Sometimes, a company that needs more funding may not be quite prepared for an initial public offering. In such an instance, the company may consider a more limited offering, which may be exempt from Securities and Exchange Commission (SEC) registration requirements.

The SEC offers several exemptions from its registration requirements. However, these exemptions only apply to the registration requirements and not to the antifraud provisions of the federal securities laws. This means that the company will be responsible for false or misleading statements, whether oral or written, in criminal, civil, and administrative proceedings, as well as private lawsuits. If the company fails to meet all conditions of the exemptions, purchasers may be able to obtain refunds of their purchase price. In addition, offerings that are exempt from provisions of the federal securities laws may still be subject to the notice and filing obligations of various state laws. So, the company should check with the appropriate state securities administrator before proceeding with an offering.

Intrastate Offering Exemption

Section 3(a)(11) of the Securities Exchange Act is generally known as the "intrastate offering exemption." This exemption facilitates the financing of local business operations. To qualify for the intrastate offering exemption, a company must:

  • be incorporated in the state where it is offering the securities;
  • carry out a significant amount of its business in that state; and
  • make offers and sales only to residents of that state.

The act does not limit the size of the offering or the number of purchasers. The company must determine the residence of each purchaser. If any of the securities are offered or sold to even one out-of-state person, the exemption may be lost. Without the exemption, the company could be in violation of the Securities Exchange Act registration requirements. If a purchaser resells any of the securities to a person who resides outside the state within a short period of time after the company's offering is complete (the usual test is nine months), the entire transaction, including the original sales, might violate the Securities Exchange Act. Since secondary markets for these securities rarely develop, companies often must sell securities in these offerings at a discount.

It will be difficult for a company to rely on the intrastate exemption unless it knows the purchasers and the sale is directly negotiated with them. If a company holds some of its assets outside the state, or derives a substantial portion of its revenues outside the state where it proposes to offer its securities, it will probably have a difficult time qualifying for the exemption.

A company may follow Rule 147, a "safe harbor" rule, to ensure that it meets the requirements for this exemption. It is possible, however, that transactions not meeting all requirements of Rule 147 may still qualify for the exemption.

Private Offering Exemption

Section 4(2) of the Securities Exchange Act exempts from registration "transactions by an issuer not involving any public offering." To qualify for this exemption, the purchasers of the securities must:

  • have enough knowledge and experience in finance and business matters to evaluate the risks and merits of the investment (the "sophisticated investor"), or be able to bear the investment's economic risk;
  • have access to the type of information normally provided in a prospectus; and
  • agree not to resell or distribute the securities to the public.

In addition, a company may not use any form of public solicitation or general advertising in connection with the offering.

The precise limits of this private offering exemption are uncertain. As the number of purchasers increases and their relationship to the company and its management becomes more remote, it is more difficult to show that the transaction qualifies for the exemption. If the company offers securities to even one person who does not meet the necessary conditions, the entire offering may be in violation of the Securities Exchange Act.

Rule 506, another "safe harbor" rule, provides objective standards that a company can rely on to meet the requirements of this exemption. Rule 506 is a part of Regulation D.

Regulation A

Section 3(b) of the Securities Exchange Act authorizes the SEC to exempt from registration small securities offerings. By this authority, the SEC created Regulation A, an exemption for public offerings not exceeding $5 million in any 12-month period. If a company chooses to rely on this exemption, it must file an offering statement, consisting of a notification, offering circular, and exhibits, with the SEC for review.

Regulation A offerings share many characteristics with registered offerings. For example, a company must provide purchasers with an offering circular, which is similar in content to a prospectus. Like registered offerings, the securities can be offered publicly and are not "restricted," meaning they are freely tradable in the secondary market after the offering. The principal advantages of Regulation A offerings, as opposed to full registration, are:

  • The financial statements are simpler and don't need to be audited;
  • There are no Securities Exchange Act reporting obligations after the offering unless the company has more than $10 million in total assets and more than 500 shareholders;
  • Companies may choose among three formats to prepare the offering circular, one of which is a simplified question-and-answer document; and
  • A company may "test the waters" to determine if adequate interest in its securities exists before going through the expense of filing with the SEC.

All types of companies that do not report under the Securities Exchange Act may use Regulation A, except "blank check" companies, those with an unspecified business, and investment companies registered or required to be registered under the Investment Company Act of 1940. In most cases, shareholders may use Regulation A to resell up to $1.5 million of securities.

If a company "tests the waters," it can use general solicitation and advertising prior to filing an offering statement with the SEC, giving it the advantage of determining whether enough market interest exists in its securities before it incurs the full range of legal, accounting, and other costs associated with filing an offering statement. The company may not, however, solicit or accept money until the SEC staff completes its review of the filed offering statement and the company delivers prescribed offering materials to investors.

Regulation D

Regulation D establishes three exemptions from Securities Exchange Act registration.

