Regulation D for business capital lets entrepreneurs take control of the largest challenges they face: raising capital. This is especially true if you’re running a start-up that has yet to go public. In some cases, the more public methods of raising capital may be inaccessible to you. In other cases, you may want to find a way to raise capital without spending a lot of time and money on filing your transactions with the Securities and Exchange Commission (SEC). In fact, many industries use the same tool to raise capital – Regulation D.
Whatever the situation, a Reg D private placement memorandum (PPM) could be the answer.
A PPM allows you to raise capital privately, thus circumventing some of the SEC’s filing requirements. Through a PPM, you can trade securities in your business for the capital you need to achieve growth. However, this trade comes with responsibilities to your investors, the state, and the SEC that you must meet.
In this article, we examine private placement memorandums to help you understand what needs to go into this document and why you may need it as an entrepreneur or business owner seeking capital. We’ll also explain what Reg D is and cover the two exemption rules related to your private placement memorandum that you need to know.
But before we do that, we’ll dig into some of the mistakes you need to avoid when raising business capital. In addition, we’ll explain what securities are and why you’ll need a lawyer by your side if you choose to go down the PPM route.
Your business needs capital for so many reasons.
There are obvious examples, such as purchasing equipment and paying for the production of your product or provision of your service. Having capital also means you’re able to pay your staff and keep your business ticking over.
There’s also one more thing that capital allows you to achieve:
It’s growth that potential investors are going to look for when deciding whether to commit their money to your business venture. If you can’t demonstrate that your business has the potential for growth, thus offering an investor a better chance of receiving a return, your attempts to raise business capital may fail.
Keeping this in mind, there are a few mistakes you have to avoid when attempting to raise business capital.
Raise too much money and you’re left with investors who are unhappy that you don’t appear to have solid plans for the funds they’ve committed to your company. Raise too little money and the funds aren’t going to facilitate the growth your investors are looking for, which also makes them unhappy.
You need to strike a balance when raising capital. The key is to figure out how much money you need to do everything that you promised to your investors. Then, add a little more on top so that you have some additional funds to cover you in the case of an emergency.
When seeking business capital, you may allow angel investors or similar entities to take control of the negotiations. This can lead to your investors setting vague or complicated terms. Signing those terms because you’re desperate for capital could cause issues for your company in the future.
Ideally, you should have complete control over the terms of any agreement you sign, which is something that a private placement memorandum offers. While there is always room for negotiation, your aim is to always understand every term attached to any deal you make.
Timing is everything when it comes to raising business capital as an entrepreneur.
If you start trying to raise money too early, you may find yourself giving away far more equity in your business than you’d hoped to. Alternatively, you might find that your offers are ignored by investors because the business isn’t established enough to draw their interest. Your business proposition carries too much risk, meaning most investors will take a “wait and see” approach.
Of course, waiting until it’s too late is also problematic. Investors will see just as much risk in a business that is struggling under financial pressure as they will in a business that hasn’t established itself yet.
Money solves a lot of issues in business.
But it doesn’t solve every challenge you might face. Sometimes, an entrepreneur doesn’t actually need to pour more money into their business venture. Instead, they need to focus on creating the appropriate processes and structures needed for a viable business model.
Attempting to raise capital when you don’t have an established and working business model may lead to you wasting investor money. Again, that leads to unhappy investors who will not continue funding your business.
How will you use the capital you raise? What are the expected returns that you can offer? What is your business model? What are the terms attached to your capital raise?
This is just a small sample of the questions you need to be able to answer without hesitation when raising capital. Your goal is to make investors feel confident that you are the entrepreneur they should commit their funds to.
Again, a good private placement memorandum, drafted by a skilled syndication lawyer, can help with this. But we’ll get to that later in the article.
We mentioned earlier that investors are looking for growth above all else. It’s through growth that they achieve the returns that make their investments worthwhile.
Using the capital you raise, especially if you’ve raised that money by giving away equity, to fund existing business operations may keep you afloat. However, it does not lead to the growth you’re looking for. Furthermore, it can lead to you losing control of your business if you sell too much of your equity.
Don’t sell equity for funds to keep the business running. Instead, look towards loans and similar debt vehicles, allowing you to focus on using equity to create growth.
