California Private Placements Attorneys
Are you raising capital for your business through a private placement?
There are a number of State and federal securities laws pertaining to private placements that you should be aware of. Before you get started, contact us. We can help.
Specifics on Common California and Federal Exemptions and California Registration
This article will address the common methods used for California and federal private placement investment offerings, although some of what is presented regarding the 25102(f) exemption, the Rule 506 exemption and the Rule 504/SCOR exemptions apply to other states as well. The offering methods covered here are the:
An "intrastate" offering is limited to one state and is not subject to federal securities laws. An intrastate offering requires that all the investors be in that state, the company be an entity formed in that state and having its principal place of business in that state, and the company must have and expect it will have 80% of its assets, expenditures and sources of revenue in that state. (In addition, investments in an intrastate offering may not be sold or transferred to others outside the state for a minimum of nine months.)
California intrastate offerings commonly use the 25102(f) exemption, the 25102(n) exemption, and qualification by permit. (The 25102(n) exemption can also be used for investors in states that have adopted the Model Accredited Investor Act -- approximately 30 states have done so -- if the offering is limited to $5 million or less and all investors are accredited.)
The most common federal exemption used for private placements is the Rule 506 exemption (which is part of Regulation D). To a lesser extent, the Rule 504 exemption (also a part of Regulation D) is used, generally in conjunction with state SCOR exemptions.
On all securities offerings, the general rule is everything must be disclosed that a potential investor would reasonably want to know before making the investment decision. Where there is any doubt, it is always better to disclose. In addition, some exemptions (such as the Rule 506 exemption when any non-accredited investors are involved) have specific financial and non-financial disclosure requirements. The disclosures need to be in writing and usually take the form of a private placement memorandum (PPM), also known by several other names, including an offering circular, prospectus, etc. (The title of it is not important, but the content is crucial.)
The California 25102(f) exemption and the Rule 506 exemption prohibit "public" advertising but allow general communications that invite potential investors to complete an investor questionnaire and allow communications with specifics about the offering to be sent to targeted recipients that the company reasonably believes meet the investor suitability standards. For more information on this, see the article Overview of Marketing, Promoting and Advertising Securities Offerings
The California 25102(f) exemption is the easiest one to use. It allows an unlimited amount of money to be raised. There may be an unlimited number of accredited investors (defined below in the section regarding Rule 506) and up to 35 non-accredited purchasers, though the latter must be "sophisticated" or have a substantial pre-existing relationship with a principal of the company, as discussed in more detail below. No public advertising of specifics regarding the offering is allowed (meaning no stock price, rate of return, percentage of ownership that will be provided per dollar amount invested, performance of past offerings, etc.)
On the other hand, a company can provide general information about what it does and its need for money and/or in general the type of investments it may make available -- and invite potential investors to submit an investor questionnaire. Those who meet the investor suitability requirements may then be given specifics about the offering, usually in the form of a private placement memorandum or other disclosure document. In addition, a company may send communications with specifics about the offering to targeted potential investors that the company reasonably believes meet the suitability standards (although if there is any doubt, the investor-questionnaire approach should be used instead).
The substantial pre-existing relationship test means that the investor must have a preexisting personal or business relationship with the company or one or more of its officers, directors or controlling persons of a nature and duration such as would enable a reasonably prudent purchaser to be aware of the character, business acumen and general business and financial circumstances of the company or the person with whom such a relationship exists. This test is often used to allow "friends and family" investors, although it can apply to suppliers, customers and business colleagues as well.
The "sophistication" test means that the investor, by reason of the investor's own substantial business or financial experience -– or that of the investor’s professional advisors (who are unaffiliated with and who are not compensated by the company or any affiliate or selling agent of the Company, directly or indirectly) -– has the capacity to protect investor’s interests in connection with the transaction. It is obviously a somewhat subjective standard and care must be exercised in using it.
Each investor must sign a provision (usually part of the subscription agreement) stating that he/she/it is buying for his/her/its own account and not with an (immediate) intent to re-sell the investment to others.
Within 15 days of the offeror receiving the first investor check, a 25102(f) form needs to be filed with the State of California.
One California exception to the general rule that a specific offering cannot be publicly advertised is the 25102(n) exemption. This allows a allows a brief "tombstone" advertisement for the offering. Generally a company must be a California entity to use this exemption. In addition, the advertisement is basically limited to the following information: The name of the company, its location and a brief description of its business; the suitability standards for investors; the type of securities being offered and the price. (There are specific rules regarding this.) A potential investor must complete an investor questionnaire and can only be given the disclosure documents and an opportunity to invest if the investor meets the requirements.
There is no limit on the number of investors.
