Within living memory, private placement of capital had been a secretive and self-selecting back channel of the financial community. It was administered by money-center banks and subscribed to by only the wealthiest individuals or institutions. But, given the twin shocks of the 2008 financial crisis and the ubiquity of smartphones, the ground has shifted.
What was once a gentlemen’s club is now an app.
Depending on their point of view, some demand and others decry what economist Robert Shiller calls the “democratization” of finance. Regardless, today’s private placement market in the United States embodies that level-playing-field ethos.
What follows is a comprehensive list of terms and concepts which startup founders will find helpful as they move forward with U.S.-based fundraising. Links are provided to more publicly available resources, which provide stepwise instructions for those seeking to raise capital under these provisions.
A private placement is the process companies use to raise money by selling securities to a limited number of potential investors. These offerings are designed to be exempt from federal securities registration requirements and, thus, from the compliance hurdles incumbent upon public offerings.
The principal law governing financial instruments in the U.S. is the Securities Act of 1933. Drafted in response to the stock market collapse, which ushered in the Great Depression, it also established the regulatory regime for publicly traded corporate issues in the U.S. A lot of case law hangs on this statute, defining what is and is not a security, what does and does not qualify as fraud and illegal trading, and under what circumstances companies can sell securities to a small, select number of private investors instead of listing them publicly on an exchange. Exemption from registration is called, in regulatory parlance, "safe harbor."
The whole landscape changed in 2012 when Congress passed the Jumpstart Our Business Startups Act. The JOBS Act brought securities issuance and trading into the Internet Age by enabling firms to raise money via crowdfunding without the compliance burdens required by the 1933 Act.
Before we proceed, there is one distinction that we must make about those who fund private placements.
Securities that are traded publicly have been well vetted. They must conform to federal and state regulations and the rules of the exchange on which they trade. They generally have a track record both as operating companies and as players in financial markets. While it is still possible for a publicly-traded company to fail, they usually do not. If they are poorly managed, or the environment they operate in becomes too adverse, they might merge with or be acquired by a competitor or private equity firm. Alternatively, they might seek temporary bankruptcy protection from the courts, but it is unlikely that they will go out of business and auction off all their assets.
Companies issuing securities under safe harbor provisions rarely have the history or the scale to offer these assurances. We must also say that financial fraudsters have an easier time posing as early-stage entrepreneurs than as executives with decades of experience. For both benign and malign reasons, the private placement space is fraught with risk. Not all investors will understand those exposures or be able to tolerate them without impoverishing themselves.
Because these protections are removed, the 1933 Act defines who can and cannot participate in private placements, identifying those qualified as “accredited” investors.
Individual investors can be considered accredited if they meet at least one of these three criteria:
If calculating joint net worth with a spouse or spousal equivalent, the property doesn't need to be held jointly, and the securities being purchased do not have to be acquired jointly. Because the value of the primary residence is not included in the net worth calculation, neither is the amount owed on the mortgage.
Following specialized knowledge tests, the licenses are issued by the Financial Industry Regulatory Authority, Wall Street's self-regulating organization, which operates under a charter from the Securities and Exchange Commission.
Other categories of accredited investors include most trusts with total assets exceeding $5 million and any entity in which all equity owners are accredited investors.
The concept is expanded via the SEC's definition of qualified institutional buyers. Banks, trust funds, pension plans, and any similarly sophisticated entity could qualify as a QIB. These generally have more than $100 million in investable capital.
When governments want to raise capital, they essentially have one option aside from taxation: the bond market. For private companies, however, there is an array of options, and for each raise, each company -- regardless of size and market presence -- needs to decide what kind of instrument would be optimal. We will not get into the rubrics of mezzanine debt, convertible securities, and some of the more abstruse instruments that companies might use. Instead, we will look at this as a two-dimensional grid: public/private and debt/equity. We will examine public/private first.
Corporate securities being sold to any random buyer constitute a public offering. Most commonly, one hears of initial public offerings. An IPO is the broad investment community's first chance to participate in the issuing company. It is usually released with great fanfare to generate the most significant awareness of the new stock. Once an IPO is launched, though, there is no law stating that the company cannot issue more stock. If its executive team chose to do that, though, it would have to contend with irate shareholders whose current holdings would be diluted by a secondary offering.
Companies tend not to issue stock to the public unless and until they have arranged to be listed on a stock exchange. Not all do, however. There is a frothy market of over-the-counter stocks. Many OTC shares can also be categorized as "penny stocks," meaning they range in share price from at most $5 down to a penny. These are "considered speculative and may involve a high degree of risk,” according to investment bank Robert W. Baird & Co. The Baird note identifies those risks as:
These risks are reduced by trading on an exchange, where there are more buyers, more sellers, and greater transparency in the market.