If you don’t know enough about the investors who are putting money into your business, that means you don’t know if they’re accredited or even if they have the experience to help you to overcome the many challenges you’ll face as an entrepreneur.
Any investor will place you under the microscope before they commit money to your company. As an entrepreneur, you need to do the same to them. Focus on working out how your business fits within the investor’s portfolio and talk to them about what they’ll be able to offer you in terms of both capital and experience.
Creating a private placement memorandum essentially pushes you into researching your investors, either by verifying their credentials or by having pre-existing relationships with them. Again, we’ll cover this in more detail when discussing PPM and Regulation D of the Securities Act.
A good attorney can guide you through the world of business capital, ensuring that you don’t place yourself at a disadvantage as you seek investment. For example, those who choose to use PPM as a way to raise capital will need the services of a syndication lawyer to help them draft the document and deal with all of the related syndication documents.
Failure to work with a lawyer doesn’t only mean that you lack the legal counsel needed to protect yourself and your business. In some cases, not working with a lawyer could cause legal issues, particularly if you attempt to draft legal documents yourself. Some states consider this as acting as an unlicensed attorney, which could lead to prosecution.
As you can see, raising business capital as an entrepreneur is not a simple task. Assuming you can avoid all of the mistakes listed here, you’ll likely raise much of your capital by selling or trading securities related to your business. This is particularly the case if you use a private placement memorandum to raise funds.
So, we have an important question to answer:
What is a security?
A security is any type of financial asset that you can trade for another type of asset. What you can and cannot call a security depends on several factors, such as the jurisdiction in which the trade occurs and the regulations created by the SEC.
Securities are often used by businesses to raise capital without the need to take out bank loans. For example, a company that declares an initial public offering (IPO) starts selling shares in the company via the stock market. These shares are securities that the public company sells in exchange for capital.
In the United States, there are four main types of securities:
Let’s look at each individually.
An equity security grants the investor an ownership share in the enterprise that’s offering the security. The IPO example shared above is a form of equity security as the business is essentially selling small ownership stakes to each of its investors.
The issuer of an equity security will typically retain the earnings and profit that the business generates. However, they’ll also pay their investors regular dividends. The investor may also receive a lump payment if the asset is sold for a capital gain. This is something we often see in real estate syndication when a property is sold for a substantial property several years after investors secured equity securities in the property.
In some cases, equity securities also grant voting rights to investors, providing them with a say in the direction the business takes.
Debt securities are similar to traditional bank loans.
The security issuer offers a security, often in the form of a bond or certificate of deposit, that the investor purchases for a set price. This money then acts as the principal of a loan, with the investor usually receiving regular interest payments to generate a return on their investment. At the end of an agreed-upon period, the principal is repaid to the investor.
Debt securities work well for investors who want to generate a regular income over time.
As the name implies, hybrid securities combine many of the best features of both equity and debt securities.
Convertible bonds are the most high-profile example of a hybrid security. Here, the investor purchases a corporate bond that entitles them to interest payments over time. But the investor also has the option to convert that corporate bond into an equity security, thus giving them an ownership share in the company. The investor may choose to do this if the business begins experiencing rapid growth to the point where the dividends they’d receive for having partial ownership outweigh the interest payments they get via the bond.
The value of this type of security depends on the value of an underlying asset or pool of assets. Derivatives tend to carry more risk than other types of securities. They involve both parties attempting to predict the future of an underlying asset. The investor predicts the asset will increase in value, making the derivative more valuable. The issuer predicts the asset will decrease, ensuring they don’t lose money and perhaps even make money over time.
Derivatives are overseen by the Financial Industry Regulatory Authority. This type of security includes options, futures, forwards, and swaps.
As an entrepreneur, you’re focused on developing your business and providing quality services to your clients. This is a good thing. However, it also means that you can’t pay complete attention to raising business capital or creating the documentation needed to attract investors.
That’s where a good syndication attorney comes in.
The right attorney can help you to draft the private placement memorandum documents that we’ll discuss later in the article. They’ll also help you to only offer the appropriate types of securities based on your business and its current needs.
But there are far more reasons than that for your company to hire an attorney.
Earlier, we pointed out that allowing inappropriate investors to come on board in a business is one of the biggest mistakes that entrepreneurs make when trying to raise capital.
