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Private Placements on Main Street: 14 Keys to Getting…
Tags: benefit, business plan, counsel office, emerging companies, equity issue, friends and family, high net worth investors, institutional venture capital, lawyer, money spent on, overwhelming majority, private placement, private placements, regard, stake, traps, wall street,Pages: 6
Language: english
Created: Fri May 27 18:18:26 2005
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Private Placements on Main Street:
14 Keys to Getting Your Deal Done and Avoiding Traps
While many naively believe that their company will the money spent on a good securities lawyer will
be amongst the chosen few, the fact remains that only undoubtedly end up saving you a lot of time and
an extremely small percentage of companies are able money in the long run. And note, in this regard, that
to attract institutional venture capital or the attention you can save yourself a substantial amount in legal
of Wall Street. The overwhelming majority of fees by initially showing up at your counsel' office
s
emerging companies in need of capital have to rely with a well-conceived, thoroughly researched and
on private placements involving friends and family, carefully written business plan.
initially, and high net worth investors the next few
times around. In other words, it' life on Main Street
s
for most small companies, not Wall Street, and Key No. 2: Be Realistic In Your Valuation.
although a private placement is probably the single Valuation is generally the single most controversial
best answer for a small company in need of equity issue in the context of a private placement. On the
financing, actually getting a deal done, and managing surface, it deals with the question of how much a
to avoiding the many not-so-obvious traps along the company is worth. Beneath the surface, however, it
way, is a big challenge for most. This is particularly is about relative degrees of control and potential
true for those that have not been through the process upside. Specifically, it is concerned with the stake
before and have not had the benefit of actually seeing investors will receive in a company based on their
how seemingly unimportant considerations on the investment and, in turn, how much existing
front end of a deal, if not managed properly, can end shareholders will be left with. Because an
up having very material negative consequences on assessment of enterprise value can be complex and
the back end. involve a large number of subjective considerations,
there can be serious differences of opinion, all too
While navigating the private placement process is by often resulting in a defensive posture on the part of
no means intuitive, and there is no substitute for entrepreneurs. Don' be one of them. Allow yourself
t
experience, by understanding and following a few instead to be guided by objective facts, both positive
key recommendations, your likelihood of success can and negative, which can be established and assessed,
be greatly enhanced. What follows, therefore, are 14 rather than by subjective ones which cannot. Be
key recommendations that, if observed, will serve business-like, in other words, about the process.
you well in getting your deal done and avoiding Compare your company to others that have already
many of the traps along the way. received financing or that have been sold outright,
and let that be your guideline in arriving at a
reasonable figure. This, after all, is what the
Key No. 1: Hire A Securities Lawyer. Don' t professionals do, and why their deals get financed.
use your real estate or collection attorney. Don' uset To be sure, insisting on an unjustifiably high
your lawyer buddy who has a general practice. Don' t valuation is a great way to keep your deal from
even use your commercial litigation attorney. Hire a getting done. It' also a tell-tale sign to prospective
s
securities lawyer. A private placement is a securities investors that they' dealing with an amateur, whom
re
transaction, and securities is a distinct area of they' assume is likely to apply poor judgment to
ll
specialization that is misunderstood by most, other managerial and operational matters and prove
including many lawyers. In addition to keeping you difficult to work with as important issues arise.
out of trouble (which, in the area of securities, is easy
to get into unwittingly), a good securities lawyer can
go a long way in helping you to present well to Key No. 3: Recognize and Be Honest About
investors by creating a professional set of legal and Your Weaknesses. Every company has
due diligence documents and insuring that your vulnerabilities or other weaknesses, and you can be
corporate and financial house is in order and ready to assured that yours is no exception. It may be an
be put on display. Although they can be expensive, unproven market, the presence of a competitive
1
technology, insufficiently protected intellectual w 506 concerns itself only with the number of
property, recent revenue reductions, poor margins or actual purchasers involved, not the number of
any number of a host of other issues, but there is at offerees (as is the case with certain other
least one issue out there that could cause things to go exemptions); and
wrong for your company, and, in all likelihood, there
are actually probably several or more. While not w 506 preempts state laws such that any otherwise
every investor will be savvy enough to identify the applicable state securities requirements are
weaknesses in your company, you would be wise to entirely avoided (with the exception of a notice
assume that many probably will. So don' try to hide
t filing and payment of a fee).
those weaknesses or avoid having to discuss them.
