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Starting a production company, a film fund or other private equity fund is a risky endeavor. Absent an exemption under applicable federal or state securities laws, you may not offer or sell securities unless the offering has been registered with the state and/or federal Securities and Exchange Commission (SEC). The object of securities laws is to ensure that potential investors are provided with accurate information so that they can make informed investment decisions. As a result, you are prohibited from making false or misleading statements in connection with the sale of securities.
Securities offerings are typically for the sale of shares in a corporation, LLC units in a limited liability company or partnership interests in a partnership. Selling securities in violation of the securities laws (both state and federal) will result in liability, including rescission of the purchase price, damages or injunction.
Raising capital for your business or project can be a constantly arduous challenge. Equity or debt financing comes in a wide range of forms, including venture capital (VC), an initial public offering (IPO), business loans and private placement.
Typically, the IPO and VC routes are taken only by established companies. An IPO can be a complex, expensive and lengthy process, and VCs generally only invest in companies which have high-growth potential, revenues in excess of $2 million and a preexisting capital investment of at least $1 million. In addition, with a VC deal, the business owners are generally required to give up all or some creative, business and financial control over to the investors. The downside to borrowing money is that your fledgling company may have to make loan repayments when the need for cash is greatest. Consequently, these sources of funding may not be suitable for most startups and smaller, less established businesses.
As an alternative to an IPO, VC and/or business loan, companies that want to raise capital can do so through a private placement investment.
A private placement (also known as unregistered offering) is a securities offering exempt from registration with the SEC. Startups, small and emerging companies, such as production companies and film funds, will engage in private placements to raise equity or debt financing from a small group of select investors instead of the public, usually from institutional investors and high net worth individuals.
In general, investing in private placements is risky: private placement offerings are not registered with the SEC; most private placement securities are restricted securities and can tie up your investment for a year or more; and most private placements do not have the same investor protections as registered offerings, such as the comprehensive disclosure requirements that apply to publicly traded companies.
The disclosure requirements that apply to registered offerings, mirror the disclosure requirements of Regulation A, or Part I of the SEC’s Form S-1 used for filing a prospectus as part of a registration statement for a publicly traded company. These requirements are extensive. They include descriptions of the company’s current business operations, past business performance, the use of proceeds, total number of units or shares being sold and price per share, information about the officers and managers, executive compensation, audited financial statements, risks, and tax and legal status of the business.
Generally, private companies will try to avoid registration, because the preparation of disclosure documents, the public disclosure obligations, and the ongoing compliance obligations that flow from registration can be time-consuming and expensive, and the companies lose the ability to remain a private company.
Private companies may avoid registration of the offer or sale of their securities by making use of any one of a number of private placement exemptions available under Regulation D (Reg D) of the Securities Act.
The entity selling the securities is commonly referred to as the issuer. Under Section 4(a)(2) of the Securities Act 1933, the obligation to register the offer and sale of securities does not apply to transactions by an issuer not involving a public offering. This Reg D exemption allows companies to raise capital while keeping their financial records private, instead of disclosing such information to the SEC, and the buying public, each quarter. All issuers relying on a Reg D exemption are required to file a document called a Form D no later than 15 days after they first sell the securities in the offering. The Form D will only include brief information about the issuer, its management and promoters, and the offering itself.
Issuers often rely on Rules 504 and 506 of Reg D to sell securities in private placements.
Rule 504 provides an exemption from registration for securities offerings of less than $5 million within a 12-month period. A company may offer and sell these securities to an unlimited number of accredited and non-accredited investors.
Under Rule 504, the issuer is not required to provide any specific information or disclosures to potential investors, so long as it does not violate the anti-fraud prohibitions of the federal securities laws. However, if an issuer provides information to accredited investors, it must provide such information to non-accredited investors as well.
An “accredited investor” is an individual who: (1) earned income that exceeded $200,000 (or $300,000 together with a spouse) in each of the prior two years, and reasonably expects the same for the current year, or (2) has a net worth over $1 million, either alone or together with a spouse (excluding the value of the person’s primary residence and any loans secured by the residence (up to the value of the residence)). An accredited investor is also any director, executive officer, or general partner of the issuer, or an entity such as a bank, partnership, corporation, nonprofit or trust, when the entity satisfies certain financial criteria.