A good syndication lawyer can ensure you don’t face the issue of working with bad investors.
Your lawyer can weed out the investors who are either incapable of providing the support you need, are unaccredited, or are simply not as invested in the success of your business as you are. An attorney can also handle much of the due diligence you need to do on any investor you’re considering providing an opportunity to.
Think about it like this.
You enter into a relationship with anybody who invests in your business. That relationship could last for several years, depending on the nature of the securities that you offer. Your attorney ensures that you’re only starting relationships with investors who will hold up their ends of the commitments they make.
Experienced lawyers have worked with a lot of entrepreneurs who were in the same position you’re in right now. For example, a good syndication attorney will likely have several years of experience in helping business owners raise capital for their companies.
Of course, this expertise is a good thing for your business.
However, it’s often the connections that come with years of working in an industry that may benefit you the most. A good attorney can connect you with investors and even other businesses that can provide opportunities or help you to raise capital. In many cases, these connections would take you years to forge on your own, assuming you were able to create them in the first place.
Try thinking about hiring a syndication lawyer in the same way you’d think about hiring a personal trainer.
With the personal trainer, you’re spending money on somebody who will help you to stay fit and healthy. This investment will hopefully lead to you living a longer and happier life. Better yet, the investment you’re making into your health will hopefully mean you avoid costly medical bills associated with conditions you’re at higher risk of suffering from when you’re in poor health.
Investing in an attorney works in much the same way.
Yes, there is an upfront cost involved. There may also be continuous fees to consider if you want to keep your lawyer on a retainer. Still, those fees pale in comparison to the fees and potential fines you may have to pay if you fail to follow all relevant regulations when offering a private placement memorandum, or engaging in any other attempt to raise capital.
Spending money on an attorney now ensures you don’t end up spending a lot more later on.
Many entrepreneurs start businesses because they already have established skills and they want to take control of their careers. For example, a veterinarian may choose to open their own practice rather than work for another practice owner.
Other entrepreneurs come up with clever ideas for products or services that fill a gap in their chosen markets.
In many cases, these entrepreneurs are very good at what they do. Unfortunately, they’re often not especially skilled in structuring a business, particularly from a legal standpoint. Some may have no experience with business ownership at all.
Again, a good attorney can help.
A syndication lawyer doesn’t only focus on helping your business to raise capital via a syndicate of investors. They can also help you to structure deals, make critical business decisions, and help you to build yourself up into a business owner.
Failure to comply with the law means you and your business get punished.
It really is as simple as that.
An entrepreneur who is looking to use securities to raise capital has to comply with state and SEC laws, even when using a more private vehicle, such as a PPM. Your syndication attorney ensures that you’re complying with all required laws at all times. They’ll also steer you away from courses of action that could damage you or your business.
This final reason for hiring an attorney leads us nicely into our next topic.
As we will explain shortly, PPM is essentially a private form of offering securities to investors. As such, PPMs fall under the jurisdiction of both the SEC and your state. Both have regulations and rules you need to follow. And in both cases, you face harsh punishments should you fail to comply with the relevant regulations.
Let’s focus on the SEC first.
Using a PPM to raise capital reduces the likelihood that you’ll face personal liability as the issuer of a security. In particular, a good PPM ensures that you represent all of the relevant facts to investors, thus avoiding the anti-fraud regulations created by the SEC.
Under Section 10(b) of the Securities Exchange Act, the SEC has the option to prosecute the issuer of a security if they’re found to have omitted or misrepresented the facts of a deal. Typically, this begins with making the initial deal null and void. In other words, the investor is no longer liable for making the investment they’d committed to because the opportunity was presented to them under false pretenses.
The issue becomes much more serious if the SEC then determines that the syndicator or securities issue omitted or misrepresented facts on purpose. When this happens, fraud has occurred. If pursued in court, this fraud can lead to a prison sentence of up to 20 years, in addition to a fine of up to $5 million.
Further to this liability, you also have to comply with any blue sky laws that your state has in place. These laws are the state’s own anti-fraud provisions, which are designed to protect investors in a similar way to the SEC’s regulations. The exact nature of these laws varies depending on the state. However, you will generally find that most piggyback on the Exchange Act. Many blue sky laws make you liable in civil courts as well as criminal courts, opening the door for lawsuits in addition to the fines and fees the SEC may make you liable for.
