Regulation D Forms & Filings

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To start a Reg D Private Stock Sale (or a Note Offering) one needs to map-out a ‘Return On Investment’ scenario (“ROI”) for potential investors, i.e., what they’re going to get in return for investing. Once that’s complete it’s time to draft the required disclosure documents, also known as a Private Placement Memorandum, or PPM. One of the most important pieces of this puzzle, and surprisingly one of the most inexpensive, is the government filings. To claim the proper exemption from securities registration, e.g., Regulation D Rule 504, or 506, one needs to file a Form D with the SEC, and then within the states where investment capital was received. The North American Securities Administrators Association, or NASAA, has provided an Electronic Filing Depository, a.k.a., EFD System. This system allows business owners to file Regulation D forms with the appropriate states. 

In most states, within 15 days after receiving capital from investors, one needs to file a Form D using the SEC’s EDGAR system, which is their electronic filing system. After this federal filing, one can file the state required forms on the ‘Electronic Filing Depository‘ (“EFD“); however, this system is recognized by 44 states. 

Note: Some states require filings to be done prior to approaching investors in their state.

The remaining six states that still require filings the old-fashioned way, which is, by fax, or snail-mail, are as follows:

• Arizona
• Connecticut
• Florida (currently does not require a notice filing)
• Louisiana
• Massechusetts
• New York

* See the Fee Schedule below:

What is a PPM?

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A PPM is the Private Placement Memorandum, also known as: Private Offering Memo, Confidential Offering Memorandum, Investment Memoranda and/or Private Placement Prospectus. It is the booklet that discloses the legal minimums an investor needs to know to make an informed decision about whether to take a risk on a particular investment. Just as important, the PPM disclaims legal liabilities and explains the risk of losses, keeping the company out of exposure to fraud; this protects the entrepreneur from expensive litigation in the event the business doesn’t work-out as planned, and the investor(s) lose their money.

A typical PPM includes: the ownership structure of the company, the investment structure, mandatory legal disclosures, management backgrounds, company operations, risk levels, use of proceeds, financial information, business plan, dilution, investor suitability, subscription agreement and more.

Typical list of items needed to develop a PPM:

  • Business plan;
  • Balance sheet, or financial statement, if available;
  • Management bios;
  • Capitalization table, ownership records; and
  • Investment scenario for investors.

PPM’s are designed as a stand-alone document, meaning that no other information is needed when presenting to investors. The PPM is sufficient for them to make an informed investment decision.

Many companies will attach their business plan, financial statements, articles of incorporation and other documents, to the PPM as supporting documentation. This is acceptable so long as the information in the business plan properly corresponds with the information in the PPM and that the investor is made aware that the business plan alone does not constitute an offer to sell securities – only the PPM can make that offer.

Investor Suitability Questionnaire

Regulation D requires the company (Issuer) to ascertain the status of all investors. All investors must be accredited, however in Rule 506(b) Issuers can accept investments from up to 35 non-accredited investors.

The Subscription Agreement

The Subscription Agreement is the “investment contract.” It is executed by the investor and returned to the Company (Issuer of the securities) with the investor’s check.

Just as the PPM provides disclosure to the investor regarding the company’s financial status, the Subscription Agreement provides full disclosure to the company regarding the investor’s financial status. In the Subscription Agreement the investor provides assurances to the issuing company that an absolute loss of their investment capital will in no way impact their standard of living or jeopardize their financial picture as a whole, hence, Reg D investors need to be qualified as Accredited Investors.

Economic Growth, Regulatory Relief, and Consumer Protection Act

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govAn exciting development has taken place in the capital raising industry. The Economic Growth, Regulatory Relief, and Consumer Protection Act (S. 2155) was enacted into law and included key legislation expanding Regulation A+ to SEC reporting companies.

Regulation A+ allows small companies to raise up to $50 million online, transparently and directly from the public without the extensive cost burden of a full SEC public offering. This is important because, initially, the SEC did not allow fully reporting companies to raise capital through Regulation A+.

Section 508 of the bill incorporates the Improving Access to Capital Act. The Improving Access to Capital Act, which amends Regulation A+ to allow SEC reporting companies to use this innovative capital raising tool, was originally passed by the House of Representatives in September 2017 in a bipartisan, 404-3 vote.

The work of Congresswoman Kyrsten Sinema (D-AZ) and Congressman Trey Hollingsworth (R-IN), lead sponsors of the Improving Access to Capital Act in the House, and collective efforts of Representatives Sinema and Hollingsworth, and cosponsors Rep. Roger Williams (R-TX), Rep. French Hill (R-AR), Rep. Luke Messer (R-IN), and Rep. Brad Sherman (D-CA), whose contributions led to this important bill becoming law.