Be forthcoming and honest about them in your Note: The only way to establish months or years
disclosure document (if you have a good securities after the fact that an offering (506 or otherwise) was
lawyer, he/she will insist upon it), and be prepared to properly qualified under a given exemption is to pull
sell through these weaknesses-- and to explain how the files and examine the documents and records that
they are being managed, contained, reduced, were kept. So be sure to keep neat, organized
eliminated or otherwise overcome. records. You will be very happy that you did.
Key No. 4: Do a 506. Private placements are Key No. 5: Go Out With A Book Deal. While
stock issuance transactions exempt from registration private placements may be viewed on a number of
at the federal level under the Securities Act of 1933. different levels, at one level, they can be divided into
There are a number of different exemptions in this either so-called "book deals" or negotiated
regard, each of which have different requirements transactions. Book deals are offerings the terms of
and associated advantages and disadvantages. which have been pre-structured by the company and
Failure to successfully qualify an offering under at packaged in the form of a printed (and often very
least one of the exemptions could result in rescission substantial) private offering memorandum (or
rights on the part of all investors in the offering. "PPM"). These documents are typically delivered to
While a discussion of each of these exemptions is prospective investors together with a subscription
beyond the scope of this article, suffice it to say that, agreement, a relatively short, simple document
all things considered, you should do a Regulation D pursuant to which investors purchase securities.
Rule 506 offering (commonly referred to as a "506"). When the PPM is circulated to prospective investors,
Some of the reasons for relying on Rule 506, as it basically presents as a take-it-or-leave-it
opposed to any of the other exemptions, include the proposition. For this reason, investors are less apt to
following: attempt to negotiate a book deal, thereby giving an
issuer a potential (and mostly psychological) upper
w Unlike some of the other exemptions, 506 hand in terms of valuation and other terms. In
provides relatively clear and explicit contrast, a negotiated transaction is just as its name
requirements, and therefore provides a greater implies, a deal negotiated between the company and
degree of certainty in terms of fulfilling its the investor(s), and which usually involves a rather
requirements; voluminous stock purchase agreement (rather than a
subscription agreement) that may or may not involve
w Compliance with 506 is easier to defend against an accompanying PPM, albeit a relatively
after-the-fact claims of non-compliance should abbreviated one. Negotiated deals are the result in
they be made; virtually all cases in which institutional or other
professional investors are involved (e.g., venture
w Unlike most other exemptions, 506 contains no capitalists) and in many cases where high-net worth
limitation on the amount of funds that can be investors are involved. Such deals are generally a
raised; function of negotiating leverage. Very experienced,
sophisticated investors typically have lots of deals to
w Because there is no limit to the amount that can choose from and will only be interested in making a
be raised in a 506 offering, the risk of having the given investment to the extent that they' able to get
re
exemption disqualified under a securities the terms they want (and that they' used to getting).
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doctrine known as "integration" (because it is Because they make these types of investments
combined with other offerings that do have frequently, they know exactly what those terms are.
limits) is dramatically reduced; They typically consider deals strictly on the basis of
business plans submitted (as follow-ups to executive
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summaries), and will generally prepare and submit to Act of 1934, technical compliance with the
the company a proposed term sheet if and when they requirements as they relate to disclosure is not always
decide to make an offer. Confronted with a book the best approach. When it comes to securities, full
deal that they otherwise like (which would be rare in disclosure is the best approach, and the disclosure
any event), most would simply say, "O.K. ... let' put
s mandate for non-accredited investors is a very good
that aside now and talk about a possible deal." standard for achieving full disclosure. Moreover, the
credible impression that a well-prepared and
In the final analysis, and if the profile of your target comprehensive PPM will create in the minds of
investors permit it, a book deal will almost always prospective investors is likely to go a long way in
provid a strategic advantage. helping to sell your deal.
