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
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.
California 25102(f) Exemption
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
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).
You are welcome to copy and distribute this document for non-commercial purposes, but both of the following must be left on it:
Bruce E. Methven
2232 Sixth Street Berkeley, CA 94710
Phone: (510) 649-4019; Fax: (510) 649-4024
Web Site: www.TheCaliforniaSecuritiesAttorneys.com
Copyright 2009 Bruce E. Methven, All Rights Reserved.
The foregoing article constitutes general information only and should not be relied upon as legal advice.