If the 25102(n) offering is limited to California investors only, there is no limit on the size of the offering. Otherwise, the offering is limited to a maximum of $5 million (there must be six months between offerings) and exemption requirements for other state’s laws must be complied with. Many states have adopted the Model Accredited Investor Act, which is extremely similar to the 25102(f) exemption. Although federal law limits a 25102(n) offering to $5 million or less if it involves investors outside of California, this approach can be used to broaden the base of potential investors.
If the 25102(n) offering is limited to California residents, potential investors must meet the federal "accredited investor" standard or in the alternative, excluding the investor’s home and cars, have either (i) at least $250,000 in net worth and at least $100,000 in income last year and expected this year or (ii) at least $500,000 net worth. (Somewhat strangely, if the offeror is a limited liability company, all investors must be accredited.)
Filings must be made with the State of California at both the beginning and the end of the offer; the offer may not be open longer than six months.
If these approach may restrict the potential investors too much to make the offering successful, full advertising is allowed if the offering is restricted to California and the offering goes through a qualification by permit process.
The default is that California Commissioner of Corporation reviews the "fairness" of the offering and can impose additional restrictions on it. Still, the Commissioner cannot review the offering for "fairness" if if the offering is limited to $5 million or less, the company has annual revenues of less than $12.5 million, and some relatively low investor suitability standards are imposed (discussed below). The process still requires completing a California application for qualification by permit, among other things, and approval by the Commissioner may take approximately six weeks. Still, once approval is granted full public advertising is allowing, though the offering must be limited to California residents. (Advertisements do have to be filed with the California Commissioner of Corporations at least three days before they are used.)
To avoid a fairness review, the minimum investment standards (substantially less than that for a 25102(n) offering) for a California qualification by permit offering are as follows: The investor (including any spouse) must have, exclusive of homes, home furnishings and cars, either: (1) a minimum net worth of at least $75,000 and minimum gross income of $50,000 during the last tax year and (based on a good faith estimate) minimum gross income of $50,000 during the current tax year, or (2) in the alternative, a minimum net worth of $150,000. In either case, the investment cannot exceed 10 percent of the net worth of the investor.
There is no limit on the number of investors. The application requires answering a lengthy series of questions and providing all offering documents. The State must issue a permit before the offering can begin; review by the State takes 30-60 days, possibly more.
The federal Rule 506 exemption is similar to the California 25102(f) exemption in that it allows an unlimited amount of money to be raised, it allows an unlimited number of accredited investors and up to 35 non-accredited investors, and it is subject to basically the same restrictions on public advertising. The advantage is that it allows investors from multiple states, though the disadvantage is that it does not allow the "pre-existing substantial relationship" class of investors that the 25102(f) exemption does. Instead, all non-accredited investors must be "sophisticated", which is defined in the same way as for the 25102(f) sophisticated category: The investor must, based on his/her/its education, career, investment experience, etc. be capable of making intelligent investment decisions -- or must have a fully independent investment advisor who can do that.
Basically, an accredited investor is any of the following:
Any organization not formed for the specific purpose of acquiring the securities offered with total assets in excess of $5,000,000;
Any director, executive officer, or general partner of the issuer of the securities being offered or sold, or any director, executive officer, or general partner of a general partner of that issuer;
Any natural person whose individual net worth, or joint net worth with that person’s spouse, at the time of his purchase exceeds $1,000,000;
Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year.
As of the summer of 2010, equity in the principal residence must be excluded from the calculation of net worth.
Specific disclosure requirements imposed if any non-accredited investors are involved (including at least an audited balance sheet unless the company is a startup).
One major advantage of using the Rule 506 exemption is that no state can require a review of the merits of the offering (and possibly stop the offering). The most a state can do is require that a short "notice" filing be made and charge some relatively minor fees. Having said that, approximately a half-dozen states also (depending on the offering) require the offeror to also register as a broker in advance.
Although widely criticized for its stance, the SEC has stated that, with offerings that must comply with federal law, if there is no pre-existing relationship between the offeror and the potential investor, the offeror should wait 30 to 45 days after receiving the questionnaire responses before providing any specifics about an offer.
With a Rule 506 exemption, Form D must be filed with the SEC at the beginning (within 15 days of receipt of the first investor check) and end of the offer, and a "notice" filing made with each state that requires it within 15 days of receipt of the first check from an investor residing in that state.
If the offering will be for $1 million or less, one option that allows advertising is federal Rule 504 exemption combined with the SCOR (Small Corporate Offering Registration) exemption that most states have adopted.
Most states have agreed to regional coordination. The country is divided into five regions; a single state is designated as the reviewer for all participating states in that region. Form U-7 must be used and approval for the offering must be given in advance. On the other hand, there can be an unlimited number of investors, there are no suitability requirements for investors and full public advertising is allowed.
One drawback is that California does not participate in the regional review program. In other words, even if the lead state for the Western region gives approval, California requires that the offering go through its qualification by permit process (described above).