Raising capital requires knowledge of not only the financial markets but the securities markets. A company must comply not only with federal securities laws, but also with the securities laws of each state in which the issuer sells a security. The overview of securities regulation contained in this section of the chapter deals only with federal securities regulation.
Virtually all fund-raising by privately held companies involves the sale of a security. While much has been written about companies attempting to raise capital by using instruments designed to avoid compliance with the securities laws, few of the schemes have succeeded. As a consequence, management should assume that the issuance of debt or equity to an investor is the sale of a security. Based on this assumption, companies must be aware of the regulatory requirements applicable to the sale of securities. Generally, it may be stated with some degree of accuracy that absent an exemption, the sale of securities requires registration of the securities with the SEC and compliance with the SEC's antifraud provisions. While this statement may be intimidating to a manager or owner of a company, the range of exemptions from registration covers most securities sales, but all sales of securities are subject to the application of the antifraud provisions of the SEC.
Privately held companies rely on two primary transactional exemptions from registration under federal securities laws. The first exemption from registration is provided by Section 4(2) of the 1933 Securities Act. This section provides an exemption for sales of securities by an issuer that does not involve a public offering. Privately held companies have relied on the so-called 4(2) exemption for the private placement of securities, but the exemption is not a defined set of rules. Consequently, issuers were forced to interpret and rely on federal case law that interpreted the legislation, but the cases evolved over time so issuers were always struggling to determine the most recent interpretation of the statute.
In contrast, the second exemption from registration is provided by a set of rules promulgated by the SEC and known as Regulation D. If an issuer follows the rules set forth in Regulation D, the issuer is afforded a safe harbor from registration for the securities issuance. It should be noted that transactional exemptions afforded by Section 4(2) and Regulation D are still subject to the SEC's antifraud provisions.
Companies raising private capital will in most cases attempt to comply with the provisions of Regulation D, since the rules are straightforward and easy to understand. Regulation D contains three specific transactional exemptions. The most commonly used exemption is contained in Rule 506 of Regulation D. Under this rule, if the issuer complies with the safe harbor rules, an unlimited amount of capital can be raised by the company.
Within Regulation D, there are several basic rules that apply to issuers attempting to comply with the safe harbor. The first rule relates to the number of investors that may participate. Under Regulation D, an issuer can sell securities to an unlimited number of accredited investors and no more than 35 nonaccredited investors. When evaluating the status of an investor, individuals qualify for accredited status if they have either a net worth of $1 million or income of $200,000 for the past two years and a reasonable expectation of the same amount of income for the current year. Corporations qualify for accredited investor status if they have more than $5 million in assets, or if all of the owners of the corporation are accredited investors.
In connection with Rule 506 Regulation D private placements, there are no specific rules for the information that must be supplied to accredited investors. If the offering will be made to a nonaccredited investor, Rule 502 of Regulation D contains detailed guidelines as to the type and intensity of financial and nonfinancial information to be supplied to the nonaccredited investors. While the intensity of the information required to be delivered to nonaccredited investors varies by the size of the offering, the general disclosure requirements follow the guidelines for small public offerings on SEC Form SB-1 or SEC Form SB-2. In any event, an issuer would be wise to follow the outlines provided in these forms as they are comprehensive checklists of information relating to all material aspects of a business, including its financial position. The document that normally is used in connection with disclosures is known as either an offering memorandum or a private placement memorandum. Companies desiring to issue securities should have a formal business plan prepared as a starting point for complying with any required disclosures. Appropriate risk factors will be developed and added to a business plan, and together the materials form the basis for compliance with any applicable Regulation D disclosure requirements.
Rule 506 of Regulation D is generically referred to as a private placement, and as such, Regulation D prohibits general solicitation and advertising. These rules apply not only to the company, but to anyone acting on behalf of the company.
In connection with the sale of securities under Rule 506, issuers are required to make a determination that the purchasers are buying the securities for their own account and without a view toward distributing or immediately reselling the securities to a third party. The issuer will take reasonable steps to ensure compliance with this provision of Rule 506 by placing a legend on the issued securities indicating that the securities are restricted and that they may not be resold without either being registered or being transferred pursuant to a valid transactional exemption. Companies are entitled to pay commissions in connection with the sale of securities under Rule 506; however, most states impose restrictions on the payment of commissions to registered broker-dealers.
