Promotion of Private Placement Stock and LLC Offerings

One problem with selling stock or LLC interests to investors by making a "private placement" is that public advertising is generally not allowed. Still, with care, some promotion can be made.

By way of background, many small companies make "private placement" sales of their stock or LLC interests by using one or more exemptions from the default requirement of the securities laws that offerings be registered. (Registration, often done as part of "going public", is generally too time-consuming and expensive for small companies.) Note that using the exemptions from registration still requires completing and filing the appropriate forms, although this process is far simpler than registration.

What type of promotion can be done depends on the securities exemption that is used, which in turn depends on the amount of money being raised, the number of purchasers, the qualifications of the potential investors and whether the investors will be in more than one state. Generally someone making a determination of whether an investor meets any requisite qualifications can rely on a substantial written questionnaire completed by a potential investor that sets out the investor’s qualifications. If there is reason to doubt the answers, though, then an investigation must be made before the potential investor can be given investment materials, much less allowed to invest.

This article generally will address California and federal exemptions, although some of what is presented regarding SCOR, Rule 504 and Rule 506 exemptions apply to other states as well.

California 25102(n) Exemption

If the amount being raised is $5 million or less, the offering is limited to California investors, and the offering is limited to financially "qualified" investors (more on that in a moment), then a California 25102(n) offering can be made. (There is no limit on the number of investors.) This allows a limited "tombstone" advertisement that can be used in a variety of ways, including on a web site. The advertisement, though, basically can provide only the following information about the offering:

1. A brief description of the business of the issuer.

2. The geographic location of the issuer and its business.

3. The price of the security to be issued, or, if the price is not known, the method of its determination or the probable price range as specified by the issuer, and the aggregate offering price.

To obtain additional information and be allowed to invest, the investor must be qualified. ASSUMING the company is a corporation instead of an LLC and has only one class of stock (since otherwise the federal accredited-investor standards, discussed in the section about Rule 506 offerings below, have to be met), the investors must be:

Businesses with more than $5 million dollars in assets;

Individuals with either: a) a minimum net worth (in conjunction with their spouses) of $250,000 and gross income in excess of $100,000 or b) a minimum net worth of $500,000. The value of the home must excluded in both cases. Moreover, the amount of the investment of each individual cannot exceed 10 percent of the net worth of the individual.

Note that this exemption is not available if the company is "blind pool" company, which is defined as a development stage company that either (i) has no specific business plan or purpose or (ii) has indicated that its business plan is to engage in mergers or acquisitions with unidentified companies or other entities.

SCOR and Rule 504 Exemptions

If the offering will be for $1 million or less, two options that allow advertising are the SCOR (Small Corporate Offering Registration) exemption and the federal Rule 504 exemption.

The SCOR exemption is available in many states, including California, although California imposes additional restrictions that many states do not. While a number of states allow regional registration (so that the forms only have to be filed once for a multi-state region of the country), California requires that a permit be obtained before the offering is allowed. The permit is granted only if California determines that the offering is "fair, just and equitable". In addition, California does not allow the exemption for "blind-pool" companies (discussed above in the section on the 25102(n) exemption), or for companies engaged in oil or gas exploration or mineral extraction. In addition, the net proceeds of the offering must be used in the operations of the business (as opposed to, for example, paying off debt), the company may have only one class of stock, and the offering price must be at least $5 per share.

On the other hand, there is no limit on the number of investors and reasonable public advertising can be made.

If the offering is going to be made in states in addition to California (more than 45 states allow the SCOR exemption), then the offering is combined with a federal Rule 504 offering. In that instance, the company also cannot be a "development stage company" and at least one state must require that a prospectus be delivered to all prospective purchasers. A development stage company is a company that either has no specific business plan or purpose or has indicated that its business plan is to engage in a merger or acquisition with an unidentified company or companies. As part of the permit process in California, a request can be made that the Commissioner require that a prospectus be provided.

California 25102(f) and Federal Rule 506 Exemptions

After that, things get more complicated. The California 25102(f) exemption and the federal Rule 506 exemption both allow unlimited amounts of money to be raised. There are no financial requirements for up to 35 purchasers; with more investors, enough of them must be "accredited investors" (defined below) so that the remaining purchasers total fewer than 35. There are additional requirements that the investors be sophisticated or have a substantial pre-existing relationship with an officer or director (or manager, if an LLC). In addition, the promotional opportunities are much more limited.