Unless otherwise specified, any corporate security issued in the U.S. is considered to be a public offering and, as such, must be registered with the SEC, the federal government’s regulator of stock and bond markets. That is, the company must file a registration statement, making disclosures required by U.S. law.
The standard template for registration statements is SEC Form S-1. It contains prompts for all the boilerplate information, such as the publicly reporting company's name, address, and tax filing number. The most critical part of the form, though, is the structure for the prospectus -- a document that discloses material information about a new financial offering and the publicly reporting company that issues it. The S-1 requires:
It is a daunting document to compose. In the current environment, many promising startups are going public via special purpose acquisition companies. A SPAC is a shell company created to pool funds to buy a growth-phase company -- yet to be identified -- which fits its investment objectives. The SPAC has no operations, so the S-1 is much easier to fill in, and thus the shell company issues a public offering and gets listed on an exchange. When it spots the startup with the operations it wants to fund, the SPAC structures a merger, so the startup's managers never need to go through the registration process.
Reg A is a middle ground between a fully registered company and the private placement market, and offerings under its auspices are often called "mini-IPOs." The rule allows issuers to sell securities to the public but with more limited disclosure requirements than otherwise required. As with OTC stocks, Reg A stocks are considered speculative, and the markets for them are illiquid.
While a full registration document is not required, the issuer must still file an offering circular, which is essentially an abbreviated prospectus. These are favored by companies that have no earnings history and few tangible assets.
Reg A allows companies to raise funds under two different tiers:
This two-tier system was established in 2015, enabled by the JOBS Act. For a while, this expansion was referred to as Reg A+ to distinguish it from the earlier, more stringent guidelines. Some still refer to Reg A+, although there are few issuers today incorporated under the old Reg A rules.
The JOBS Act also provides for the niche of very small companies or startups looking to raise modest amounts of capital via crowdfunding.
The SEC has registered several dozen online platforms and broker-dealers through which a firm can raise up to $5 million under Regulation CF. Individuals are constrained as to how much they can invest across all Reg CF offerings in 12 months: between $2,200 and $107,000, depending on their financial resources.
Reg CF requires a short and unaudited offering circular called a Form C to be filed with the SEC.
It is not always worth the effort and expense for a company to register with the SEC, yet operations and expansion must be funded. That is where the private placement market comes into play.
Private placements are not subject to some of the investor protection laws that govern the issuances available to the public. The SEC gives investors few assurances about the securities on offer, limiting the investors that can participate in preventing widespread fraud.
The 1933 Act has a rule known as Regulation D that permits companies to market their securities to specific investors without going public.
Reg D comprises the safe harbor provisions which allow for the issuance of unregulated securities, as long as they are not sold directly to unsophisticated investors. Under its auspices, Reg D issuances cannot trade on exchanges which, by their nature, attract investors of all levels of sophistication.
Within Reg D is a provision, Rule 504, which permits microcaps to solicit investments. Rule 506(b) and Rule 506(c) cover more established entities which choose not to trade on exchanges.
While most of these rules allow the issuer to decline to offer a formal prospectus, companies that comply with them must electronically file a Form D once they first sell their securities. This is a brief notice that includes the names and addresses of the company's insiders and details about the offering. It is not a formal prospectus and does not prompt any financial disclosures. Still, it is reasonable and customary to present investors with an informal prospectus known as a private placement memorandum. A PPM should include, at a minimum:
The SEC had granted reg D exemptions on an exceptional basis since the 1980s, but the JOBS Act's amendments have led to the current surge of crowdfunded enterprises.
Rule 504 enables issuers to offer up to $10 million of securities in any 12-month period. These may be sold to any number and type of investor, and the issuer is not subject to specific disclosure requirements.
The rule prohibits investment companies and SPACs from filing under its provisions.
Rule 505, which is no longer operative, allowed issuers to offer up to $5 million of their securities in any 12-month period. The issuer could sell to an unlimited number of accredited investors but no more than 35 non-accredited investors. Since 2016, The SEC has rolled up its provisions into Rule 504.
Rule 506(b) allows issuers to sell an unlimited amount of securities to an unlimited number of accredited investors, providing these are investors with whom the issuer has a pre-existing relationship. However, issuers cannot engage in “general solicitation,” which is how securities law refers to advertising to the public.
No more than 35 investors may be non-accredited. All non-accredited investors, though, must have “sufficient knowledge and experience in financial and business matters to be capable of evaluating the merits and risks of the prospective investment,” according to the SEC.
If even one non-accredited investor participates, the issuer:
This is the one Reg D rule that mandates a PPM.
