This is a two-part blog series. Part I covers the reasons for a PPM and Part II covers the available options (including costs) for getting one.
Part I: Do I Really Need a PPM?
You are an entrepreneur with a fantastic business idea. You have a business plan and you are ready to start raising money!
You may have learned that there are rules and regulations that apply to raising capital for your business. Federal and state securities laws apply whenever you seek capital from investors, regardless of whether they are friends, family, crowdfunding investors, high net worth individuals, angel investors, accredited investors, or otherwise.
A private placement memorandum (PPM), as you may have also learned, is the legal document provided to prospective investors when selling equity or debt in your business. It is sometimes referred to as an offering memorandum or offering document. It provides investors with the information they need as well as protects the company in the event that of an investor complaint.
Now you may be asking yourself, do I really need a private placement memorandum? If so, can I write it myself? Can I use a template? Do I need an attorney? And how much do I need to budget for this?
A Little History
The US Federal Securities laws were drafted and enacted primarily as a result of the Great Depression of 1929, in an attempt to avoid a similarly devastating stock market crash from happening again. The spirit of these laws is based on the notion that the Great Depression and the stock market crash of 1929 occurred because companies were selling stock to investors without providing investors with enough accurate and honest information about their companies for that investor to truly make an informed decision about investing.
The Securities Act of 1933 and the Securities Exchange Act of 1934 were enacted to ensure full disclosure was offered by companies whenever they sold stock to investors. In this way, material information would be available and investors would be able to make an informed decision before investing; accordingly, rampant speculation leading to another market crash would be avoided. As time went on, more rules and regulations were added to these initial laws, but by and large, the spirit and letter of these laws have served their purpose quite well over the years.
The overhanging rule behind these federal securities laws is that a company may not sell its securities to investors without first registering with the SEC, unless there is an exemption that applies. The registration process involves providing the SEC with the disclosure of all material information (any information that a reasonable investor would need to know to make a decision about whether or not to invest). The registration process, which is sometimes referred to as an initial public offering (IPO), is lengthy, protracted, and expensive. In fact, it would not be unusual to take 10 months and cost a company $150,000 to conduct a registration. In light of this significant hurdle, the SEC has enacted a number of exemptions to the registration rules that are specifically designed to allow startups and small businesses raise capital more quickly and at much lower cost. Regulation D is one such exemption.
Regulation D Exemption
Regulation D is an exemption that allows companies to raise capital in what is known as a private placement. There are various rules under Regulation D that are designed to allow for different sized offerings. There are four distinct offerings provided under Regulation D. Each of the four offerings is controlled by a rule: Rule 504, Rule 505, Rule 506(b), and Rule 506(c).
The vast majority of offerings are conducted under Rule 506(b) or 506(c). Each allows for the company to raise any amount of money, but differ as follows:
- Rule 506(b). This is a private offering only to investors with whom the company has a pre-existing relationship. Up to a maximum of 35 investors may be unaccredited, but audited financials would be required if there are any unaccredited investors. There is no limit to the amount that can be raised.
- Rule 506(c). This offering allows for general solicitation, which means the company can advertise the offering, list it on their website, use an equity crowdfunding site such as EquityNet, and/or use social media, email, seminars, radio, TV, print, and any other means to market the offering. All investors must be accredited and there are enhanced requirements for qualifying investors. There is no limit to the amount that can be raised.
Regulation D provides entrepreneurs and startups with a truly flexible and lightly regulated means for raising capital. However, raising capital from investors is a securities transaction, and even under Regulation D, and the Anti-Fraud Rules apply. Compliance with these rules is critical to avoid severe civil or even criminal liability, which can include investigation by the SEC, state securities commission, or a State Attorney General, potentially leading to enforcement action. Investors can also pursue civil damages. Rescission – an order to return all funds received to investors – is not an uncommon outcome of such investigations. One purpose of a comprehensive customized PPM is to avoid these outcomes by protecting your company in the event of a complaint.
For a full discussion of the Anti-Fraud Rules, see my blog on Risk Factors and Securities Laws.
Yes, if you want to sleep at night, and avoid devastation in the event an investor decides to make a complaint, then you absolutely need a PPM.
Part 2 of this blog series will cover the available options and associated costs for getting a PPM drafted.