Private placements and the small business owner who does not want to go public
You have now consulted with your small business attorney and to your surprise the attorney has advised you as a small business owner that a selling LLC interests may be subject to securities laws.
Related article: Selling Interests in an LLC: Securities Considerations
Selling a piece of your limited liability company, even if it is a small business, may put you on the radar of the Securities and Exchange Commission (SEC). It doesn’t mean that you have to go public. “Going public” for those not in the know basically means that you have to register the securities with the SEC. Think big bucks for your securities lawyers and investment bankers. The SEC provides this succinct guidance: “Under the Securities Act of 1933, any offer to sell securities must either be registered with the SEC or meet an exemption.”
Related article: Investors for Startups: Terms of Engagement
That is pretty much it: if you have a security, and please refer back to our article on whether a LLC interest may be considered a security, then you either have to register with the SEC or you must meet an exemption. If you fall within an exemption to the securities laws, you do not need to register the securities. Just to hammer home the point, the SEC succinctly states: “If a small business is offering and selling securities, even if to just one person, the offer and sale of the securities must either be registered with the SEC or conducted in accordance with one of the many registration exemptions under the Securities Act.”
As a small business owner, if the membership interests may be considered securities, you are looking for an exemption as you do not want the risk of substantial fines from the SEC and possibly worse yet, you do not want the purchaser to try to rescind or undo the purchase of the membership interests.
Related article: Selling a Small Business: Not as Easy as you Thought
Private placement exemptions: non-public offerings
The most relevant exemption is what is known as the private placement exemption under Section 4(a)(2) of the 1933 Securities Act. The courts have provided varying interpretations of the language in the 1933 Act that “transactions by an issuer not involving any public offering” are not subject to registration. So a private offering is a non-public offering. That seems obvious, but where things get tricky is what makes an offering “private.” Part of this problem arises from the Securities Act of 1933 not actually defining the difference between a public offering and a private offering.
The courts have explored and defined what constitutes a private offering. The leading case in all of this is SEC v. Howey Co., 328 U.S. 293 (1946). In that case, the Supreme Court struggled to come up with a definition of what constituted an “investment contract” subject to the securities laws, finally determining that any interest that “involves an investment of money in a common enterprise with profits to come solely from the efforts of others” is an investment contract. The courts have refined the Howey test over the years, establishing a guiding principle for determining whether an offering is public or private—whether a person needs the protection that the Securities Act provides by requiring registration. The courts have held that sophisticated investors have sufficient investing knowledge or experience to evaluate the risks and rewards of a particular investment.
To provide more certainty, the SEC adopted Regulation D, a non-exclusive safe harbor. A safe harbor means you get rid of the uncertainty by taking your ship into the protected waters of a safe harbor: if you meet the requirements and comply, you are good to go. The company can conduct limited offerings and sales of securities without registration. The non-exclusive part means that you still may be exempt from registration but you may have a hard time proving it and may be subject to SEC scrutiny. In short, you want to fall within one of the safe harbors of Regulation D.
The rules under Regulation D depend on several factors, including whether the investor is sophisticated or should be sophisticated enough to make a decision, how much is involved in the offering, and over what period of time, and whether you have to prepare a private placement memorandum (PPM).
Accredited investors fall under a separate category of protection
There are varying standards of protection depending on the sophistication of the investor. As discussed below, the rules make a distinction between “accredited investors” and those who are not accredited investors. You can find the definition of an accredited investor in the general rules and regulations for the Securities Act of 1933.
In general, accredited investors are people who have either a minimum net worth of $1,000,000 or an annual income of more than $200,000 (or $300,000 for a couple) for the last two years, and who are permitted to make high risk investments normally intended only for sophisticated investors. The definition of accredited investors has been the subject of debate: some say that it is too narrow and the SEC has proposed to include in the definition people who don’t meet the dollar threshold so long as they have the education or job experience to enable them to have professional knowledge of a subject related to a particular investment.
An accredited investor may also be an entity such as a private business development company with assets exceeding $5 million. An accredited investor can be a bank, a savings and loan association, or any other similar institution—regardless of whether they are acting in an individual or fiduciary capacity. Similarly, an accredited investor can be a registered investment broker or dealer, or it can be a registered investment company. Basically, accredited investors are people or institutions who may suffer a limited amount of economic harm from their investments, or at least they understand the economic harm that they might incur from investments.
Besides accredited investors, a purchaser can be any group of individuals that could be treated as one unit. For example, relatives of a purchaser sharing the same primary residence would be treated as one purchaser. Similarly, a corporation or partnership would be treated as one purchaser so long as that organization both exists for the specific purpose of acquiring the securities offered and is not an accredited investor. (In which case, each beneficial owner of securities or interests in the entity is treated as a separate purchaser for all provisions of Regulation D.)
Some of the exemptions allow the company to sell securities to non-accredited investors, but that doesn’t mean you can sell your membership interests to some poor schmo on the street corner. Even non-accredited investors must have some sophistication in investments. According to the SEC discussion on Rule 506, they must “have sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment.”
If you have a LLC and you do not want to go public but want to sell LLC membership interests, you can avoid registration if you comply with the rules and meet the requirements of one of the exemptions. Then generally you simply file what is known as a Form D. It is a whole lot easier than going public. For most small business owners, the choice between registering and going public, on the one hand, or fitting into one of the exemptions and filing a Form D, on the other hand, is relatively straightforward.
Federal exemptions under Regulation D
The SEC has adopted the following three exemptions, not surprisingly, Rule 504, Rule 505 and Rule 506. We have already considered in another article the new rules governing crowdfunding and you should refer to that article on crowdfunding for more information.