Under Rule 506(b), a company can raise an unlimited amount of money from an unlimited number of accredited investors, but from no more than 35 non-accredited investors. However, unlike Rule 504, the non-accredited investors must be financially sophisticated, that is, have sufficient knowledge and experience in financial and business matters to evaluate the investment. This sophistication requirement may be satisfied if the non-accredited makes the investor invests through a registered broker-dealer.
Unlike Rule 504, Rule 506(b) requires a company to give non-accredited investors comprehensive disclosure documents. However, the company has discretion what information to give to accredited investors, in view of the anti-fraud prohibitions of the federal securities laws. In addition, if the issuer provides information to accredited investors, it must also provide this same information to non-accredited investors.
Under Rule 506(b), a company cannot use general solicitation or advertising to market and sell securities. However, under Rule 506(c), the company may use general solicitation, marketing or advertising to market and sell securities to accredited investors only. The company must take reasonable steps to verify that the investors are accredited investors, which could include reviewing documentation, such as W-2s, tax returns, bank and brokerage statements, credit reports and the like.
Securities laws are designed to ensure that investors fully understand what they are investing in and fully appreciate the risks before they invest. Therefore, even if a company is exempt from registration under securities law, it must provide potential investors with access to company records if they ask for them, be available to answer questions by potential investors, and must take care to provide sufficient information to investors so that they can make an informed decision.
To avoid violating the antifraud provisions of the securities laws and liability for securities fraud, any disclosure (oral or written) to investors must be free from false or misleading statements, must include all material facts concerning the investment, and should not exclude any information if such omission makes what is provided to investors false or misleading.
In practice, issuers often provide a document called a private placement memorandum or offering memorandum (PPM) that introduces the investment and discloses information about the securities offering and the issuer.
A PPM is a legal disclosure document that provides full and transparent disclosure regarding the terms of the investment offering, information about the company, operations and management, the use of the proceeds, and describes the risks factors inherent in the business and industry. The PPM is not filed with the SEC.
A PPM can be as much for a company’s protection from legal liability, as it is for potential investors to be fully informed before they buy the company’s stock. The SEC has even warned prospective investors that the absence of a PPM is a red flag to consider before investing. A carefully drafted PPM protects the issuer from claims by securities regulators or litigation by disgruntled investors, for improper disclosure.
A PPM must contain accurate, truthful and current information. While many PPMs share some similarities, they are all completely customized and unique to each investment deal. For example, a well-prepared PPM will avoid using formulaic risk factors. Instead, they will detail the specific risks associated with the company’s industry, such as market trends, competitive analysis, or regulatory and tax issues. In addition, a well-prepared PPM will avoid sales/revenue projections, especially overinflated ones, that are not based on expected reality and that are the exception. Investors will likely expect you to achieve those financial targets, and the SEC will closely scrutinize such performance forecasts set out in the PPM.
Whether a company needs to use a PPM or not, and the amount and type of information in the PPM, will, in general, depend on (1) which exemption from registration is being used, (2) the type of issuer, (3) the number of investors, (4) the level of sophistication and type of investor, (5) the amount of money being raised, and (6) the complexity of the terms of the offering.
Less than $5 million: No PPM is required.
More than $5 million: No PPM is required if all are accredited investors.
B. Type of Issuer
Private Equity Fund
Most Private Equity (PE) funds rely on the Rule 506 of Reg D exemption from registration for their securities offerings. While Rule 506 does not technically require any specific disclosures to accredited investors, in practice, a PPM is used when raising money from institutional or qualified individual investors. Generally, a PE fund’s PPM contains the same disclosures and information found in a prospectus filed with the SEC as part of a registration statement. Of course, the PPM is not in fact filed with the SEC.
For prospective investors, the PPM is often the starting point in their investment decision process. Once the investors are interested in the PE fund’s investment offering, they do further research and due diligence before they invest.
A broker must be licensed and registered with FINRA (Financial Industry Regulatory Authority), the SEC and a state securities regulator (depending on the type of business the broker and his or her firm conducts). FINRA Rule 5123 requires member firms to file the private placement memorandum, term sheet or other offering document that sets forth the terms of the offering.
Under federal securities laws and FINRA rules, a broker-dealer has a duty to conduct a reasonable investigation of all securities that it recommends to its investor clients. In practice, most broker-dealer firms will require a PPM in order to have the offering approved for retail to their investor clients.