Rule 504

Rule 504 provides an exemption for the offer and sale of up to $1,000,000 of securities in a 12-month period. A company may use this exemption so long as it is not a blank-check company and is not subject to Securities Exchange Act reporting requirements. Like the other Regulation D exemptions, in general the company may not use public solicitation or advertising to market the securities, and purchasers receive "restricted" securities, meaning that they may not sell the securities without registration or an applicable exemption. However, the company can use this exemption for a public offering of its securities, and investors will receive freely tradable securities under the following circumstances:

  • The company registers the offering exclusively in one or more states that require a publicly filed registration statement and delivery of a substantive disclosure document to investors;
  • The company registers and sells in a state that requires registration and disclosure delivery and also sells in a state without those requirements, so long as it delivers the disclosure documents mandated by the state in which it registered to all purchasers; or,
  • The company sells exclusively according to state law exemptions that permit general solicitation and advertising, so long as it sells only to "accredited investors," a term described in more detail below in connection with Rule 505 and Rule 506 offerings.

Even if a company makes a private sale where there are no specific disclosure delivery requirements, it should take care to provide sufficient information to investors to avoid violating the antifraud provisions of the securities laws. This means that any information it provides to investors must be free from false or misleading statements. Similarly, the company should not exclude any information if the omission makes what it does provide investors false or misleading.

Rule 505

Rule 505 provides an exemption for offers and sales of securities totaling up to $5 million in any 12-month period. Under this exemption, you may sell to an unlimited number of "accredited investors" and up to 35 other persons who do not need to satisfy the sophistication or wealth standards associated with other exemptions. Purchasers must buy for investment only, and not for resale. The issued securities are "restricted." Consequently, a company must inform investors that they may not sell for at least a year without registering the transaction. The company may not use general solicitation or advertising to sell the securities.

An "accredited investor" is:

  • a bank, insurance company, registered investment company, business development company, or small business investment company;
  • an employee benefit plan, within the meaning of the Employee Retirement Income Security Act, if a bank, insurance company, or registered investment adviser makes the investment decisions, or if the plan has total assets in excess of $5 million;
  • a charitable organization, corporation, or partnership with assets exceeding $5 million;
  • a director, executive officer, or general partner of the company selling the securities;
  • a business in which all the equity owners are accredited investors;
  • a natural person with a net worth of at least $1 million;
  • a natural 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; or
  • a trust with assets of at least $5 million, not formed to acquire the securities offered, and whose purchases are directed by a sophisticated person.

It is up to the company to decide what information to give accredited investors, so long as it does not violate the antifraud prohibitions. But the company must give nonaccredited investors disclosure documents that generally are the same as those used in registered offerings. If it provides information to accredited investors, it must make this information available to the nonaccredited investors as well. The company must also be available to answer questions by prospective purchasers.

This type of filing mandates the following financial statement requirements:

  • Financial statements need to be certified by an independent public accountant;
  • If a company other than a limited partnership cannot obtain audited financial statements without unreasonable effort or expense, only the company's balance sheet, to be dated within 120 days of the start of the offering, must be audited; and
  • Limited partnerships unable to obtain required financial statements without unreasonable effort or expense may furnish audited financial statements prepared under the federal income tax laws.

Rule 506

Rule 506 is a "safe harbor" for the private offering exemption. If a company satisfies the following standards, it can be assured that it is within the Section 4(2) exemption:

  • The company can raise an unlimited amount of capital;
  • The company cannot use general solicitation or advertising to market the securities;
  • The company can sell securities to an unlimited number of accredited investors (see Rule 505) and up to 35 other purchasers. Unlike Rule 505, all nonaccredited investors, either alone or with a purchaser representative, must be sophisticated - that is, 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;
  • The company must decide what information to give accredited investors, so long as it does not violate the antifraud prohibitions. But it must give nonaccredited investors disclosure documents that generally are the same as those used in registered offerings. If it provides information to accredited investors, it must make this information available to the nonaccredited investors as well;
  • The company must be available to answer questions by prospective purchasers;
  • Financial statement requirements are the same as for Rule 505; and
  • Purchasers receive "restricted" securities. Consequently, purchasers may not freely trade the securities in the secondary market after the offering.

Accredited Investor Exemption: Section 4(6)

Section 4(6) of the Securities Exchange Act exempts from registration offers and sales of securities to accredited investors when the total offering price is less than $5 million.

The definition of accredited investors is the same as that used in Regulation D. Like the exemptions in Rule 505 and 506, this exemption does not permit any form of advertising or public solicitation. There are no document delivery requirements. Of course, all transactions are subject to the antifraud provisions of the securities laws.

California Limited Offering Exemption: Rule 1001

SEC Rule 1001 provides an exemption from the registration requirements of the Securities Act for offers and sales of securities, in amounts of up to $5 million, that satisfy the conditions of § 25102(n) of the California Corporations Code. This California law exempts from California state law registration offerings made by California companies to "qualified purchasers" whose characteristics are similar to, but not the same as, accredited investors under Regulation D. This exemption allows some methods of general solicitation prior to sales.

Exemption for Sales of Securities through Employee Benefit Plans: Rule 701

The SEC's Rule 701 exempts sales of securities if made to compensate employees. This exemption is available only to companies that are not subject to Securities Exchange Act reporting requirements. A company can sell at least $1,000,000 of securities under this exemption, no matter how small its size. It can sell even more if it satisfies certain formulas based on its assets or on the number of its outstanding securities. If the company sells more than $5 million in securities in a 12-month period, it needs to provide limited disclosure documents to its employees. Employees receive "restricted securities" in these transactions and may not freely offer or sell them to the public.

Source: Securities and Exchange Commission

Copyright 1999 Findlaw Inc.