Related article: Crowdfunding ABC’s: Small Business Funding by the Hordes
The following table gives a general summary comparing each of the three rules. There are more restrictions but this gives a quick snapshot.
|Rule 504||Rule 505||Rule 506(b)||Rule 506(c)|
|Maximum amount||$1 million||$5 million||No limit||No limit|
|Duration||12 months||12 months||No limit||No limit|
|Soliciting||No general solicitation to the public. Only preexisting contacts||No general solicitation to the public. Restricted securities that cannot be sold for six months without registering them||No general solicitation to the public. Only preexisting contacts||Broad solicitation and general advertising allowed|
|Disclosures||None required but “sufficient information to avoid violating the antifraud provisions of the securities laws”||None required for accredited investors but “sufficient information to avoid violating the antifraud provisions of the securities laws.” If NAI, then registration disclosures required||Same as for 504 and 505||Same as for 504 and 505|
|Accredited||No limit||No limit||No limit||No limit|
|Non accredited (NAI)||No limit||35||35 (receive same information as registered offering)||Not allowed|
|State/Fed||Must be exempt under state law in every state of investors||Federal preemption||Federal preemption|
|Other||Not a blank check company (no business plan or purpose)||Financial statements certified with some exceptions||Restricted securities cannot be sold for 1 year||Restricted securities cannot be sold for 1 year|
- Rule 504
Under this exemption, securities do not need to be registered if they are part of a private placement not exceeding $1,000,000. The dollar limit is a major constraint of this exemption. There can be any number of purchasers of the securities and the investors may be accredited or non-accredited. The issuer, however, cannot be an investment company. A company that has no specific business plan or purpose, or one that only has a business plan to engage in a merger with or acquisition of an unidentified company is not eligible to use this exemption. Rule 504 does not require federal registration, but registration is required in every state in which there are investors. Because of the various constraints, companies do not rely on this exemption very often.
- Rule 505
Under this exemption, securities do not need to be registered if they are part of a private offering that neither exceeds five million dollars $5,000,000. Another significant restriction is that there are no more than 35 investors. Even though the total value of the securities issued is greater than 504, the number of purchasers is limited. There are also audit and disclosure requirements. Not surprisingly, companies rarely use Rule 505.
- Rule 506
The vast majority of companies that sell securities rely on Rule 506. A major advantage of Rule 506 is that it “preempts” state laws so the company does not have to register in various states. And if the company sells securities only to accredited investors, there is not a requirement that you provide information regarding the investment. Nevertheless, of course most companies prepare private placement memoranda to further insulate the company from exposure to litigation. The traditional approach to Rule 506 is now what is 506(b), which allows both accredited and non-accredited investors. If you were selling a security under 506(b) to an accredited investor, you had to have a “reasonable belief” that the investor met the accredited standard. Rule 506(c) is a recent addition and requires the companies to have not only a reasonable belief that investors are accredited investors, but also to take “reasonable steps” to verify an investor’s status before the investor may invest. As a tradeoff for this higher standard, 506(c) allows general advertising.
Other private placement exemptions
If your sale of membership interests or stock does not fall within one of the exemptions, you may still be exempt under the general exclusion of non-public offerings under Section 4(a)(2) of the 1933 Act. The problem here is that you can no longer take cover in the safe harbor of Regulation D and there is no certainty until you get a knock on the door by the SEC. Consequently, you should try to structure your transaction to fall within one of the Regulation D exemptions. Nevertheless, if your offering does not fall within one of the exemptions, there are some general rules about what you should do to minimize the risk.
If you are unable to fall within one of the safe harbor exemptions, you are stuck with some uncertainty. There may not be one factor that is decisive but there are ways to minimize your risk that your transaction may be considered a public offering. If you want to have a private offering, then you should of course avoid using any general advertising or solicitation such as through the Internet. You should keep the number of offerees as small as possible. You may have heard of a friends or family round of financing. While there is no such thing as a friends and family round of financing, nevertheless, if you limit the offering to friends and family or sophisticated investors with whom you may have a pre-existing relationship, then you are more likely to escape from being deemed to be holding a public offering. And for any offering, it is good practice to disclose as much information as you have about the offering. You should include financial statements and the risks involved with the investment such as that you may lose all of your money. Finally, make sure that prospective investors have access to the company’s facilities and company records.
But even if you do all of these things, you still don’t know if you have cleared the bar because each transaction is looked at separately based on the facts and circumstances which may include a potpourri of factors such as: the dollar amount of the offering; how many prospective investors to whom the offering has been made to; the sophistication and wealth of the offerees; the availability and access to information about the company; the manner of the offering; the absence of further transfers of securities. Because of this jumble of factors, you may understand why you are generally advised to fall within one of the safe harbor exemptions under Regulation D.
In addition to the federal exemptions, there are also state exemptions. Section 3(a)(11) allows an exemption from registration for “any security which is part of an issue offered and sold only to persons resident within a single state by an issuer which is a resident and doing business within such state.” State exemptions typically apply to securities that require less regulation for public interest or investor protection (much like the federal exemptions). Ultimately, exemptions vary from state to state and the company must ensure that it has complied with all state regulations. The state’s security commissioner may have the discretionary power either to grant exemptions to securities or to revoke exemptions.
A small business owner ignores securities laws at his or her peril. Securities laws can be a major issue in any sale of LLC interests. Even those interests of a small business may be subject to the securities laws. Consequently, small business owners must consider how to assure that each sale of interests in the business complies with state and federal securities laws.