In this case, the company raising money is owned by the protagonist of an upcoming motion picture, Princess Hialeah.
Princess Hialeah wants to make sure that all of her fundraisings complies with the applicable federal and state securities laws before offering or selling her securities to investors.
As her attorney, I explain to Princess Hialeah that the Securities and Exchange (SEC) Securities laws exist to ensure that potential investors are provided with accurate information so that they can make informed investment decisions. Hence, compliance with the SEC laws is in alignment with the spirituality of Princess Hialeah because companies are prohibited from making false or misleading statements in connection with the sale of securities, and will be liable for any violations.
As a Floridian, Princess Hialeah owns a Florida corporation that produces motion pictures. Because she would like to raise capital from investors, I explain to her that there are various forms of debt or equity financing to choose from such as an initial public offering (IPO), venture capital (VC), private placement, and business loans.
Princess Hialeah explains that her motion picture company is new, thus, I tell her that normally the VC and IPO form of financing are utilized by established companies with revenue in excess of $2 million and with a capital investment of $1 million or more. On that note, I mention that the best option may be the private placement memorandum (PPM) offer.
By utilizing the PPM to raise funds Princess Hialeah may avoid the disclosure requirements that apply to registered offerings, which are extensive, and include descriptions of the company’s current business operations, previous business performance, the use of funds, total number of issued shares, price per share, office and managers background, audited financial statements, risks, executive compensation, and the legal status of the company. A PPM offer is one where there is no public advertising about the offering. The only way the company communicates with the potential investor is private.
Thus, to avoid the registration requirements Princess Hialeah’s company may use one of a number of exemptions available under Regulation D (Reg D) of the Securities Act, as well as the exemption available under Title 111 of the Jumpstart Our Business Startups Act (JOBS Act). Princess Hialeah agrees that she wants to avoid registration because she wants to remain a private company while keeping her cost of raising capital efficient and low.
We now discuss which of the exemptions may be the best fit for Princess Hialeah’s company.
In general, before you offer securities to investors you must register the offering with the relevant authorities. For the federal government, it is the SEC and for the states, it is the applicable state agency responsible for securities compliance and regulation.
I explain to Princess Hialeah that crowdfunding via Indiegogo, Kickstarter and similar platforms is not offering security because security is defined as any arrangement that allows the contributor of funds to receive a financial return on his or her investments, provided the investor is not actively involved in the management of the company.
I note that with the JOBs Act, the federal crowdfunding exemption, anyone can technically invest via equity crowdfunding exemption. This exemption allows all Americans, accredited and non-accredited, to invest in startups and small businesses over the Internet utilizing crowdfunding portals.
To make an offer of equity on a crowdfunding portal under the JOBS Act the issuer must be a private company based in the United States, therefore, Princess Hialeah’s company qualifies. However, investment companies, including mutual funds and private equity funds, may not raise capital via crowdfunding portals.
An issuer may raise up to $1,070,000 (adjusted for inflation at least once every 5 years) in any 12-month period through equity crowdfunding portals that are registered with the SEC and FINRA. Issuers may sell to an unlimited number of investors in a deal, within the $1,070,000 raise limit. Also, the issuer may publish a notice advertising certain specific offering terms and directing investors to the crowdfunding portal where the offering is being conducted. Additional communications with potential investors regarding offering terms must take place through the crowdfunding portal, and the portal charges a fee for the service. The issuer must file the offering information with the SEC, as well as the annual reports, and must share the annual reports with the investors The issuer will be held liable for fraudulent or intentionally misleading statements or material omissions made in connection with the offering.
We then discuss the definition of an accredited investor who makes up only about ten percent of the population. An accredited investor is defined as a person with an annual income exceeding $200,000, or $300,000 for joint income, for the last two years with the expectation of earning the same or higher income in the current year The individual must have earned income above the thresholds either alone or with a spouse. A person is also considered an accredited investor if he or she has a net worth exceeding $1 million, either individually or jointly with a spouse. In addition, the SEC considers a person to be an accredited investor if he or she is a general partner, executive officer, director, or a related combination thereof for the issuer of unregistered securities. Moreover, if an entity consists of equity owners who are accredited investors, the entity itself is an accredited investor,
Also, in 2016, the U. S. Congress modified the definition of an accredited investor to include registered brokers and investment advisors. In addition, if a person can demonstrate sufficient education or job experience showing his or her professional knowledge of unregistered securities, he or she can qualify to be considered an accredited investor.
A non-accredited investor is an investor who does not meet the income, network, or educational requirements set out by the SEC.
There are many strategies that will allow Princess Hialeah to include accredited and unaccredited investors because the SEC exemptions promote capital formation by reducing the cost of offering securities to investors.
The most common exemptions under the registration requirements include private offerings to a limited number of persons or institutions; Offerings of limited size; Intrastate offerings; and Securities of municipal, state, and federal governments.
Because Princess Hialeah’s company would like to limit the offer to Florida investors, I recommend that the company comply with exemption Section 3A (11) of the Securities Act and Florida Statutes Section 517.161. These laws are known as the “intrastate offering exemption. This exemption seeks to facilitate the financing of local business operations. To qualify for the intrastate offering exemption, a company must: be organized in the state where it is offering the securities; carry out a significant amount of its business in that state; and make offers and sales only to residents of that state. The intrastate exemption doe not limit the size of the offering or the number of purchasers, however, the offering is subject to state securities laws.
