Private Companies Get Public Platform: Closely-Held Firms Cleared for Wide-Scale Investor Advertising
This summer, the Federal Securities and Exchange Commission (SEC) adopted and issued new rules permitting privately-held companies to raise capital through “general advertising.” With this new rule, firms can now widely circulate offering materials to more than simply friends, family and business contacts. At the same time, closely-held firms can issue stock or bonds under the private placement exemption — which exempts closely-held firms from expending time and capital by publicly offering securities.
New Rule – Advertising of Private Placements Permitted
These new rules now permit closely-held companies to generally advertise their search for new shareholders, while also qualifying for the coveted “private placement” exemption from registration. Without the private placement exemption, a firm would have to spend hundreds of thousands of dollars to comply with the extensive SEC filing and approval requirements of an initial public offering, requirements more appropriately applied to a firm with thousands of employees and a value approaching half a billion dollars.
For decades, smaller firms have contorted their offering documents to qualify for the private placement exemption. Among the most important prerequisites for that critical exemption was a condition not to generally advertise the securities offering. If the federal government, or a court, found that a firm was not strictly selling stock to friends, or at least friends of friends, investors could immediately demand the return of their money, with interest.
The Future of Fundraising
Companies may now distribute prospectuses for investors to many, many potential buyers. Smaller firms may canvass large numbers of potential purchasers without jeopardizing the streamlined and much less expensive “private offering” exemption. Companies may now approach customers, affinity groups, employees and neighbors as part of investor recruitment efforts. Offering documents and procedures will become more streamlined, since firms no longer need to work around many of the prior rules and procedures restricting “general advertising and solicitation.” Now, it does not matter.
The Way We Were
In the past, to avoid this compliance calamity, firms could only offer securities through issuance of quiet, tightly controlled, offering documents. The prior law imposed a myriad of rules governing public offerings on private firms promoting their offerings on internet, radio, newsletters or other “non-private” media. The precautions recommended by courts and regulators had become unwieldy. Recordkeeping, long disclaimers, and almost secretive distribution of documents were required to prudently avoid violating securities laws. Mistakes could prove financially fatal.
Now, companies can have their investment cake and advertise it, too.
What This Means
Just as new rules several years ago permitted drug companies to advertise medications on television, this new rule will open the doors to an entirely new set of mass media investment promotions. Privately-held firms will be able to advertise on television (unlikely), or send thousands of spam emails promoting the latest way to get rich (likely). Other possible avenues for aggressive promotions include web sites, newsletters, speeches at Holiday Inns, infomercials, and colorful booths at fairs.
For more traditional companies, the new fundraising freedom will lead to a restrained, but less cumbersome, campaign of mailings and public presentations. Companies can now deliver investment booklets, much like a job seeker mass mailing resumes.
Stranger-Danger, the Investor
Most sophisticated private companies appreciate that the greater the number of investors, the greater the headaches in managing the firm. Attracting too many investors can result in “stranger danger” owners. Such anonymous investors can include, in the worst case, a wolf in investor’s clothing, poised to file a nuisance suit simply to extract “buy-off” money from a company wishing to avoid the inconvenience of defending a claim. Such anonymous investor lawsuits are often based on minor non-compliance with the securities laws, or failure to accurately predict financial troubles. Even if a suit has no ultimate merit, numerous hostile investors can extract significant sums from innocent companies.
The result: most private firms will cautiously deploy restrained “advertising” programs for new investors. Nevertheless, the benefits of having cleared the old compliance minefield will enable firms to streamline initial offering documents and accelerate fundraising.
The Fine Print – Conditions to Qualify for Advertising
To qualify for this new world of investment promotion, firms must undertake the following:
• All purchasers must be accredited investors. An accredited investor includes, among others, persons with incomes over $200,000 per year, married couples with incomes over $300,000 per year, or persons with a net worth exceeding $1 million (excluding one’s home).
• The issuer must document that it tried to verify that the potential purchasers were “accredited.” This new exemption now requires “trust, but verify” (the old rule: “trust, and don’t bother to verify”). The SEC provides specific examples of methods for such verification. These include: review of the purchaser’s tax returns for the prior two years; purchaser self-certification regarding income levels; bank statements; brokerage statements; certificates of deposit; third-party appraisals; or a credit report. The list is not exhaustive. Securities issuers should require additional reliable evidence of investor wealth in the case of offerings to many inexperienced investors, or in situations where company information is limited and difficult to find.
If the Rule Fits, Wear It
Firms should determine whether the new exemption for broadly-distributed investment materials is appropriate. Companies should assess the following before jumping into the world of mass-marketed investments:
• Firms that will aggressively advertise fundraising will likely be those that can benefit from smaller checks and a higher profile. These include stores, consumer product makers, retail services, or websites that require a high profile. Also, some passive investment opportunities such as real estate or other similar single asset investments might use more aggressive promotional methods.
• Will the company need future funding from its shareholder base? The new exemption is more likely to be “one and done.” Large numbers of shareholders with smaller amounts invested are less likely to return should the company need more funds. Firms that raised the same amount of money from a handful of deep pockets will have more chances to return to these investors should the need for more cash arise.
• Simple, low-risk businesses are easy to explain; complicated, risky businesses are vulnerable to misunderstanding. A larger pool of investors will require frequent updates about the business. A volatile R&D-driven business model makes for a difficult story to sell to multitudes of investors. Better to stick with a small number of stoic deep-pocketed owners.
• Venture capitalists are afraid of crowds. If a firm intends to raise institutional money, a large investor base will deter venture capital money. Venture capitalists hate the uncertainty and distraction of large numbers of unruly investors who might complain (in court) if the venture capitalist gets too much of the future return.
• Just as beer can be a bad combination with liquor, the new mass-market exemption does not mix well with other securities exemptions. In fact, some exemptions will be explicitly prohibited once the company uses the new general advertising exemption.
Next Stop: Crowd Sourcing
This new rule has been issued in connection with a set of rules that permits more companies to seek investment from more persons. The SEC plans to release more crowd-funding rules that will expand the fundraising. This new “general advertising” alternative is a dramatic first step.
Craig McCrohon is a Corporate and Securities attorney at Burke, Warren in Chicago. He specializes in stock offerings, venture capital and acquisitions, as well as bank regulatory counseling. You may contact him at firstname.lastname@example.org or