Private Placements: Reg D Offerings

Raising capital is critical to your company’s long-term success. As you enter the later stages of growth, you may consider issuing securities under a private placement to secure additional funding. A private placement can be either a stepping stone to an IPO or another liquidation opportunity. For an overview of other IPO alternatives, please see our article Alternatives to an IPO. This article contains information about what a private placement is, what is required when issuing a private placement, and the advantages and disadvantages of pursuing a private placement.

What is a Private Placement?

A private placement is an offering of either debt or equity securities to private investors. In an IPO, a company offers securities to a wide variety of investors, but a company will issue securities to only a few interested parties in a private placement. Private placements are advantageous because a company can sell securities to a limited number of trusted parties, and the company does not need to register the securities with the SEC.

Under the Securities Act of 1933, “any offer or sale of a security must either be registered with the SEC or meet an exemption.” Regulation D (Reg D) is one such exemption and outlines the conditions that allow a company to issue either debt or equity securities without registering them with the SEC. Rules 504 and 506 within Reg D are most commonly applied to exempt securities when issuing private offerings.

Reg D: Rule 504

A company may sell up to $5 million of securities to accredited investors¹ in a twelve-month period if the company is not a blank check company² and is not required to file reports under the Securities Exchange Act of 1934. The securities received by the investor are generally classified as “restricted stock.” This means that the securities may not be publicly sold until the securities are either subsequently registered with the SEC or qualify for an exemption. Typically, restricted stocks include a holding period requirement of six months to one year.

States often interpret Rule 504 differently than it is written at the federal level and have varying disclosure and registration requirements to meet Rule 504. This becomes an issue when selling securities under a private placement in multiple states. Your company should double check state requirements before proceeding to issue securities under the Rule 504 exemption if offering securities in multiple states.

Reg D: Rule 506

A company may sell an unlimited amount of securities to accredited investors and up to 35 other purchasers. The 35 other purchasers must be financially sophisticated, meaning that they have sufficient knowledge and experience in financial and business matters to make an informed decision about the investment. The securities received by investors under this rule are also restricted.

The JOBS Act of 2012 amended Rule 506 to allow a company to advertise its securities to investors. However, if the company chooses to advertise its securities, the company may only sell them to accredited investors. Though companies often meet the $5 million threshold of Rule 504, most companies use Rule 506 when issuing securities because most states recognize this rule as it is written at the federal level.

What is Required?

Though the company does not need to register its securities with the SEC, the SEC requires that a company must (a) provide enough information to investors to meet antifraud provisions and (b) notify the SEC of the private placement by submitting Form D. A company is expected to use applicable documents in facilitating the sale of securities with investors.

Antifraud Provisions

A company submitting Form D has more discretion about what it discloses to potential investors than a company filing for an IPO and is not tied to the stringent disclosure requirements of a public offering. To protect investors, antifraud provisions require a company to provide accurate information to the investor and to not exclude material information, if the exclusion of that information would cause the company’s financial statements to be misleading. The company should also be available to answer any questions about its securities. A company must provide the same information to non-accredited investors that it provides to accredited investors and must provide non-accredited investors additional information, such as financial statements from prior years and other operational activity.

Form D

When issuing a private placement, the company must notify the SEC of the transaction by issuing Form D within 15 days of selling the securities. Form D includes basic information about the company, the names and addresses of executive officers and directors, the exemptions claimed in the offering (e.g., Rule 504, Rule 506), the type of securities offered, the size of the offering, and the date of the first sale.

Other Documents

A company will use other documents to facilitate the private placement offering. A Private Placement Memorandum (PPM) meets the antifraud provisions mentioned above by outlining the details of the offering, such as the purchase price, number of shares being sold, maturity date, expected rate of return, and risk factors. This document also outlines the investors’ risk of losses and states the legal liabilities associated with the offering.

A Subscription Agreement is a document signed by the investor, indicating that the investor has reviewed the offering details, including the risk of the investment, and agrees to invest in the securities. A Promissory Note Agreement rather than a Subscription Agreement is used to secure the loan agreement between the investor and the company in a debt offering.

