Volume 18, Number 2
March 2001

Business and Commercial Law

Outside Bucks

A Practical Guide to Raising Capital for a Business

By William W. Barker

Of primary importance is the need to keep your client’s financing activities private in nature, whether they are between your client and investors or between a placement agent and investors.

Your client will at some point probably need some type of offering document, whether or not it is required under the securities laws. A private placement memorandum (PPM) gives investors the same general type of information that registration would provide, which would include a description of your:

• Market.

• Business, products or services, and properties.

• Material legal proceedings.

• Capitalization and securities being sold.

• Management and principal shareholders.

• Material risks.

• Selected financial data and financial statements.

• Some type of discussion and analysis of the financial statement and operations.

Typical documents in a private financing may include:

• Term sheet.

• Business plan or PPM.

• Board of director resolutions.

• Stock purchase agreement.

• Certificate of designations/ amended and restated articles of incorporation.

• Investors’ rights agreement.

• Co-sale agreement.

• Warrant.

In addition to documenting the business terms, in all private placements each purchaser must represent that he or she is acquiring the securities for his or her own account and not on behalf of others; acknowledge that the securities received have not been registered and, therefore, are "restricted securities"; and agree not to dispose of them in the absence of registration or an available exemption. In offerings premised on access to or receipt of financial and other information about the issuer, the purchaser also represents that he or she had access to or received this information, and is sufficiently sophisticated to understand the information.

Basic representations and warranties typically requested by investors include status of your client as a legal business entity; proper authorization of the transaction and issuance of shares; assurances that your client owns the necessary assets or technology to operate its business; disclosure of material contacts; and that there are no undisclosed material liabilities or litigation. Of interest to your client are representations and warranties establishing proper corporate and board of director authorization of the transaction; receipt by the investor of information regarding the issuer; the factual basis for the exemption relied on; the investor’s understanding that the shares he or she receives are "restricted securities"; and the investor’s intention to hold the securities until eligible for resale.

You and your client have an obligation to conduct due diligence. Basic due-diligence items are likely to include charter documents; board of director minutes, resolutions, etc.; prior financing documents including any registration-rights agreement; agreements with affiliates (voting agreements, rights of first refusal, etc.); material contracts (leases, contracts with certain customers or suppliers, etc.); and stock option and other agreements potentially involving issuance of additional shares.

While the deal points are being worked out, think about which exemptions from the registration requirements of the federal securities laws are available to your client. If all conditions of the exemptions are not met, the sale will not be exempt. Following are the most common federal exemptions.

Section 4(2). Section 4(2) of the Securities Act exempts from registration "transactions by an issuer not involving any public offering." To qualify for this exemption, the purchasers of the securities must have sufficient knowledge and experience in finance and business matters to evaluate the risks and merits of the investment, or be able to bear the economic risk of investment; have access to the type of information normally provided in a prospectus; and agree not to resell or distribute the securities to the public. No form of public solicitation or general advertising may be used in connection with the offering.

Regulation A. Section 3(b) of the Securities Act authorizes the SEC to exempt from registration securities offerings based purely on their small size. Regulation A was created to exempt public offerings not exceeding $5 million in any 12-month period. If you rely on this exemption, your client must file an offering statement with the SEC. The offering statement consists of a notification, offering circular, and exhibits. 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.

Regulation D. The three exemptions from Securities Act registration under Regulation D are Rule 504, Rule 505, and Rule 506.

Rule 504 provides an exemption for the offer and sale of up to $1 million of securities in a 12-month period. Your client may use this exemption if it is not a blank-check company and is not subject to Exchange Act reporting requirements. Your client can use this exemption for a public offering of its securities, and investors will receive freely tradable securities under the following circumstances:

• Your client 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.

• Your client registers and sells in a state that requires registration and disclosure delivery and also sells in a state without those requirements, provided your client delivers the disclosure documents mandated by the state in which your client registered to all purchasers.

• Your client sells exclusively according to state-law exemptions that permit general solicitation and advertising, provided your client sells only to "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, your client 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, your client must inform investors that they may not sell for at least one year without registering the transaction. Your client may not use general solicitation or advertising to sell the securities.

As discussed above, Rule 506 is a "safe harbor" for the private offering exemption. If the following standards are followed, your client can be assured that it is within the Section 4(2) exemption:

• Your client can raise an unlimited amount of capital.

• Your client cannot use general solicitation or advertising to market the securities.

• Your client 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 have sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment;

• Your client decides what information to give to accredited investors, as long as he or she does not violate the antifraud prohibitions. But your client must give nonaccredited investors disclosure documents that generally are the same as those used in registered offerings. If you provide information to accredited investors, your client must make this information available to the nonaccredited investors as well.

• Your client must be available to answer questions by prospective purchasers.

• Financial statement requirements are the same as for Rule 505.

• Purchasers receive "restricted" securities.

Section 4(6). This provision 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 506, this exemption does not permit any form of advertising or public solicitation.

Rule 701. This provision exempts sales of securities if made to compensate employees according to a written plan of compensation. It is available only to private companies that are not subject to Exchange Act reporting requirements. Your client can sell at least $1 million of securities under Rule 701, no matter how small the company.

William W. Barker is of counsel at Nixon Peabody LLP in Washington, D.C.

- This article is an abridged and edited version of one that originally appeared on page 15 of Business Law Today, July/August 2000 (9:6).

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