References

Crapo, M. (2017). S.2155 – 115th Congress (2017-2018): Economic Growth, Regulatory Relief, and Consumer Protection Act. Retrieved June 5, 2018, from https://www.congress.gov/bill/115th-congress/senate-bill/2155

Types of Reg D Securities Sales

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The two general types of Reg D securities sales are: (1) Equity, and (2) Debt. These can also be combined into a Convertible hybrid of the two (see #3 below).

  1.  An ‘equity‘ offering is where the company sells partial (or a majority) ownership in the company. The ownership, or equity, is transferred to investors via a security; for example, stock shares, partnership interests, or membership units. Equity offerings are preferred by early stage companies because there is typically no structured repayment schedule; the investors receive a return when the company profits and those profits are then dispersed; however, the payment terms vary depending on how the investment is structured.
  2. A ‘debt‘ offering is where the company raises debt financing by selling promissory notes to investors with a set annual rate of return, and a maturity date for when the investors will reap a ‘Return On Investment,’ or ROI. A debt offering is much like a business loan, but, instead of a bank providing the financing, a single investor (or group of investors) lends capital directly to the company. These debt instruments can also be referred to as debentures.
  3. A ‘convertible‘ offering is a combination of the aforementioned types; for example, a ‘debt’ offering that allows the lender/investor to ‘convert’ his/her debt note into shares of ‘equity,’ which then satisfies the debt obligation in-part, or in-full, depending on how the deal is structured.

* Preferred Business Structure: The Reg D exemptions can be used by domestic as well as foreign corporations. While the rules can be used by any corporation type the preferred structure is a “C” Corporation or Limited Liability Corporation “LLC.”

Setting Up Investor Relations – After The Offering

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Following up with private investors (new shareholders, or members) is key to continued success. It’s also a great way to keep them from calling once a week to check on company progress. Many entrepreneurs make the mistake of failing to plan for what comes ‘after’ the capital is raised, that is, with regard to shareholders. After capital is raised and the Reg D offering is closed, one needs to send out the stock shares, member certificates or promissory notes as agreed. One could also set up an investor follow up system using the same type of system used to market to clients; after-all, investors are clients of a different sort. This is called ‘Investor Relations.’

Investor Relations is actually an industry. There are thousands of professionals who have made a science of keeping shareholders informed and appeased, after-all, shareholders are owners of the company. Smart entrepreneurs incorporate Investor Relations systems for keeping shareholders up to date with progress on major projects, such as, global software implementation, additions to executive leadership, acquisitions, large sales transactions, year-end accounting reports, etc.

Note: It’s important to refrain from sending too many reports. Applying some discretion to the information is highly recommended.

* Setting Up Investor Relations – After The Offering

Capital Raising in the U.S.: An Analysis of Unregistered Offerings Using the Regulation D Exemption, 2009‐2012

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By VLADIMIR IVANOV AND SCOTT BAUGUESS
Division of Economic and Risk Analysis (DERA)
U.S. Securities and Exchange Commission

In 2012, we issued a report on capital raising in the U.S. through unregistered offerings, using
information extracted from Form D filings received by the U.S. Securities and Exchange
Commission since the beginning of 2009 through the first quarter of 2011. In this report we
update our analysis through the end of 2012 and provide additional analysis on the types of
issuers, investors, and financial intermediaries that participate in such offerings. As with our
previous report, the results are intended to inform the Commission about the amount and
nature of capital raised through unregistered offerings claiming a Regulation D exemption, and
to provide some perspective on the state of competition and potential regulatory burden in
capital markets. In particular, we compare the amount of capital raised in reliance on
Regulation D to capital raised from registered and other unregistered offering methods. This
information may be particularly useful in assessing the potential need for current or future
rulemaking activity. This analysis is not intended to inform the Commission about compliance
with or enforcement of federal securities laws.

The complete analysis is available below:

Source: U.S. Securities and Exchange Commission

Disclosing Dilution

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Along with specific risk factors, disclosing ‘dilution’ is one of the most important sections of a private placement memorandum. It’s one of the first sections investors review when reviewing a potential investment.

Look at it this way, if you were investing your money, wouldn’t you want to know whether your equity position in the company was going to remain at a certain percentage to secure your investment? Many investors have been burned by unscrupulous entrepreneurs who methodically diluted the investor’s ownership down to near zero. Most notably, it happens on the Penny Stock Exchanges. However, many professionals are predicting this will happen in the new Crowdfunding space, which is why many have expressed concerns about fraud.

Assuming a company only needs 1-2 rounds of capital to get started, it can work out great for investors. However, if the company starts burning through cash it can be devastating for everyone.