The simple message is that you need to focus on providing full and accurate disclosure to any investor you work with. Even if misrepresentation occurs as a result of a mistake, you may still face punishment. A private placement memorandum can help you to avoid the issue of misrepresentation or omission.
A PPM is a legal document that you give to a prospective investor when you’re trying to sell securities related to your business to them. Also referred to as either an offering memorandum or an offering document, a PPM is typically used when you’re conducting a private transaction in which the transaction will not need to be registered under state or federal law.
So, you avoid some key regulations with a PPM, meaning it is a far faster way to gain access to business capital. However, as highlighted above, not having to register your transaction is not the same thing as not facing any liability for mispresenting or omitting facts.
You can conduct transactions using a private placement memorandum thanks to Regulation D of the Securities Act. This regulation details a set of rules and regulations you must follow to complete an unregistered transaction, the most important of which we’ll discuss later in the article.
Many equate PPMs to business plans. There is some truth to this because a PPM contains details about your business, its model, and your plans for future growth. But a business plan is essentially a marketing document that you use to promote your business to investors, lenders, and anybody else who has an interest.
A PPM has an element of that marketing about it, especially as you will use the document to convince investors to provide you with capital. But the more important role of a PPM is to serve as a disclosure document related to the transaction you wish to carry out. As such, a PPM will be more descriptive than a business plan, which is typically written to be more persuasive. You also need to focus on providing clear and accurate facts in a PPM, allowing them to do all of the persuading for you.
Ultimately, a PPM is what you use to inform investors about the opportunity you’re presenting to them. It may indirectly serve as a marketing document, especially if your presentation is of such a high standard that the document demonstrates your professionalism. However, its main purpose is not to market your company or its services.
There is no concrete format to follow when creating a PPM. Furthermore, the information you provide may vary depending on the type of securities you’re offering. For example, those making a private placement debt offering will include details about interest rates and loan repayment. By contrast, those making a private placement equity offering will focus more on dividends, time scales, and whether the offering provides a measure of control in the business.
A good syndication attorney can help you to create a PPM that’s relevant to your business.
Still, some standard sections tend to find their way into most PPMs:
Your introduction is your chance to briefly discuss your company and the opportunity that you’re presenting to the investor. You’ll outline the key terms of your offer here, in addition to providing short statements about the nature of your company and its core business offering. You may also add something about yourself here, especially if you have previous successes as an entrepreneur. But generally speaking, information about you comes later in the PPM.
Here, you’ll provide some more details about the offer you’re making to the investor.
Key details to include here are as follows:
You will provide more information about the securities offered and how the investor can access those securities later in the document.
This is a list of any potential risks the investor may face concerning the opportunity you’re presenting to them. The risk factors section does not need to cover the general risks involved in investing in a business or syndicate. The investor should understand those risks as part of their general knowledge. Instead, this section is for the risks involved with the specific opportunity you’re offering.
For example, your business may face risks related to competition. It may also face risks related to personnel or structure. This is all relevant information that helps an investor to make their decision.
Investors want to know about you. They want information about your entrepreneurial background, as well as details to help them understand why you’re pursuing your current business venture. Whether you are using Reg D to raise capital for a crypto business or a brick and mortar business the investors must understand the details.
They also want to know about your company, its history, and the services it offers. Investors want to see detailed financial performance metrics, as well as proof of intellectual property and any other material information relevant to the business and its operations.
You’ll share all of that information in this section of the private placement memorandum.
Use of Proceeds
No investor is happy to hand over their money so you can do whatever you want with it. As a syndicator, it’s your job to tell potential investors exactly how you’re going to use their money to grow your business so it can generate returns for them.
Discuss how much you intend to raise through your syndication efforts. Create an itemized list of expenditures to demonstrate how your business will spend the money. Finally, explain why you’ll spend the money as you’ve described, placing your focus on how your spending enables the business to grow.
This section allows you to go into more detail about the nature of the securities you’re offering. You’ll build on the information you shared in the summary by discussing the specific type of securities offered, any restrictions related to the offer, and the rights the investor will have should they accept the offer.