In the limited circumstances where a company desires to issue securities and the company cannot qualify for a transactional exemption, or where the company desires to access the public markets, the registration process is required. While this chapter is not designed to present a comprehensive overview of the going public process, an overview of the general tasks and time lines may be instructive for management of companies considering an offering.
Prior to beginning the registration process, a company must prepare a detailed business plan with comprehensive historical and forecasted financial statements. With these materials in hand a company begins the process of attempting to convince investment bankers that the company is qualified to operate as a public company.
Once the investment banking team is selected, a working group is assembled. The working group typically meets in what is known as an allhands meeting. Attending this meeting will be a lead investment banking team, supporting investment bankers from additional investment banks, accountants, attorneys for the company and the investment bankers, and management. In the all-hands meeting the lead investment banker provides a time line for completing the offering.
The time frames associated with completing a public offering include the following segments:
Filing with the SEC, after which approximately 30 days elapse prior to receipt of detailed comments from the SEC on the contents of the prospectus.
Approximately 60 days during which the company and the SEC correspond and the company files amendments to the prospectus.
After the prospectus is cleared by the SEC, the company prints the prospectus, circulates the prospectus to participating investment banks, and completes approximately two weeks on the road making presentations to institutional investors, also known as the road show. At the end of the road show, the company and the bankers hold a pricing session in which the demand generated during the road show will determine whether the company consummates the offering and at what price.
After pricing, the company will within a day direct the investment bankers to begin sales of the securities being issued, either on an exchange such as the New York Stock Exchange, or over the counter on Nasdaq. At this time, the company will have completed the going public process. The elapsed time for completion of this process is, for most initial public offerings, approximately six months.
Other forms of offering for companies that are already public include offerings on Form S-3, otherwise known as a short-form offering. Form S-3 can only be used by companies that have been public for at least one year and have filed all of their SEC required filings in a timely fashion, and for company offerings, by companies with $75 million in securities owned by the public and not by insiders.
Form S-4 is used by public companies to register shares issued in connection with business combinations. Transactions covered by this form include most mergers and acquisitions. Included in Form S-4 is an analysis of each company and a description of the operations of the combined companies.
Form S-8 is the form used to register shares issued in connection with a public company's employee plans. For example, publicly traded companies register incentive option plans under Form S-8. When a company has shares registered under this form, the employees receiving option grants may exercise an option grant and sell the shares simultaneously. Public companies typically have arrangements with investment banks that permit the simultaneous sale with minimal paperwork. Upon completion of the sale, the underwriter forwards the proceeds of the sale to the company for the option strike price, and to the employee for the difference between the strike price and the fair market value sale price of the shares sold.
Deal Structures and Specialized Offerings
As companies search for new and creative financing techniques, the alternatives available are increasingly unique and focused on the capital needs of the company. As investment bankers, accountants, and attorneys examine the needs of their constituent companies, alternative financing structures are generated to fulfill these needs. While these alternatives seem unlimited, a few of the basic transaction structures used to obtain capital or liquidity that are utilized by public and private companies fall within a limited number of general categories. These categories of specialized deal structures and finance structures include private investments in public equities (PIPEs), high yield offerings, reverse mergers into public shells, fairness hearings, and shelf registrations.
Private Investment in Public Equities
PIPEs are being increasingly used by public companies as a fast and inexpensive method of raising capital. In a traditional PIPE transaction, a company will select an investment banker with experience in the company's core business segment. The bankers typically are familiar with not only the company's operations, but the types of investors willing to invest in the company's industry. Because companies using this type of financing technique are already public, there is a to the company.
As the company begins the PIPE investment process, the investment bank will assist in the preparation of a private placement memorandum. The memorandum contains virtually all of the information required to be disclosed in connection with a public offering. After the investment bank has scouted the pool of potential investors, management of the company will generate a presentation to be used in private meetings with investors. The meetings will be conducted in a manner similar to the road show conducted in connection with a public offering. If the meetings generate sufficient interest, the investment bankers will begin to compile a book of potential purchasers. If investors indicate sufficient interest at an acceptable price for the company, a closing will take place. The closing is typically a private placement meeting the transactional exemption afforded by Rule 506 of Regulation D. Securities purchased in a PIPE transaction may be common or convertible preferred stock. In the perfect case, the entire fund-raising process may take as little as 30 days.
