When making an offer to potential investors, the company wants to choose the securities exemption (offering type) that best fits its needs. Each exemption has pros and cons. The key questions are 1) Where are potential investors located? 2) What sorts of communications with potential investors are needed? and 3) What qualifications for investors are acceptable? The amount of money to be raised is sometimes a consideration as well because there is a $5 million limit on some exemptions.
Location of Potential Investors
If expected investors are located in more then one state (foreign investors do not matter), then the usual choice would be a federal Rule 506 offering or the Model Accredited Investors Exemption (MALE), which has been adopted with one variation by 30-35 states. (California’s version is the 25102(n) exemption.)
Communications with Potential Investors:
This is the situation with the Federal Rule 506 exemption and the California 25102(n) exemption. With many exemptions, no “public” advertizing is allowed. The company can only use general ads about what it does (without mention of any past, present or future offerings) and ask investors to complete an investors questionnaire or 2) send offering information to potential investors it reasonably believes meet the investors requirement for offering. The MALE andCalifornia251 02(n) exemptions allow use of a brief “tombstone” ad regarding the offering. It’s called a “tombstone” ad because it’s jokingly been said that one can only use as much text as one could fit on the tombstone. Potential investors are instructed to submit an investor questionnaire to obtain further information.
There are also registrations that allow full public advertizing – but only after the offering is approved by a securities regulator. These include theCaliforniaqualification by permit and a federal “direct placement offering” using form S-l. Both though require substantially more time and money than earlier.
Investor Qualifications
The qualifications for the investors vary too. For a Rule 506 offering, all investors must be either accredited or non-accredited but sophisticated, (and there can be only up to 35 of the latter.) “Accredited” for individuals basically means more than $ 1 million in net assets (excluding the personal residence) or at least $ 200,000 a year in income. (for entities like corporations or limited liability companies, it’s at least $ 5 million in assets.) “Sophisticated” means having the ability to make good investment decisions, either personally (which is a bit subjective) or through the advice of an independent investment advisor (CPA Certified Financial Planner, etc.) The company cannot Provide or pay for this advisor.
The MALE/251 02(n) exemption involving aCaliforniacorporation (as opposed to another type of entity) requires that all investors be accredited. For a California-only offering, the 25102(n) exemption does allow “half-accredited” investors, meaning investors with roughly half of the qualifications of an accredited investor. InCaliforniaonly 25120(n) exemption allows not only accredited investors and sophisticated investors but also investors with a pre-existing substantive relationship-the “friends, family and colleagues” exemption. There can only be up to 35 non-accredited investors, though this is useful for letting such individuals in early (before the price of the shares/unit increases) even though they are not accredited or sophisticated.
For even lower investor qualifications, theCaliforniaqualification by permit will allow investors with as little as $ 150,000 in net assets (excluding the personal residence) or $ 75,000 in annual and $ 75,000 in net assets. The offering must be kept to less than $ 5 million, though, to avoid a merit (fairness) review by the state. (There are also additional restrictions on LLC’s that invest in real estate.) The down side is that a California qualification by permit is more complicated and has to be pre-approved by the state so it takes two to three months longer (and cost more) than other methods. (there’s also a similar federal method using Form S-l, although it is even more complicated and takes even longer.
Other Methods
Other exemptions exist as well, but usually they are not practical. The Federal Rule 504 (SCOR) exemption requires pre-approval of the offering in whichever of five regions in the country the company wishes to make offerings. It’s also limited to $ 1 million. FurtherCaliforniadoes not participate in the regional Approval system, so any SCOR offering made toCaliforniainvestors must go through theCaliforniaqualification by permit process.
Federal Rule 505 does not pre-empt state securities law (unlike Rule 506). In other words, one has to also find a state exemption in each state where there are investors. Given this, Rule 505 is rarely used.
Federal Reg. A in theory allows a “test the water” phase that could be useful, But again state securities laws apply. InCalifornia, for example, a completeCaliforniaqualification by permit application must be on file before one can “test the waters” for potential investors. In addition, if the company decides to proceed with the offering, a federal permit process must be completed if there will be investors in more than one state. As a result, although Reg. A sounds good in theory, it is seldom used as a practical matter.
For more information, see Background on the Securities Laws.
The foregoing constitutes general information only and should not
be relied upon as legal advice.
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