A PPM must allow the broker-dealer to determine whether an investment is suitable for its investor client. The broker-dealer would be very involved in the drafting process and assists the company in all aspects of fundraising in exchange for a fee. This fee is typically a percentage of the total capital raised. This makes use of a broker-dealer quite expensive. For this reason, PPMs are most likely to be utilized by mature companies that have hired a broker-dealer. For example, nearly 65% of private equity funds engage the services of third-party marketers/placement agents for their investment offerings.
On the other hand, very few small and emerging companies utilize the services of a placement agent, banker or broker-dealer to raise capital. Often, the amount of the investment being raised by small and emerging companies is small (usually, less than $5 million) and accordingly, the potential commission for a broker-dealer is not worth the time and risk associated with such transaction. As a result, in general, most small and emerging companies do not need to use a PPM to raise capital from investors.
In practice, all you need to gain the monetary support of a VC is a thorough business plan. VCs will almost never require a PPM. A VC may agree immediately to invest just from your pitch. If they like your company idea and decide that they want to invest, the VC will then provide you with a term sheet, representing its investment proposal.
If you want Hollywood to invest in your movie, don’t send them a PPM. Studios will usually finance a movie idea if it’s a proven concept or appeals to the biggest demographic. No amount of fancy disclosures about the market and sales predictions will make a difference. You don’t need a PPM to pitch your project to Hollywood or to obtain studio financing.
Angel investors are high net-worth individuals who provide capital for early-stage companies or startups. Angels are accredited investors. Therefore, technically, you are not required to provide a PPM, or any specific disclosures contained in a PPM, when offering securities to angel investors. A PPM would be a mere formality, since these sophisticated investors usually perform their own extensive due diligence and risks assessment before they invest.
For angels, an important step in the due diligence process usually involves reviewing the company’s business plan.
Like VCs, angel investors typically like to negotiate the terms of the deal with a term sheet. However, unlike VCs, who will be the one to supply the term sheet, the company will provide its own term sheet. Once the deal is fully negotiated, the term sheet goes back to the company’s attorneys who use it to draft a subscription agreement or stock purchase agreement, LLC operating agreement, or other document establishing the rights and preferences of the angel investor.
The most common source of seed capital when starting a business is friends or family. However, in general, the amount that can be raised from friends or family is no more than $100,000. As such, a PPM is generally not required to raise capital from family members and close friends.
For investment offers of $5 million or more to family and friends who are non-accredited investors (but they must possess a degree of financial sophistication), reviewing the PPM is an important step in the due diligence process. The PPM may serve as a stand-alone document, so that, without having to review any other material, the family member or friend is able to make an informed decision about the investment.
A major downside of seeking money from non-accredited investors is the much greater disclosure requirements. On the other hand, in general, the legal disclosure burdens are dramatically reduced (subject to the antifraud provisions of the securities laws), when only accredited investors are involved. In which case, you may avoid using a PPM to raise funds.
Having family and friends as early stage investors can be a dangerous endeavor. Investing in a startup has inherent risks, which most professional investors understand, but your friends and family may not. They may not understand that there are a million things that can go wrong between raising the initial capital for forming the business entity, covering the initial operating expenses, attracting angel investors and the delivery of the finished goods or services. Therefore, whether or not you provide a PPM to your family or friend investors, you should be prepared to present them with your investor deck, pitch deck, financial statements, business plan and any other relevant documents that describe your business strategy and goals, how much capital your business needs, why you need the money and how you plan to spend it.
While there is some overlap, a PPM is not the same thing as a business plan.
PPMs are often structured to include:
Business plans are often structured to include:
The detailed “description of the securities” and the “risks factors” are perhaps the most important difference between the PPM and a business plan.
Unlike a business plan, the PPM focuses on the structure and terms of the deal, and the attendant risks of the investment, whether they be equity securities or debt securities. The PPM should be a descriptive document. It should allow readers to reach their own conclusions regarding the merits of the deal.
On the other hand, a business plan is a persuasive document that goes into great depth regarding the financial projections, forward looking statements, marketing, distribution and sales strategy and tactics of the business.
While the business plan may be helpful as a tool to pitch a business idea to potential investors and for setting out the business’s future objectives and strategies for achieving them, it is not an offering document. The business plan does not normally present sufficient details required for an adequate offer for investment, nor is it used to actually raise capital and secure the funds. This is normally reserved for the PPM (or a term sheet).