Why Issue a Private Placement?

A company may or may not wish to issue a private placement. Your company should evaluate its long-term business strategies and goals in addition to the following advantages and disadvantages of issuing a private placement.

Advantages

Fewer Regulatory Burdens: A private placement typically takes less time, money, and effort than an IPO. There are fewer disclosure and filing requirements when issuing securities through a private placement rather than issuing securities to the public. Additionally, a company can better prepare for the public market by buying time with a private placement. The short-term and profit-driven market pressures of the public marketplace a burden on the company to meet earnings goals, often at the sacrifice of a long-term vision. A broader discussion of the advantages and disadvantages of an IPO is found in our article IPO Advantages and Disadvantages.

‍Flexibility: Private placements allow a company to have greater control over its investor base. Investors in a private placement often include individuals or small companies interested in the company’s long-term success. They take this long-term view partly because they may not see returns for as long as ten or fifteen years down the road, depending on how close the company is to a liquidation opportunity.

Because companies issuing a private placement are only working with a handful of investors, they have more structural flexibility. For example, a company may issue equity, debt, or convertible securities, depending on the company’s needs at the time. The amount of money that can be raised in a private placement is also flexible. A company can raise either $100k or $100m, assuming that the company can find interested investors.

Disadvantages

Expensive Capital: Investors require a deep discount when buying private securities. In addition to receiving restricted stock with a mandatory holding period, investors in private securities can only liquidate their investments by registering their securities and selling them, waiting for the company to go through an IPO, or finding other interested private investors. To compensate investors, a company will either provide a discount on private securities or negotiate other terms, such as giving up a seat on its board of directors.

‍Limited Market Capacity: Because private placements are inherently risky, and the majority of investors must qualify as accredited investors, the investment pool of interested investors is small when compared to public markets. Thus, finding investors that have adequate financial knowledge, sufficient risk tolerance, and substantial interest in a potentially long-term investment may be difficult. As a company continues to expand its business, it will eventually outgrow private placement funding as well. At some point, the amount of funds that can be raised in a private placement is capped. For example, a private offering above $1b is likely not feasible, while public offerings commonly raise proceeds in excess of $1b.

Private Placements in Practice

Private placements and other private offerings have been on the rise as private companies delay entrance into the public market. This delay is possible, in part, because of the passing of the JOBS Act in 2012, which allows more people to invest in a company before the company must register with the SEC. Preferences of public investors also have contributed to the delay in going public, especially in the tech industry. The public is becoming more interested in investing in larger, more established tech companies than in small startup tech companies.

Airbnb is an example of a large tech company that has reached a unicorn status³ but has remained private. Airbnb was founded 10 years ago in 2008 and is still a privately-held company as of 2018. To financially sustain its operations, Airbnb secured $1.5 billion through the issuance of private securities in 2015—one of the largest private offerings to date. This round of funding indicates how large Airbnb has become, yet Airbnb continues to stay private as it waits for the right time to enter the market. Investors believe that Airbnb will go public as early as 2019.

Conclusion

As your company enters the late stages of funding, you should consider a private placement as a potential way to secure additional funding. Depending on your company’s circumstances and current market conditions, choosing to issue securities through a private placement may be the right move for you as you wait for the right time to go public or for another liquidation opportunity.

Resources Consulted

• Securities and Exchange Commission: Investor Bulletin: Private Placements Under Regulation D
• Trevir Nath. Nasdaq: Why Unicorns Like Uber and Airbnb Aren’t Going Public
• Telis Demos. The Wall Street Journal: Airbnb Raises $1.5 Billion in One of Largest Private Placements
• Begum Erdogan, Rishi Kant, Allen Miller, and Kara Sprague. McKinsey&Company : Grow fast or die Slow: Why unicorns are staying private
• FINRA: Private Placements, Explained
• inc.com: Private Placement of Securities
• PPM Fast: Regulation D Basics
• nibusinessinfo.co.uk: Advantages and disadvantages of raising finance through private placements