Here’s how dilution works:

1. Let’s say you start the company with 30,000,000 shares authorized for use.

2. You issue 10,000,000 of those shares to founders at .001 per share (par value) or $10,000. These shares are classified as ‘common shares.’

Note: This scenario can get even more complex if the entrepreneur issues ‘preferred shares’ and allows them to become convertible into common shares, e.g., 5 common shares for every 1 preferred share. Voting rights can also become an issue here. But for our scenario let’s keep it simple.

3. Your current ‘book value’ is $.001.

($10,000 ÷ 10,000,000 shares = $0.001 per share)

4. You then reach into your Authorized Share pool and offer 4,000,000 common shares to new investors in a Reg D Rule 504 Private Placement at an assumed value of $1.00 per share, based on projections, patents, trademarks, intellectual property, etc. You raise $4,000,000.

5. After this first capital raise you will have issued 14,000,000 shares which now defines the percentages of ownership at 71% (founders) and 29% (new investors).

Note: Ownership percentages are figured by ‘issued’ shares NOT ‘authorized’ shares.

6. After the offering is sold and closed, this leaves you with 16,000,000 shares for further issuance later (from the pool of authorized shares).

7. With the cash infusion of $4,000,000 your new book value is $0.29 per share.

($10,000 + $4,000,000 = $4,010,000 ÷ 14,000,000 shares = $0.29 per share)

8. This leaves the ‘dilution per share’ to first round investors, at $0.71 per share.

($1.00 – 0.29 = $0.71) or (Stock Price – Book Value = Diluted Value)

9. After receiving investment capital from first round investors, and closing the offering, you immediately start raising more capital using a different Reg D Rule, e.g., Rule 504 for the first offering and Rule 506 for the second offering. I.e, you can only use Rule 504 once every 12 months, but you can use Rule 506 immediately following the close of a 504 offering.

10. Let’s say you sell and issue 2,000,000 more shares from the pool of Authorized Shares at $2.00 per share, raising an additional $4,000,000.

11. After the sale and close of this second offering your new capitalization total is $8,010,000.

($10,000 + $4,000,000 + $4,000,000 = $8,010,000)

Note: This is all assuming you don’t have expenses to deduct from the capitalization total. If you have expenses those would be deducted from the total when figuring the book value. This is only for the sake of our scenario.

12. This brings your new book value to $.50 per share.

($8,010,000 ÷ 16,000,000 shares = $0.50 per share)

13. Second round investors experience an immediate dilution of $1.50 per share.

($2.00 – $.050 = $1.50) or (Stock Price – Book Value = Diluted Value)

14. Now the ownership percentages change to 62% (founders), 25% (first round investors) and 12.5% (second round investors). Founders lose 9% and first round investors lose 4% of their equity ownership.

15. The company still has 14,000,000 shares to issue from its Authorized Share pool.

(30,000,000 – 10,000,000 – 4,000,000 – 2,000,000 = 14,000,000)

Every time the company raises more capital, issuing more shares, the percentage of ownership decreases for the previous investors. If the company starts burning through capital, and needs to keep raising money, the first round investors could end up owning less than 5%. Moreover, if the company continues burning through capital without replacing the capital with revenue (and profits) the book value of the stock drops along side the ownership percentage. We call this a ‘death spiral.’

So, you can see why some professionals are concerned about dilution, and also, why it’s important to disclose this information to new investors.

Thanks for reading and best of luck!

Here’s our dilution formula:

Stock Price – Book Value = Diluted Value

Diluted Value ÷ Stock Price = Dilution Rate

Facebook’s Use of Regulation D

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Facebook’s use of Regulation D was vital to their success. If you’re like us you’re probably wondering how Facebook got started. Well, according to the SEC’s archives, they had very humble beginnings, just like every other startup. Facebook, Twitter, Tesla, and thousands of other companies have gotten started using a purposely engineered loophole in the securities laws, also known as Regulation D of the Securities Act of 1933. Regulation D is used to keep companies from going through the time-consuming and expensive process of registering their securities with the SEC, a process for publicly traded companies. No matter how small your company is, and no matter how small the investment is, Regulation D should probably be used to help you raise capital. As you can see from the Form D below, Facebook had early wisdom of this loophole when they used the proper forms to take their very first investment of $6,790. They then went on to conduct numerous follow-on offerings using Reg D each time, until finally they filed their S-1 to start the process of going public. It’s important to also acknowledge that the stock being sold under Reg D was then converted into other types of shares: preferred, common, and yes, some tradable in the IPO.

Basic Share Structuring

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To start a Regulation D private securities sale you will need to start by developing an investment structure. The basic share structure should detail what the investors will get in return for their investment.

For example:

XYZ Company is offering 100,000 shares of common stock at $1.00 per share with a minimum investment of $5,000 (5,000 shares).