In connection with the private placement, the company will covenant to register the common stock, or the common stock into which the preferred stock may be converted. The covenant is typically twostaged. The first stage is an agreement to file for registration of the covered securities with the SEC within 30 to 90 days of the closing of the transaction. The second trigger is a covenant that the registration statement will be declared effective within six months of the closing. In the event that the company does not meet either deadline, a penalty is assessed. The penalty is normally stated as a cash payment due to the investors, and the amount of the penalty varies but is generally in the range of 1 percent of the offering for each month that a deadline is not achieved.
For the company, a PIPE provides access to institutional investors for the most part. As opposed to an initial public offering where 30 to 40 percent of the offering will be sold to individual or retail investors, a PIPE is typically sold exclusively to institutions.
High Yield Offerings
Public or private companies may desire to raise capital through the high yield offering process. If the issuing company is public, the process may be expedited because the materials prepared for prior public offerings may be referred to in the process of generating disclosure documents. Where the company is private, the process may take as long as an initial public offering of equity securities, because the issuance of the high yield notes will subject the company to the ongoing filing requirements of the 1934 Securities and Exchange Act. In addition, with recent legislation, companies with publicly traded high yield debt are subject to the Sarbanes-Oxley requirements for independent directors and audit committees.
A high yield offering is similar to a PIPE in that the initial issuance of securities is limited to certain institutional investors. Private placements of this nature qualify under Rule 144A. Participating qualified institutions are willing to invest in private companies, but they require an issuer to register the high yield notes within six months of the closing of the high yield transaction. Once the company has registered the notes, it becomes subject to the reporting requirements of a public company.
In structuring high yield transactions, the investment bankers will determine whether the company has the ability to pay interest on the notes prior to their maturity. High yield notes are generally structured as interest only during the life of the note. In addition, the notes may not generally be repaid or redeemed for a minimum period of time. The minimum time during which prepayment is precluded varies from deal to deal, but is normally not less than three years. After the three-year period ends, most high yield offerings have some type of prepayment penalty associated with an early payoff.
Virtually all high yield offerings are established as unsecured loans. In order to facilitate this type of offering, most high yield transactions are structured as loans to a holding company. In this respect, the issuer can place secured debt at its operating company level. Placing secured debt at the operating company level insures that senior lenders have their loans located where the issuer's assets are located.
High yield offerings are debt offerings so the investment banking expenses are lower than in equity offerings. Although the initial transaction is structured as a private placement, and therefore the company may receive the proceeds of the offering more quickly than in an IPO, investor requirements to register the high yield notes cause the transaction to be essentially equivalent to a public offering in terms of legal, accounting, and printing expenses.
Reverse Mergers into Publicly Traded Shells
Private companies face a daunting task in convincing an investment banker to dedicate the time and attention that it takes to evaluate a company. Assuming that the time is invested to evaluate a company, it is even a greater risk for an investment banker to devote a team of professionals to run the going public gauntlet. Not only must market conditions be right in general, but the company industry segment must be in favor in order to achieve a successful initial public offering. Throughout the evaluation period and the public registration process, management must juggle the demands of registration with maintaining the operations of the business in a manner that is consistent with the forecasts that the investment bankers relied upon to make their initial investment decision. If operations falter in the midst of the registration process, or if market conditions suffer an adverse change, the probability of a successful offering is diminished significantly. With all of these risks encircling a company and standing between the company and going public, it is not a surprise that many companies have searched diligently for an alternative process.
Merging a private company with a publicly traded shell accomplishes this objective. Publicly traded shell corporations exist as a result of two primary plans. Either the company sold or liquidated its business, leaving the shell, or the sponsors of the company devoted the resources to getting the company public with a long-term plan of leveraging the public registration into a significant ownership interest in a private company desiring to enter the public markets on an expedited basis.
Structuring the transaction results in the public company issuing shares to the private company in a transaction that normally qualifies for transactional exemption treatment under Rule 506 of Regulation D. The combination of the two companies is accomplished by the public company creating a wholly owned new subsidiary. The private company is then combined with and into the subsidiary in a manner that results in the private company becoming a wholly owned subsidiary of the public company. This transaction structure is known as a reverse triangular merger.