You will also talk about liquidity here, with a focus on how flexible your offer is to those who may want to access the liquid elements of their securities.
Investors need to know how to become a part of the investment syndicate you’re creating with your private placement memorandum.
Here, you’ll give them step-by-step instructions. You’ll also include any terms or conditions the investor must adhere to in order to complete the proposed transaction.
You may need to provide a range of other investment and syndication documents to bolster the information shared in the PPM. Examples include financial statements, contracts, licenses, and company organizational documents.
This section acts similarly to an appendix. Your syndication lawyer can help you to compile the documents required here.
We’ve touched on the concept of Regulation D at several points in this article. Naturally, you’re probably wondering what this is.
Regulation D is essentially a list of rules in the Securities Act that you must follow to be exempt from registering the sale or offer of securities with the SEC. It’s only by meeting the exemptions outlined in Regulation D that you’re able to create a private placement memorandum.
If you choose to use this regulation to make a private offering of securities, you need to complete a Form D filing. This filing can be completed electronically using the SEC’s website and serves as a brief notice of the transaction that has occurred. It includes the addresses and names of your company’s directors, executive officers, and promoters. The Form D filing also includes information about the offer itself. However, the filing does not go into the high level of detail required to register a public securities transaction with the SEC.
As the syndicator or securities issuer, it’s up to you to choose which of the Regulation D exemptions you will follow to allow for the creation of your PPM. Ultimately, this decision comes down to the choice of Reg D 506(b) vs 506(c). These are the two versions of Rule 506, with each offering different provisions. Making the right choice between these two exemptions is one of the keys to ensuring a successful PPM offering.
Under this rule, you’re able to offer your PPM to both accredited investors and sophisticated investors. A sophisticated investor is somebody who does not have accreditation but can demonstrate proof of both their expertise and their ability to meet the financial obligations of the investment. There is no limit to the number of accredited investors that a syndicator can bring on board. But you can only have a maximum of 35 sophisticated investors.
One of the key advantages of Rule 506(b) is that the securities issuer does not have to go out of their way to verify the credentials of their accredited investors beyond the course of natural due diligence. However, this is balanced out by the fact that the issuer must be able to prove they had a substantive relationship with a chosen investor before providing the investor with information about the PPM and the opportunity it contains.
The reason for this provision is that you’re not allowed to advertise your offer under Rule 506(b). Failure to demonstrate a prior relationship with an investor suggests that you’ve advertised your offer, meaning the SEC may prevent the deal from taking place.
With Rule 506(c), you’re not allowed to work with sophisticated investors. But you can still invite an unlimited number of accredited investors into your syndicate. You also face no limits in terms of how much money you request from each investor or how much capital you raise in total.
However, you do face the burden of verifying the credentials of every investor you present your opportunity to. This rule requires you to undertake “reasonable” efforts to verify your investor, which may include examining tax returns, looking at bank statements, or gaining written confirmation about the investor’s status from a certified accountant or attorney.
Verification is a complex process. Many securities issuers choose to outsource verification to third-party providers, both to free up their time and to transfer the liability for incorrect verification to somebody else.
The main benefit of Rule 506(c) is that you are able to directly advertise your offering to investors. As such, you also don’t need to demonstrate any evidence of a prior relationship with any investor you attract.
Though a private placement memorandum offers you some freedom from the typically strict SEC regulations, this does not mean that you don’t have any legal concerns to consider when creating one. You must still abide by all anti-fraud measures by ensuring the information in your PPM is accurate and up-to-date. You may also need to provide certain syndication documents that can only be created by an attorney.
That’s where we come in.
At Moschetti Law Group, we help entrepreneurs raise business capital by creating high-quality PPMs. With us, you’ll be protected by the knowledge that you’re working with a syndication attorney who has almost a decade of experience working with clients that have similar requirements to your own.
Our investment-grade PPMs ensure your potential investors have all of the information they need to make their decisions. We also ensure your PPM is consistent with the messages your investors have previously received and that it contains only accurate and timely information.
Simply put, we take all of the hassle out of creating a PPM, allowing you to focus on running your business.
To find out more about how Moschetti Law can help you to draft a private placement memorandum that demonstrates the level of professionalism investors want to see, book a free consultation with us today.
Contact our syndication and private placement memorandum law firm today!