Instruments sold under Rule 506(b) are almost always restricted securities, meaning issuers cannot resell them for a specified period -- typically six months or a year -- unless they become registered for public trading or, as will be discussed below, fall under the provisions of Rule 144A.
Rule 506(c) permits issuers to solicit and raise unlimited capital using whatever advertising they choose to promulgate their offerings. While this marketing can appear on the screens of the general public, only accredited investors are permitted to participate in the market for these securities, which, as with those covered under 506(b), are usually restricted.
The U.S. is unique among leading economies in that it regulates financial markets at both the federal and state levels. Whether this redundancy is a net positive or negative is a subject of robust debate, but it is a reality that investors and issuers need to acknowledge. In fairness, state securities regulation predated the federal layer by decades.
These state statutes referred to as Blue Sky laws are intended to protect investors against financial fraud. These laws vary from state to state, but the template is the Uniform Securities Act, first passed in 1956 and most recently updated in 2005. Through Blue Sky laws, states require companies to register their offerings before being sold in a particular state. It licenses brokerage firms, their brokers, and investment adviser representatives.
While equity is, by definition, part ownership in a company, debt is its obligation to repay a lender the amount borrowed plus interest on an agreed-to schedule. While there is a market for direct, peer-to-peer lending, we will focus here on the issuance of debt securities called -- interchangeably -- bonds or notes.
One concept that many novice investors have difficulty understanding is that it is often more desirable for a company to go into debt instead of pursuing another available option, such as selling more equity. In the U.S., we are culturally averse to debt and consider it the burden it can become rather than the opportunity it might present. The cost of debt is fixed at a given interest rate or a given spread above a benchmark rate. This cost is also generally lower than issuing equity, which dilutes the founders' and original investors' stake in the company.
Novices might also blanch at the thought that many investors prefer to buy a company's debt rather than a share of its ownership. If debt is to be avoided, why would a rational person purchase someone else's? Again, this is a cultural rather than a financial perspective. If an investor has no interest in influencing the company's management, then the appeal of equity ownership is diminished. If the investor is seeking steady cash flows rather than a longshot chance of an astronomical return, debt becomes more attractive. Further, should the company fail, the debtholders will be paid back first when the entity is liquidated, and the stock price goes to $0.
Also, a quirk of the U.S. tax code favors companies with capital structures that lean toward debt rather than equity. Interest payments are tax-deductible; dividend payments are not.
While many private lenders are individual accredited investors, there are also specialized lenders, funds, and non-bank finance companies that participate in this market.
Any of the Reg D rules outlined above can be applied equally to equity or debt issuances. However, it should be noted that there is room for confusion between raising debt under two different Rule 504s. In addition to the Reg D Rule 504, there is a Small Business Investment Act Rule 504 under which the Small Business Administration guarantees loans to firms operating in economically disadvantaged areas. Aside from the nomenclature, these rules are completely unrelated.
One key distinction between equity and debt funding is that equity is permanent. Still, debt is expected to be retired as of a maturity date established before the note is issued. The impact on issuers is that, when raising debt, they would be well advised to ensure that the use of proceeds outlined on Form D or in the PPM matches the term of the note.
Another is that equity holders understand they could lose their entire investment. While debt holders likewise acknowledge that, they also know that they have more legal protections. If a payment is missed, they might elect to foreclose and require the issuer to liquidate all its assets. More often, though, they would put forward a forbearance agreement and allow for restructuring the debt, albeit at a higher interest rate.
One other provision of Reg D is Rule 144A, which provides a safe harbor from registration requirements for private resales, thus providing liquidity to the secondary market. While this is not explicitly geared toward debt as opposed to equity instruments, debt accounts for the bulk of the volume.
The investor pool is different for Rule 144A than that for the initial offerings. Rather than limiting the pool to accredited investors, the rule extends it to all QIBs.
Rule 144A's purpose is to increase liquidity in the private placement markets and has also enabled non-U.S. companies to raise funds in the U.S. Liquidity was further enhanced when Nasdaq opened its PORTAL platform for trading 144A issues; it has since been renamed Nasdaq Private Market Solutions.
Rule 144A should not be confused with Rule 144, which covers unregistered public resales of restricted securities.
A founder might have had a brilliant idea, assembled a polymath core team, going through the time and expense of putting the "Inc." after the entity's name, dutifully filed the Form D, and even made a credible effort of projecting pro forma financial statements. It is all for naught if nobody with any money to invest knows about it.
A progression of financing rounds has emerged, although the specific steps are more a factor of convenient labeling than of formal procedure. As a company passes through each gate, it generally raises more capital but offers a smaller percentage of equity or pays a lower interest rate.
