Small businesses seem to always need money, but sometimes getting a business loan just isn’t possible. An alternative might be to use a private placement, a process for selling securities without going public or registering the sale. Your small business can use this type of funding under special Securities and Exchange Commission (SEC) regulations.
What Is a Private Placement?
The SEC requires new offerings of securities to be registered to protect investors by giving them as much information as possible, but it also offers an alternative to registration called a private placement. A private placement is a securities offering that is exempt from registration with the SEC.
- Alternate name: Unregistered offering (but private placements are just one kind of unregistered offering)
Securities in a private placement include stocks, bonds, and membership interests in limited partnerships or limited liability companies (LLCs). This type of securities offering isn’t made to the public, like an initial public offering (IPO).
SEC Regulation D sets out the requirements for the private placement exemption under Rule 506(b) of the Securities and Exchange Act of 1933. One major type of private placement exemption uses SEC Rule 506(b). It’s considered a safe harbor, meaning that it protects your business from liability or penalty for your actions in connection with the private placement, as long as you meet the requirements of the law. If you sell securities without getting the exemption, you risk lawsuits from investors and penalties from the SEC.
Because private placements are unregistered, they are considered restricted securities. You must clearly state to buyers that the shares can’t be sold for at least six months or a year without being registered.
Rule 506(b) exempt offerings aren’t subject to state registration, but other exempt offerings may be.
How Does a Private Placement Work?
Let’s say your LLC wants to do a private placement offering memberships to potential investors, including friends and family. Rule 506(b) allows you to raise an unlimited amount of money and to sell securities to an unlimited number of accredited investors.
Complying With Private Placement Regulations
First, you must make sure you meet the requirements of Section 506(b):
- You can’t advertise or solicit to market your security offering, since that would create a public offering.
- You can’t sell to more than 35 non-accredited investors. An accredited investor is a “natural person” (not a bank, organization, or business) who has enough investment knowledge and experience to evaluate securities without all of the information provided by registered securities.
The requirements for accredited investors differ depending on which SEC Rule is being used, and they are based on the investor’s earned income or net worth. An accredited investor can also be an entity (a business, for example) in which all the equity owners are accredited investors.
Non-accredited investors in your private placement must receive the same disclosure information that’s given to investors in registered offerings. In addition, you should be available to answer questions from prospective non-accredited investors.
Preparing a Private Placement Memorandum and Subscription Agreement
You’ll need to create a private placement memorandum (PPM) announcing your offering and giving potential investors information about it. It should include:
- Information about your offering: type of offering (common stock or preferred stock, for example), total amount, initial share price, and when the sale will begin
- A discussion of risk factors
- Information about your company (basically, a business plan)
- Information about your company’s management, executive compensation, and any pending court cases the company is involved in
Along with the PPM, you must create a subscription agreement, which is basically a sales contract. The contract describes the share price, purchase procedure, and payment details. It also includes the state law that applies and a certification by the buyer that they have read the entire agreement.
You must vet all of your potential investors before you begin the offering, to make sure they are accredited.
You can use a sample investor questionnaire or include a qualification statement in the contract.
Filing an Exemption Notice
After you have begun to sell your securities, you must notify the SEC about this event using SEC Form D. This form must be filed with the SEC online within 15 days after the first sale of securities in the offering. Before you file, you’ll have to apply for access to the SEC’s Electronic Data Gathering, Analysis, and Retrieval (EDGAR) system and get an access code.
SEC filings are complicated, and you want to be sure everything is done correctly. Contact a securities attorney to walk you through the process. You’ll also need either a broker or financial depository (like a bank) to handle the funds transfers.
- Raising funds from private investors through a private placement can be a good alternative to registering securities sales or public offerings of securities.
- You must make sure your investors are accredited or know as much as possible about their investment.
- You will need to give potential investors details of the offering and you both must sign a subscription agreement (sales contract).
- Notify the SEC of your private placement exemption to make sure you have safe harbor protection against liability.