indicated following a formula using the year-end numbers.

Warrants are just another tool that help you raise the capital you need. The trickiest part of the whole warrant conversation will be anti-protection. As the Issuer you will want to run through a variety of scenarios to make sure you understand how your value will be impacted when anti-dilution triggers kick in.

Why A Private Placement Memorandum

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Why would you need to draft a Private Placement Memorandum? Where do you go for capital if you run or own a private company? There are several sources of capital for privately held businesses. One is the capital generated internally by judiciously managing the company’s working capital. Another source is your local bank, which is the one the primary financing vehicles for private companies. And of course, there is always the owner’s pocket.

But where do you go if your capital needs outstrip what is available from a bank, especially if your company is in need of permanent capital to fund long term growth objectives, capitalize a start-up, or finance an acquisition? If you do not have the wherewithal to write checks yourself, you will need to raise outside capital.

Junior Capital
Junior capital is a term used to describe capital that sits below bank debt, and includes mezzanine, or subordinated, debt, and equity. Sources of junior capital include institutional investors, such as insurance companies, hedge funds, private equity funds, mezzanine funds and SBICs.

Individual Investors
Another source of junior capital is individual investors. This class of investor includes friends, family, and high net worth individuals. And if you are issuing securities to individual investors, you may be required by law to write and distribute a private placement memorandum to each of your potential investors.

Protect Yourself Against Securities Fraud Claims
Besides the compliance issues, there are two major reasons for preparing a Private Placement Memorandum. First is to give you cover against securities fraud claims. By writing and delivering a PPM, you are establishing a record of what has been communicated to the investors about the offering and the company. When issuing securities, state and federal law is most concerned with securities fraud issues. Anti-fraud requirements call for the issuer to not make any unture statements of a material fact, or to leave out a material fact, the absence of which would make any statements made misleading; i.e. the issuer must disclose all relevant and material facts of the issuance and the company. A well-prepared PPM will establish a record of the information presented to investors, and will provide a level of protection for the company and issuer against claims of securities fraud.

Professional Image
The other reason for writing a Private Placement Memorandum is that it presents a professional face to the issuance. The image presented to investors by presenting a document that is well-prepared is one of professionalism and competency. Approaching sophisticated investors with a poorly drafted offering document will scream “unprofessional”, “novice”, “don’t know what they’re doing” – the exact opposite of what you are trying to project.

There are many reasons to use a PPM. And now with the availability of PPM templates, the upfront costs of using a PPM are manageable.

Contents Of A Private Placement

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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.