Key No. 6: Avoid Selling to Non-Accreds, But Key No. 7: Back-Up or Back-Down; Don' t
Use A Full-Blown PPM. When a company does a Overstate or Make Promises. When it comes to
506, it' permitted to sell its securities to 35 non-
s disclosure, avoid making any assertions that you
accredited (but "sophisticated") investors and an can' substantiate by way of an authoritative and
t
unlimited number of accredited investors. Forget the reliable third party publication. Have solid back-up
non-accredited investors. Although there is for your assertions, in other words, or back down
invariably a huge temptation to take advantage of the from making them. If you believe something to be
opportunity to sell to non-accredited investors (which true that you are unable for any reason to
are generally much easier to find and convince to substantiate, qualify it as being your own belief.
invest), exercise restraint and avoid the temptation. While these rules apply to written disclosures,
It' not worth it. Determining "sophistication" can be
s including private placement memoranda, business
tricky, and, in any case, non-accred' (as they are
s plans, executive summaries, PowerPoint
often referred to) are the first to sue when a presentations and correspondence, note that they
company' performance falls short of expectation.
s apply equally to oral statements.
So what' an accredited investor? For an entity, the
s Similarly, avoid overstating facts or presenting
definition essentially includes a number of different financial projections that are anything other than
types of institutional investors, funds, businesses, carefully conceived and extremely conservative. To
organizations, trusts and the like, all of which have to do otherwise invites later claims of misrepresentation
have $5 million in assets and none of which can be that are likely to prevail.
formed for the purpose of making the investment.
For a natural person, the definition is essentially
anyone with (i) a net worth of at least $1 million, or Key No. 8: Do An All-or-Nothing or Min/Max
(ii) income in the last two years of $200,000 per Offering. When you raise funds from investors, the
individual or $300,000 per couple. In order to securities laws deem you to be irresponsible if you
determine accreditation, and as evidence to raise too little, while basic business sense dictates
substantiate it, you should have all investors that you' being foolish if you raise too much. The
re
complete and return an investor questionnaire which problem with raising too little is that your company is
contains representations as to their qualification. left undercapitalized after the offering and the
investors who did invest will have a strong case when
If a company sells to non-accredited investors under they drag you into court and argue that you should
Rule 506, it is required to deliver a private placement have known that and either raised more or none at all.
memorandum that is extremely comprehensive in Raising too much money, by contrast, will have you
scope and that, among other things, includes audited selling a greater percentage of your company than is
financial statements. By contrast, the disclosure necessary at a time when your company' valuation
s
requirements are dramatically simpler if a 506 is relatively low. A commonly used mechanism to
offering is limited exclusively to accredited investors. avoid undercapitalization in this regard is the so-
However, even though this obligation can be legally called "all-or-nothing" offering. Under such an
avoided if you don' involve non-accredited
t arrangement, the company agrees that it will only
investors, do yourself a favor and prepare the close on any subscriptions received to the extent that
comprehensive document and, if audits are available, it is able raise the entire stated amount of the
include them. For reasons having to do with offering. A "min/max" offering is similar, but
potential liability under the antifraud provisions involves a minimum threshold amount which, if met,
contained in Rule 10b-5 of the Securities Exchange is (at least in theory) enough to avoid
3
undercapitalization, but which may also be exceeded introductory services are merely incidental to their
to further capitalize the company' needs. The
s primary business and something they only do
"max" concept is designed to provide comfort to infrequently from time to time, and (ii) they strictly
investors that they will not be diluted down below a limit their activity to making an introduction, and
certain percentage ownership threshold, at least not in have no part in negotiations or any other aspect of the
the current round. transaction. So while these unscrupulous types
cannot themselves rely on the federal finders'
exemption, because raising money for companies is
Key No. 9: Avoid "Professional" Finders. their primary business, note that your lawyer,
Almost invariably, owners of small companies find accountant and other professionals probably can act
themselves introduced at some point to one or more as finders for your company, because it is not their
of the many individuals who refer to themselves as primary business. Bear in mind, however, that many
independent financial consultants or investment investors will insist that all of their investment
bankers and who hold themselves out as, among proceeds go directly into the company to further its
other things, capable of raising money for companies. development, not into the hands of an intermediary.