Qualifications of Potential Investors

Before getting to what promotion is allowed, some understanding of the requirements of these exemptions is needed.

The 25102(f) exemption requires all potential purchasers to either 1) have a preexisting personal or business relationship with the offeror or any of its partners, officers, directors or controlling persons, or managers (as appointed or elected by the members) if the offeror is a limited liability company (in other words, have a "substantial relationship"), or 2) by reason of their business or financial experience – or the business or financial experience of their professional advisers who are unaffiliated with and who are not compensated by the issuer or any affiliate or selling agent of the issuer – could be reasonably assumed to have the capacity to protect their own interests in connection with the transaction (in other words, be "sophisticated"). The term "preexisting personal or business relationship" includes any relationship consisting of personal or business contacts of a nature and duration such as would enable a reasonably prudent purchaser to be aware of the character, business acumen and general business and financial circumstances of the person with whom such relationship exists.

The Rule 506 exemption, if sales are going to be made in more than one state, also requires that potential purchasers be "sophisticated". As with the 25102(f) exemption, only up to 35 investors may be sophisticated only; additional investors must be "accredited". Basically, an accredited investor is any of the following:

1. Any organization not formed for the specific purpose of acquiring the securities offered with total assets in excess of $5,000,000;

2. Any director, executive officer, or general partner of the issuer of the securities being offered or sold, or any director, executive officer, or general partner of a general partner of that issuer;

3. Any natural person whose individual net worth, or joint net worth with that person’s spouse, at the time of his purchase exceeds $1,000,000;

4. Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year.

One major advantage of using the Rule 506 exemption is that no state can require a review of the merits of the offering (and possibly stop the offering). The most a state can do is require that a short "notice" filing be made and charge some relatively minor fees.

Whether the requirements (which depend on the number of purchasers) are for "sophisticated" investors (or investors with a "substantial relationship") or for "accredited investors, offers can only be made to or solicited from potential investors who have been "prequalified". This evaluation has to be done before the investors are given any information regarding the offering (including even the existence of the offering). 

According to the SEC, a broker or dealer registered with the SEC may determine whether an investor is accredited. The SEC has left the door open for officers or directors of an issuer who are not licensed as brokers or dealers but who have the requisite ability to make the determination that an investor is accredited; still, if a company wants to be absolutely safe, a broker or dealer should make the determination. The prequalification is effective if the investor returns answers to a questionnaire that are sufficient to for someone qualified to be able to reasonably determine that the investor is accredited. The Securities and Exchange Commission has said that it has concerns about whether an investor simply checking a box stating that the investor is accredited is sufficient, so a more comprehensive questionnaire is needed.  

Prequalification via Web Sites and Seminars

As long as the company’s web site does nothing that could be construed as an offering or a solicitation to invest, then the site can say something like "For more information regarding our company, click here." That link should then contain an investor questionnaire and a statement that it must be completed and returned before more information can be provided. Someone responsible must then review the questionnaire and determine if the person reasonably appears to be qualified. If and only if the person appears to be qualified, then offering materials may be sent and/or a password given to a special section of the site with offering materials.

It is also possible to have educational seminars where the company presents what it is doing and gathers information for an offering to qualified investors. The seminars, of course, cannot make or solicit any offer to invest. At some point – in response to pre-seminar inquiries about the seminar, at the seminar and/or following up after the seminar – the company needs to send investor questionnaires. As before, only those potential investors who reasonably appear to be qualified can be told of the existence of the offering and provided with offering materials. Obviously, to show that nothing in the presentation mentioned the offer, all seminar presentations should be put in tangible format – whether paper (e.g., lecture notes and handouts ), electronic (e.g. PowerPoint slides), or tape (audio or visual) – and kept permanently in a safe place.

While this type of approach arguably may not be as effective as the advertising allowed by some of the other securities exemptions – and care has to be taken not to violate any of the rules – it still allows at least some promotion to be conducted.