We discuss Regulation D, Rule 504 that provides an exemption from registration for securities offerings of less than $5 million within a 12-month period. Under Rule 504 Princess Hialeah’s company may offer and sell the securities to an unlimited number of accredited and non-accredited investors.
Under the Regulation D, Rule 504 exemption, Princess Hialeah’s company is not required to provide any specific information or disclosures to potential investors, so long as the company does not violate the antifraud prohibitions of the federal securities laws.
Under Regulation D, Rule 506(b), Princess Hialeah’s company can raise an unlimited amount of money from an unlimited number of accredited investors, but from no more than 35 non-accredited investors. It preempts the states from imposing their substantive requirements but the states can require notice filing, and the issuer must file Form D with the SEC. However, unlike Rule 504, the non-accredited investors must be financially sophisticated, that is, have sufficient knowledge and experience in financial and business matters to evaluate the investment. This sophistication requirement may be satisfied if Princess Hialeah’s company makes the investor invests through a registered broker-dealer.
Also, if Princess Hialeah’s company uses the Regulation D, Rule 506(b) exemption, the company cannot use general solicitation or advertising to market and sell her company’s securities. and the company must give non-accredited investors comprehensive disclosure documents. However, the company has discretion what information to give to accredited investors, in view of the antifraud prohibitions of the federal securities laws.
Under Regulation D, Rule 506(c), the company may use general solicitation, marketing or advertising to market and sell unlimited securities to accredited investors only. The company must take reasonable steps to verify that the investors are accredited investors, which may include reviewing documentation, such as W-2s, tax returns, bank and brokerage statements, credit reports and the like.
For public offerings, the Regulation A exemption is available for up to $20 million, the securities are not restricted but the registration process is greater than for Regulation D but lesser than an Initial Public Offering (IPO). Under Regulation A+, up to $50 million per year may be raised, the securities are not restricted and they can be sold to non-accredited investors. And under the accredited investor exemption of Regulation A+ up to $5 million may be raised, there is no general solicitation, and no disclosure is required.
If Princess Hialeah’s company utilizes one of the exemptions from registration under the securities laws, the company must still provide potential investors with access to company records if they ask for them, be available to answer questions by potential investors, and must take care to provide sufficient information to investors so that they can make an informed decision.
I explain that to avoid violating the antifraud provisions of the securities laws and liability for securities fraud, any disclosure (oral or written) to investors must be free from false or misleading statements, must include all material facts concerning the investment, and should not exclude any information if such omission makes what is provided to investors false or misleading
The PPM is not filed with the SEC and it will provide full and transparent disclosure regarding the terms of the investment offering, information about the company, operations, and management, the use of the proceeds, and describes the risks factors inherent in the business and industry.
I note that whether a company needs to use a PPM or not, and the amount and type of information in the PPM, will, in general, depend on (1) which exemption from registration is being used, (2) the type of issuer, (3) the number of investors, (4) the level of sophistication and type of investor, (5) the amount of money being raised, and (6) the complexity of the terms of the offering.
While Rule 506 does not require any specific disclosures to accredited investors, in practice, a PPM is used when raising money from institutional or qualified individual investors. The PPM contains the same disclosures and information found in a prospectus filed with the SEC as part of a registration statement but the PPM is not filed with the SEC
If a broker will be utilized by the company the broker must be licensed and registered with FINRA (Financial Industry Regulatory Authority), the SEC and a state securities regulator (depending on the type of business the broker and his or her firm conduct). FINRA Rule 5123 requires member firms to file the PPM, term sheet or other offering documents that set forth the terms of the offering. Under federal securities laws and FINRA rules, a broker-dealer is required to conduct a reasonable investigation of all securities that it recommends to its clients.
Princess Hialeah’s company will not need a PPM to raise funds from VCs and angel investors who are high net-worth individuals who provide capital for early-stage companies. The VCs and angel investors will review the company’s business plan and the VC will provide the company with a term sheet. In case of the angel investor, the company will provide the term sheet and once the term sheet is finalized, as Princess Hialeah’s attorney, I will prepare the subscription agreement and the other documents establishing the rights and obligations of the angel investor.
Princess Hialeah’s company would like to offer $5 million or more to family and friends who are accredited and non-accredited investors who are required to possess a degree of financial sophistication. In this case, the PPM will serve as a stand-alone document, so that, without having to review any other material, the family member or friend is able to make an informed decision about the investment. If only accredited investors are involved, the company may avoid using the PPM to raise funds. However, by failing to raise funds from non-accredited investors, the company will be leaving out over one hundred twenty million (120,000,000) potential investors.
The company’s PPM will include the company’s investor deck, pitch deck, financial statements, business plan and any other relevant documents that describe the business strategy and goals, how much capital the company needs, why the company needs the money and how the company plans to spend it.
A PPM may be required by a particular state’s securities laws, also known as Blue Sky laws. Even if a company is not required to register its securities with the SEC, it may be required to register them with the state where the potential investors reside or otherwise obtain a state exemption from registration.
In addition, even when state registration is not required, states are permitted to require that the issuer file a copy of Form D (along with a filing fee) with the state, if the issuer has sold or intends to sell its securities to the state’s residents.
Because Princess Hialeah’s company would like to limit the offer to Florida investors, I recommend that the company comply with exemption Section 3A (11) of the Securities Act and Florida Statutes Section 517.161. These laws are known as the “intrastate offering exemptions”. The exemptions allow the company to sell its securities to no more than 35 purchasers in any 12-month period without the need to register the securities with the Florida Division of Securities. However, the 35 purchaser limit does not include accredited investors or purchasers who invest more than $100,000.