Because the challenge of raising capital on their own In such instances, any finder' fee will have to be
s
is daunting to many, and because the likelihood of payable in stock or warrants.
their attracting the attention of a licensed broker-
dealer to serve as a placement agent for their deal is Note: Many of these independent consultants charge
slight (as it is for any offering involving a very early- significant, non-refundable up-front fees for their
stage company or an amount less than $10 million), services (with no guarantees of success), and, often
many entrepreneurs are tempted by the lure of these times, never end up raising a dime for their clients.
often fast-talking self-promoters. However, unless
they can prove that their firm is a registered broker-
dealer, and that they themselves are appropriately Key No. 10: Create Your Own Prospects.
licensed, both of which are necessary for them to More often than not, the single most challenging
lawfully engage in capital-raising initiatives on your aspect of completing a private placement is finding
behalf, steer clear of these individuals. The reality is investors. Unfortunately, though, under the federal
that the overwhelming majority of them are not, nor securities laws, securities sold in a private placement
are they affiliated with, registered broker-dealers. can only be sold to persons who are relatively
Most entrepreneurs that allow themselves to get wealthy and with whom those trying to raise the
swept into a deal by one of these independent money (typically management and/or other owners)
consultants soon come to very much regret it. The have a "pre-existing relationship". This means that
problem is that any investors who purchase securities you can' advertise, cold call, or do anything else that
t
through an unregistered broker-dealer (which is what would constitute a "general solicitation", and, in fact,
a professional finder is) have automatic rescission you can only approach people that you actually
rights, which means that they can demand an already know or have otherwise dealt with in the
immediate return of their entire investment at any past. For most, this means that after a couple of calls,
time, no questions asked. And the Form D which is their universe of potential investors has been
required to be filed with the SEC for any Regulation exhausted. The unfortunate reality is that most small
D offering (including a 506) requires specific company owners simply don' have an existing
t
disclosure of any parties that have received network with lots of rich doctors, dentists, lawyers,
compensation in connection with the offering. accountants, investment bankers, entrepreneurs and
other high net-worth country club types.
When faced with having to explain how they intend
to raise money without a broker-dealer affiliation, So, what' the answer? Plan ahead so that you can
s
these individuals will generally respond by build your network over time and actually establish
explaining that they are merely "finders" and that "pre-existing relationships" with those to whom you
there is an exception under the securities laws that ultimately intend to market your deal. Selling
allows them to pursue this activity without such an securities, like selling your products or services,
affiliation. Don' believe it. While it is true that an
t requires planning and work-- identifying your target
exemption for finders does exist, it is not true that market through research, and then plotting a course
these types of independent consultants qualify to rely of access to that market.
on it. The federal finders' exemption is a narrow one
applying only to those who receive compensation for So, plan ahead and do your homework, ideally six
introducing investors to the extent that (i) their months to a year ahead of time. Exhaustively
4
research other companies in your business segment
(or related segments if you' in a relatively new or
re Note: Whatever type of securities are sold should be
narrow space) that have been built up and sold within bundled in the form of "units" priced to coincide with
the past 4 to 5 years, and identify the entrepreneurs the lowest total investment amount expected to be
behind them. Track these people down, contact received by any single investor (e.g., $25,000).
them, and try to hire them-- even if only for a day-- Where stock is being sold, each unit should be
as consultants for your business. Don' be a t comprised of a certain number of shares (as well as a
nuisance, but be persistent. Once a relationship is warrant, if that' how the securities package has been
s
established, consider inviting them to serve on your structured). Where the securities package consists of
company' board of directors or advisory board.
s notes coupled with warrants, each unit should consist
Spend money to develop these relationships. It' be
ll of one note and one warrant.
worth it in the long run, probably many times over.
