Raising Capital

An Overview of Raising Capital Through Private Offerings

Early-stage and mature companies alike seeking to raise money to support their continued growth and success must do so in compliance with certain legislation that has evolved over more than 75 years. Following the stock market crash of 1929, Congress began to enact the regulatory framework governing the issue and sale of “securities”. The principal legislation to come out of the Great Depression was the Securities Act of 1933 (the “Act”). At its core, the Act aims to protect investors from fraud by requiring the disclosure of “material” information by issuers of “securities” thereby promoting market stability. “Material” means any information that could reasonably affect an investor’s evaluation of the potential investment (the securities). The Act’s definition of “security” is remarkably broad and includes any promissory note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, transferable share, investment contract, certificate of deposit for a security, or, in general, any interest or instrument commonly known as a “security”, or warrant or right to subscribe to or purchase, any of the foregoing. Beyond the Act, other key legislation impacting the purchase and sale of securities includes the Securities Exchange Act of 1934, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (www.practicallaw.com/4-502-8619), and the Jumpstart Our Business Startups Act of 2012 (www.practicallaw.com/2-518-7869) (together with the Act, the “Securities Laws”). The U.S. Securities and Exchange Commission (“SEC”) and the Financial Industry Regulatory Authority (www.practicallaw.com/1-382-3462) are the primary federal agencies charged with managing various aspects of the U.S. capital markets and enforcing the Securities Laws.

Pursuant to the Act, an “issuer” (e.g., the company desiring to raise money) must register the securities they intend to offer for sale (e.g., shares of company stock) with the SEC unless an exemption applies. Registration is an expensive (often cost-prohibitive for emerging companies) and time consuming process. One of the largest associated costs is the preparation of a prospectus. Therefore, a company electing to conduct an offering of securities under one of the many exemptions can save itself time and money and, if done correctly, still avoid the liability associated therewith by availing itself of one of the many “safe harbors” promulgated under the Securities Laws. Such an unregistered sale is commonly conducted through a private placement. This post is intended to offer a general overview of private placements and certain key federal exemptions to registration. It is important to note, however, that the sale of securities is also regulated at the state level, however, a state-specific “blue sky” analysis is beyond the scope of this post. This post is cursory outline of certain criteria of various registration exemptions that might be attractive to a growing business; this is not a legal opinion and should not and cannot be relied on as such. Companies must consult a lawyer and conduct a state-specific analysis before issuing any securities.

Private placements are one of the nation’s most frequently used methods of raising capital. However, determining which exemption the company should employ is case specific, requires a detailed analysis with counsel and depends on a number of other factors including: the amount of money sought to be raised, the number and sophistication of potential investors and whether the company desires to engage in “general solicitation” in marketing the securities for sale to the general public (as opposed to a targeted investment audience). The most frequently used registration exemptions (and those which this post will focus on) are Section 4(a)(2) of the Act (“Section 4(a)(2)”) and Regulation D of the Act (“Reg D”). Rule 504, Rule 505, Rule 506(b) and Rule 506(c), all of Reg D, each establish a “safe harbor” for issuers engaging in an unregistered sale of securities. If considering an offering of, or investor resales of, securities outside the United States, then Regulation S of the Act also provides a few “safe harbors” worth examining.

Section 4(a)(2) provides an exemption for “transactions by an issuer not involving any public offering”. There is no limitation to the amount of capital that can be raised under an offering conducted in reliance on Section 4(a)(2). As with most exemptions, securities sold under such an offering must be purchased for investment purposes only and there are limitations as to how and when they can be resold. The Section 4(a)(2) exemption has been the source of significant debate over the years due primarily to its brevity (and lack of clear guidance); however, it is understood as allowing the unregistered offering of securities exclusively to investors who have substantial means and are capable of evaluating the merits of the investment. The focus under Section 4(a)(2) on the sophistication and nature of offerees (people to whom a security is offered for sale) stands in stark contrast to Reg D (which focuses instead on purchasers (people who actually purchase the security) wealth and sophistication). Moreover, the limitations on the total number of offerees under Section 4(a)(2) is poorly defined. Even so, it is clear that the greater the number of offerees, the lower the likelihood the offering will fall within the Section 4(a)(2) exemption. In terms of the “hassle of paperwork”, however, Section 4(a)(2) is the only exemption that has no filing requirement (compared to Reg D which requires the filing of a Form D with the SEC within 15 days of the first sale as well as any various state-specific filing requirements). For all of the foregoing reasons and many others, counsel must guide their clients through offerings that satisfy the conditions establishing the various “safe habors” (which ensure there has not been a public offering without registration which is violative of Securities Laws) such as those found in Reg D; Section 4(a)(2) is then relied on as a fall-back incase the “safe harbor” fails for some unforeseen reason. A summary of certain Reg D “safe harbor” conditions and the corresponding Rule is provided below.


As you can see, each “safe harbor” has its own compliance requirements which dictate material terms of the offering. In addition to paying close attention to the above referenced requirements, it is critically important that an issuer comply with all other state and Federal “safe harbor” provisions (chief among, disclosure requirements) because the failure to satisfy even one element of the exemption has the potential to destroy the “safe harbor”, ruin the entire offering and expose the company and its principals to significant criminal and/or pecuniary liability. Accordingly, counsel should be actively engaged at all stages of the capital raise to help navigate the issuer around the many stumbling blocks. In my following posts, I intend to explore crowdfunding (a particularly hot topic among start-ups) and choosing the best business entity in expectation of a capital infusion or recapitalization (e.g., funding from venture capitalists).

Nelson Mullins Riley & Scarborough LLP

Timothy M. Zwerner, Esq.

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[1] Someone whose individual net worth, or joint net worth with the person’s spouse, exceeds $1 million at the time of the purchase, excluding the value of the primary residence of such person or person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year.


[2] Someone with enough knowledge and experience in business matters to evaluate the risks and merits of a potential investment.