The trick at this point is to find the right funders at the right time. Before delving into the various rounds and the investors they attract, it is essential to note that not every company touches all these bases. The first three headings below are not necessarily distinct; they can all be lumped into one raise if the timing is right.
And those who have been through this process more than once generally advise founders not to take any money they do not absolutely need in the short run.
The first people new founders might approach are their friends and family. In fact, the investment community has come to regard the friends and family around as a customary pre-seed activity.
Typically around 6% to 8% of equity is promised in this round but will probably not be delivered immediately. The standard instrument issued at this point is the simple agreement for future equity, or SAFE, note. If the company takes off, each participating friend or family member will have the opportunity to convert the note to equity and enjoy all the upside benefits. If the company folds, then the SAFE is retired as a loan that will not be paid back.
SAFE notes are also the currency of most platforms chartered under Rule CF so that crowdfunding can be conflated with the friends-and-family round.
“Angel” was originally a show business term for a wealthy individual who invested money out of pocket to pay the upfront costs of putting on a stage play. It was not a stretch to apply that label to patrons of Silicon Valley innovators and the rest of the “maker” culture that developed worldwide in their wake.
And for many years, it was the same informal process: Someone who has the wherewithal to invest but prefers to put that money into something more interesting than blue-chip stocks meets a go-getter with a great concept. A check gets written, and the angel understands the risk being incurred on a qualitative if not a quantitative basis.
This phase has, for better or worse, getting more sophisticated in recent years. While individual angel investors still exist, they are becoming harder to find and are more likely to hire a team of subject matter experts to perform due diligence before making any commitments. More likely, the angel has teamed up with like-minded people in the same city and the same tax bracket to form an angel investor group, through which investment decisions are made by committee.
Pre-Seed round is characterized by the absence of institutional investors. By this definition, friends-and-family and angel funding can be lumped into this category.
Once a concept has been proven, a minimally viable product has been demonstrated, and the first revenues have come in, the institutional players begin to take notice.
“Round sizes range between $10,000 and $2 million, though larger seed rounds have become more common in recent years,” according to Crunchbase.
Venture capital firms dominate the private placement landscape from here on out. Series A and Series B raises range between $1 million and $30 million, again according to Crunchbase. Series C rounds and onwards are for more mature companies and typically attract in excess of $10 million.
Up to this point, we have kept this discussion broad, addressing concerns faced by all founders seeking to raise funds via private placements. Now we focus on the particular case of fund managers.
While it is true that these are among the people whom other issuers target for their own funding needs, it is also true that fund managers are also founders of their own small enterprises. To some degree, they might compete for financial backing against the same startup teams who might be soliciting them. And yet, fund managers are also fundamentally different from other entrepreneurs in one critical way: Fund managers, as participants in the financial services sector, are much more highly regulated than issuers in any other sector (with the possible exception of health care).
Increasingly, fundraising is done online via portals that match issuers and investors. For non-financial issuers, that is often enough. For fund managers, though, that is only the beginning of the functionality required. A private placement portal that adequately serves their interests should also:
Connect with placement agents. There is an additional layer between the fund manager and the investor by industry custom, which is generally absent in the broader economy. A portal would need to actively reach out to the placement agents who serve as middlemen.
Promote compliance. The portal would need to parse accredited from non-accredited investors before presenting other details to the fund manager. It should also flag anyone who has been labeled a "bad actor" by regulators and otherwise provide the kind of know-your-client, anti-money laundering, anti-terrorist financing, and anti-tax evasion data the fund manager will need to present later in the onboarding process.
Consolidate account management. The portal should serve as a platform that streamlines administration and provides precise inputs into the investment decision-making process.
Provide a positive user experience. It is an overstatement to say that, for most private placement purposes, a standard Web 1.0 chat room could be used -- it is just a matter of introducing innovators to investors. Everything else can be done offline. Still, this would not serve fund managers whose business needs are more complex. A dashboard that presents all client data in a sortable, filterable, ordered format, all presented on a single pane of glass, has become table stakes for serving the fund management community.
Offer full Client Relation Management functions. Fund managers also demand that the platform serves as CRM software, helping them communicate with their clients with a click, helping them execute transactions on their clients' behalf with another click, then helping them electronically transfer dividends to their clients' bank accounts with yet another.
Provide endpoint-to-endpoint data protection. It is clear that, at the time of this writing, in mid-2021, regulation is coming to ensure that companies across all sectors raise their data security standards. In the meantime, robust attention to security online is a high-priority best practice. At a minimum, the portal should adhere to ISO 27001 and ISO 27002 information security standards.
Stay up-to-date with the latest articles, tips, and insights from the AET team