Private Placements . . .

are sales of company securities that do not involve a public offering and that are not required to be registered with the federal and state securities commissions. "Private Placement" refers to offerings that comply with the requirements of an exemption to the registration requirements of the securities laws. In most cases, the exemption calls for the preparation of an offering memorandum that describes the company and the risks associated with investing in it. Sometimes the exemption permits a sale of a limited number or securities to certain qualified investors without a formal offering memo.

Failure to register the sale of securities or to comply with the requirements for an exemption from registration can impose serious liabilities on a company and its management. Experienced counsel should be consulted before any offering of company securities is made, including an offer to a professional venture capitalist.

Whether an offering is a private placement depends upon a number of factors, including requirements and limitations relating to the

• Number of offerees (not purchasers).
  

• Experience and knowledge of the offerees in making investments.
  

• Ability of the offerees to bear the economic risk of the investment.
  

• Number of securities offered.
  

• Size (in dollars) of the offering.
  

• Manner in which the offering is conducted.

The company issuing securities also bears the burden of establishing that each offeree in a private placement has had appropriate access to sufficient information about the company and is capable of fending for himself in analyzing such information to reach an investment decision. To fulfill this burden the issuing company must document the identity of each offeree, the characteristics that make him an appropriate purchaser, and the nature of his access to company information.

This requirement can be hard to meet with any certainty. This is because it requires the issuing company to make judgments about the nature of the offerees. While this may be relatively easy to do with institutional investors (such as established venture capital funds), which are clearly sophisticated and able to fend for themselves (based on the fact that they have made many other investments), judging the qualifications of individual investors is more difficult. As a general rule, individuals who are officers of the issuer or who have made similar investments before and are familiar with the issuer’s operations will be easier to qualify than individuals who are not involved in the company’s ongoing operations or who have not made investments in similar ventures.

Companies must also be sure that the purchasers of their securities are acquiring shares for investment and not for the purpose of redistributing them. If those purchasers, in turn, transfer the securities to others, the company may be deemed to have engaged in a public offering from the outset and to have violated the registration requirements.

In order to prevent such transfers, companies should require each purchaser in a private placement to state in writing that he is purchasing the securities for his own account and without a view to their subsequent distribution. In addition, the company should place a restrictive legend on the share certificate that is delivered to the purchaser. The legend should state that the securities represented by the certificate cannot be transferred unless pursuant to an effective registration statement or an exemption from the registration requirements, which is satisfactory to the company’s counsel. The company should also instruct its transfer agent not to transfer any of the securities (containing the legend or not) without counsel’s written approval.

It is not difficult to see that the general exemption for private placements (Section 4(2) of the 33 Act and corresponding state laws) contains subjective requirements that can be difficult for a company to fulfill with any certainty. Because of this, the Securities and Exchange Commission (SEC) and the state securities commissions have identified a number of more clearly delineated "safe harbor" exemptions that companies can use to avoid the registration requirements of the securities laws. These safe harbors set out very specific objective requirements that must be followed in order for them to apply. Because of this specificity, companies find them easier and safer to use than the general 4(2) exemption.

The federal safe harbor exemptions include the Rule 504, 505, and 506 exemptions of Regulation D (discussed in detail in the Reg D entry), the federal intrastate exemption, and the Regulation A exemption. In general, these exemptions provide for three types of offerings with different requirements for disclosure, investor sophistication and maximum number of investors. One exemption permits offerings of up to $1 million, another allows offerings of up to $7.5 million, while the third contains no dollar limitation but imposes sophistication requirements on "unaccredited" investors.

The federal intrastate safe harbor provides a registration exemption for local offerings by local companies that are conducted entirely in one state. It provides objective standards companies can follow to be sure of obtaining the more general intrastate exemption contained in Section 3(a)(11) of the 33 Act. The standards are contained in Rule 147. In general, they permit sales only in the state of residence of the issuing company and only to residents of that state. They require that the issuing company derive a substantial percentage of its revenues from the state and limit resales of securities purchased in the offering. Under the rule, resales may be made only to residents of the state for a period of time after the offering. If any resales are made outside the state during the period, the exemption for the entire offering can be disqualified. Because of this resale requirement and the restriction of the exemption to local companies, other exemptions are more commonly used than the intrastate exemption.

The SEC’s Regulation A permits offerings of up to $5 million of securities under specified conditions. To meet this exemption’s requirements, a company must prepare an offering circular (unless the offering is for less than $100,000) that includes two years of financial statements. The offering circular is reviewed by the SEC, much like a public offering circular. Also, as in registered public offerings, there is no limitation on the number of persons the shares may be offered or sold to and no special investor qualification requirements. Nonetheless, the Reg A exemption has been used infrequently compared to other exemption because of the restrictions on the amount of money that can be raised and the expense generated by preparing the offering circular and completing the SEC review. See: Blue Sky Laws, Investors, Legend Stock, Public Offerings, Reg D, Restricted Securities, SEC (Securities and Exchange Commission), Safe Harbors, 10b5, 33 Act.