When setting up ownership in a company one should define the ownership by the percentage of stock each shareholder owns in the company. When filing the initial incorporation documents the founders are asked to list how many shares are “authorized” for use. This does not mean that they plan to “issue” all of those shares. It simply allocates shares that ‘can be’ used for whatever purpose necessary. A general rule of thumb we use, is:

Authorizing 30,000,000 shares, while issuing 5% of those shares (1,500,000 shares) to investors. Of course, this all needs to sync with whatever valuation method is being used.

Before setting up an offering to capitalize a company, one should sell a block of “founders shares” to themselves, and other founders. Founders shares are typically purchased at par value, which can be just about any price. A typical layout is .001 per share, e.g., 1,000,000 shares X .001 = $1,000. With that said, it would not be wise to sell stock shares to outside investors at “par value,” this would likely throw a wrench in valuations; nevertheless, the founders would need to determine an estimated value of the stock “after” the offering is closed, and use that number as a potential sales price. When shares are sold to investors the founders would then allocate a portion of the “authorized” stock shares to sell. Once they’re sold they become “issued and outstanding.”

Another consideration is designating different classes of stock shares. The typical classes are ‘preferred stock’ and ‘common stock.’ Moreover, their can be different classes of preferred stock and common stock, e.g., preferred class A, B, C, etc. Founders who are concerned about voting rights typically set up different classes to give them more control, for example, shareholders who own preferred class A may have 3 votes per share, whereas, common class A may have only 1 vote per share. Some founders also setup conversion scenarios, e.g., upon a successful IPO preferred class A may convert 1 for 10 into shares of common stock, so if one owned 10,000 shares of preferred class A they would received 100,000 shares of common stock.

To keep things simple in a first round, we typically issue only “common stock” to investors, but it can be done using just about any configuration, within reason.

* Basic Share Structuring

Seven Steps To Raising Capital

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Preparing a Regulation D securities sale involves seven steps to raising capital:

1. A Great Business Idea.

2. A Great Business Plan: A full copy of the business plan should be included in the PPM (see below) as an Exhibit. See sample business plans.

3. Investment Layout & Disclosure Documents: Most entrepreneurs are not experts at raising capital, thus typically have poorly structured investments. An improper investment structure will portray an unprofessional image to potential investors. The first step in an offering is properly developing the structure. Structuring usually includes, setting stock price or note amounts, determining how much of the company to sell (in equity transactions), which Reg D program to use, setting the maturity date and rate of return for promissory notes (in debt situations), share allocations to principals (so they maintain a set amount of control in the company), minimum and maximum offering amounts which set the effective range of the offering, minimum amount of investment per investor, etc.

4. Document Creation: Preparing an offering involves the creation of the Regulation D Offering documents.

These documents include:

– Private Placement Memorandum: The Private Placement Memorandum, or “PPM”, is the document that discloses all required information to the investors about the company, proposed operations, the transaction structure (whether you are selling equity ownership or raising debt financing from the investors), the terms of the investment (share price, note amounts, maturity dates, etc.), risks involved, etc. Note: This document typically contains much of the information found in a business plan and also includes an extensive “return on investment” structure, along with an investment contract or “Subscription Agreement” (see next bullet point).

– Investor Suitability Questionnaire: This questionnaire must be completed by each investor and attached to the Subscription Agreement. This document qualifies the investor as an Accredited Investor.

– Subscription Agreement: The Subscription Agreement explains the terms and conditions of the offering. It is the “investment contract” for purchasing the securities. Typically an investor will complete this document and then attach a check for the investment.

– Promissory Note: In debt offerings you need to have a Promissory Note outlining the terms of the loan arrangement with the investors. The note is the actual “loan document” between the company and the investor.

5. Form D SEC Filing: The Form D is the form filing that is sent to the SEC in Washington, DC. It notifies the SEC that you are using the Regulation D program and provides them basic information on the company and the offering. Note: It is not an approval document or registration, rather it is a filing that notifies the SEC that you have a Regulation D Offering in place.

6. Marketing and Capital Acceptance: The offering is now ready for marketing to investors. The JOBS Act of 2012 has reversed a 80 year old rule whereby solicitation or advertising to investors was strictly prohibited. Investors can now advertise their offerings to accredited investors provided they file Form D and notify the SEC that they intend to use general solicitation; and

7. State Form D Filing: Also called “Blue Sky” Filings, most states require a specific form to be filed along with a copy of the SEC Form D and some require a copy of the PPM. Nearly all states charge a fee ranging from $50 to $1,500. In most states the form does not need to be filed until capital has been received from an investor in that state. After receiving the capital you typically have 15 days to file the appropriate documentation, with a few exceptions like New York, who requires filing prior to raising capital.