After a few months, you' hopefully have a group of
ll Key No. 12: Forget About Exit Strategies. For
prospects for your next round of financing not only most high net worth investors, any passive
with whom you' already established a "pre-
ve investment into a small growing private company is
existing relationship," but who already know and pretty much viewed as a flyer. If they score at all,
understand your business, are very familiar with it' be big, but there' a good chance that they'
ll s ll
early-stage companies generally, and who probably never see their money again. Sophisticated investors
have money to invest in speculative ventures. If know that you' either got to sell your company or
ve
you' successful in either getting them on your
re go public in order for them to recoup their principal
board of directors or your advisory board, and/or investment and/or realize any return on it. No one
getting them to invest, and if they' willing to do it,
re can possibly have any idea whether one of these
you can then pursue their network of contacts as events is ever going to occur. So don' bring it up,
t
investor prospects as well since, at that point, they, it' sophomoric.
s
too, will be part of your company.
If that all seems a bit too complicated, the alternative Key No. 13: Limit Your Offering Period.
is to join a country club and start rubbing elbows Successful book deals are typically structured so that
with all of those doctors, dentists, lawyers, the term of the offering period lasts for no more than
accountants and investment bankers. 60 to 90 days. There are several reasons for this.
First, because of a concept referred to as
"integration" under the federal securities laws
Key No. 11: Sell Securities Most Likely To (alluded to briefly in Key No. 4), which can result in
Appeal To Your Target Investors. The lost exemptions, offerings are best spaced apart from
sophistication and experience of your target investors one another by a period of at least 6 months and
should dictate the type of securities that you sell in must, therefore, have fairly well-defined beginning
your offering. If you' appealing, for example, to a
re and end points (against which to measure those 6
group of semi-retired entrepreneurs who have been in month periods). Second, and assuming the offering
and around the world of venture capital financing for involves an operating company rather than a pure
a while, they' likely to want to purchase-- and may
re start-up, it usually takes about 60 to 90 days for
even insist on purchasing-- convertible preferred material information contained in the PPM to become
stock, which is a senior security that can carry with it stale as a result of intervening events and
a number of advantages relative to common stock circumstances. Third, and finally, a deal simply
(e.g., liquidation preferences, anti-dilution protection, starts to look less appealing, psychologically, if it's
redemption rights, special voting rights, consent been out there being shopped around for any longer
rights, board seats). Or they may want unsecured than 90 days. The existence of a firm end date
notes (or debentures) coupled with warrants. If, creates a dynamic whereby prospective investors are
however, you' selling to a group of practicing
re forced to make a decision one way or another about
physicians who may not be so versed in the subtleties investing.
of corporate finance, you might be wise to go out
with a simpler deal that involves straight common
stock. Although at times difficult to know, the point Key No. 14: Time Your Offering Strategically.
here is that you should be selling a package of Because they typically occur over a period of only a
securities that is likely to satisfy the demands of the few months, book deals are typically timed to
market, but not exceed them. optimize the likelihood of receiving the most
5
attention. Well-planned offerings either commence
in mid-September and are closed out before
Thanksgiving, or, in the alternative, commence in
mid-to-late February and are closed-out before
Memorial Day. As a general rule, people tend to be
much more willing to devote time to new
opportunities during these periods.
* * * * * *
As noted previously, for emerging companies in need
of equity financing, a private placement is probably
the single best answer. But the path to actually
getting a deal done and avoiding the many not-so-
obvious traps along the way is a challenge for most.
With careful planning, however, as well as attention
to detail, observance of applicable requirements and
some practical advice, this challenge can be met.
_________________
Michael M. Membrado is a principal in the law firm
of M.M. Membrado, PLLC in New York, which
specializes in corporate, securities and related
transactional matters. He writes and lectures
frequently on topics of current interest in each of
these areas. The firm' Website can be found at
s
www.mmmembrado.com.
© 2005 Michael M. Membrado
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