Although the private company shareholders receive restricted stock and cannot immediately sell the shares, liquidity can be achieved by either negotiating registration rights or by holding the shares for a year and then selling under the guidelines of SEC Rule 144. Rule 144 permits the sale of 1 percent of the outstanding shares of a company by an investor every 90 days.
While a reverse triangular merger avoids the time, expense, and risk associated with the going public process, unless the publicly traded shell has retained capital or raised capital in its initial registration process, the resulting value to a private company is minimal. That is to say that the private company owners have been diluted in the combination by an amount equal to the percentage of ownership that is ceded to the public shareholders, and now in a diluted state, the combined companies must go back to the market if additional capital is needed. It is rare that a combination of a public shell and a private company would not immediately need to access the markets for capital.
Although for the reverse merger strategy the cost is high to the owners of the private company, by merging with the public company they gain access to a much larger body of potential investors. This body of investors requires the liquidity afforded by the public registration process and serves as a pool of investors for the newly combined company. The cost of capital is high in this arena, but the capital serves a legitimate need and these investors have provided much needed cash to many companies that would not be in existence today without the start-up cash.
In contrast with large corporate mergers where securities issued by a public company in connection with a merger are registered on SEC Form S-4, issuers look for private placement exemptions in smaller transactions due to the cost and time required in connection with the Form S-4 registration process. While some transactions clearly qualify for a transactional exemption under Rule 506 of Regulation D, where the target company has a large number of shareholders, complying with the limit of 35 or less nonaccredited investors may be impossible. Section 3(a)(10) of the Securities Act provides a solution in many cases involving an exchange of securities in connection with a merger or acquisition.
Section 3(a)(10) describes a process by which securities can be issued in connection with a merger or acquisition and qualify for an exemption from registration. Unlike Rule 506 of Regulation D, however, a shareholder in the target does not receive restricted securities, and if the acquiring company is publicly traded, the target shareholders may immediately sell shares received in the transaction, subject to certain volume limitations imposed on affiliates. In effect, the exemption is essentially equivalent to a registration of the securities for nonaffiliates in that they receive freely tradable shares.
In order to qualify for the transactional exemption, (1) the securities must be received in an exchange, (2) a state governmental entity must have authority to approve the fairness of the transaction, (3) there must be a hearing in which the governmental agency approves the fairness of the transaction, and (4) the hearing must be open to the public. If these criteria are met, the fairness hearing procedure provides an effective method for complying with securities regulations and providing target shareholders with an opportunity for immediate liquidity without navigating the timeconsuming and expensive SEC registration process.
SEC Rule 415 covers matters relating to shelf registrations. A shelf registration is a registration statement filed by an issuer where the issuer is preparing for an offering of securities, but cannot specifically identify the transaction structure at the time of the initial registration. The SEC permits this type of registration in order to provide companies with an opportunity to access the public markets when the timing for a transaction has been identified. In this respect, the normal process would require the company to identify its transaction and begin the registration process with the SEC. Although large issuers might finish the process in a relatively short period of time, smaller issuers are in many cases subject to review, which can cause the registration process to take 60 to 90 days.
Where a company needs to act quickly, either to consummate a transaction or to raise capital, the shelf registration process affords a solution. The issuing company, having completed the registration process, simply files an update to the shelf registration statement, and the securities can be issued. This technique is used to permit companies to more accurately time access to the capital markets when the so-called market windows are open, and to issue shares in connection with mergers and acquisitions. The issuance of shares in connection with mergers and acquisitions is especially useful in the context of a public company's roll-up strategy. In a roll-up scenario, the public company makes a series of acquisitions over a short period of time. In lieu of registering shares for each deal, the company simply pulls down from its shelf registration an amount of shares sufficient to close each deal, thereby avoiding the cost and time that would otherwise be required to register each transaction.
Shelf registrations permit a company a great deal of flexibility in that they permit the company to dispose of the registered shares over a two-year period. In addition, a company may file what is known as an unallocated shelf registration statement. Unallocated registration statements permit a company to wait to see market conditions, and only later at the time of closing the transaction determine the amount of securities to be offered and whether the offering should be debt or equity or a combination of both. This financing flexibility has gained increasing importance for companies operating in capital-intensive industries.