A Term Sheet, generally non-binding, is a deal memo or letter of intent, which contains all the important terms of the investment offering. By signing the Term Sheet, the potential investor agrees to begin the legal and due diligence process, and the issuer’s counsel begins the process of drafting the actual financing documents, prior to the closing.
Although a Term Sheet is generally non-binding, a few provisions of the Term Sheet may be legally binding obligations (whether or not the financing is actually consummated) such as confidentiality, expense reimbursement, no shop/exclusivity and/or governing law, jurisdiction and dispute resolution terms.
There are several benefits to entering into a Term Sheet prior to starting the due diligence process and definitive agreements are executed and delivered by all parties:
Once the terms in the Term Sheet are negotiated and agreed upon, the potential investor will typically involve its lawyers in the due diligence process. Meanwhile, the issuer’s lawyers prepare definitive financing agreements and supporting documents to match and reflect the terms of the Term Sheet. These documents include, a subscription agreement, operating agreement, limited partnership agreement, stock purchase agreement, investor questionnaire, shareholders agreement, and/or promissory note. Legal issues identified during due diligence will frequently influence how these documents are drafted.
The type of information that goes into a Term Sheet include:
Unlike the Business Plan, both the PPM and Term Sheet describe the deal. Both the Term Sheet and PPM define exactly what the investor is getting, who else is in on the deal and what percentages of the company is owned by them.
However, unlike the PPM, a Term sheets does not have adequate warning about the risks of the investment. Risks factors in a Term Sheet would be a mere formality, since experienced accredited investors perform their own due diligence and risks assessment before they invest.
A Term Sheet is typically used for a negotiated transaction with a small number of investors. On the other hand, A PPM normally sets fixed terms the company wants, and which can be circulated to a relatively larger group of potential investors.
A PPM may be required by a particular state’s Blue Sky law. You should check the specific requirements of the securities law of each state in which you intend to sell securities prior to commencement of the offering.
Pursuant to Section 18(a)(1) of the Securities Act, Rule 506 preempts state registration requirements, whereas Rule 504 does not. However, even if a company is not required to register its securities with the SEC, it may be required to register them with the state where the potential investors reside or otherwise obtain a state exemption from registration. In addition, even when state registration is not required, states are permitted to require that the issuer file a copy of the Form D (along with a filing fee) with the state, if the issuer has sold or intends to sell its securities to the state’s residents. For private placements under Rule 506 of Reg D, New York requires a notification filing on its own Form 99 (and pay a filing fee) in addition to the filing of the federal Form D.
Under New York state’s securities law, there is no requirement to provide a PPM to investors, except for intrastate offerings.
Under New York’s Blue Sky law (Article 23-A, §359-e, § 359-f and § 359-ff of the General Business Law (“GBL”), known as the Martin Act), unless otherwise exempt from registration, a PPM will be required if all the potential investors are residents of New York. The New York GBL § 359-ff requires registration of intra-state offerings by filing an offering prospectus which makes full and fair disclosure of all material facts. An “intrastate offering” is any offer or sale, directly or indirectly, of securities only to residents of New York state. New York’s Blue Sky law requires that the PPM (or PPM-like disclosure document), or the application for an exemption from registration pursuant to GBL § 359f(2)(d), be filed prior to making an offering of securities to only New York investors.
To successfully raise capital for your startup, emerging business, film or television production, you need a great story and vision, a proven concept, a problem solving product or service, an experienced team, significant knowledge about your potential buyer, a solid growth plan and a great investment offer. Usually you will draft a well-thought-out business plan first.
A PPM is not required for every capital raise. While Rule 506 of Reg D and the antifraud provisions of the federal securities laws mandate that issuers disclose truthful and accurate information to investors, there is no requirement to provide any specific information or disclosures to accredited investors.
There are two general approaches to raising capital via private placement: (1) an offering with fixed terms to a relatively large group of potential investors, and (2) a negotiated transaction with a lead investor or smaller number of potential investors. For an offering to a small number of sophisticated (experienced) investors, usually only a term sheet will be necessary. However, for a larger group of investors, a PPM may be required or prudent. In any event, for offerings of more than $5 million to non-accredited investors, you must prepare, draft and deliver a lengthy PPM.
In order to help you determine which approach to take, you need to know how much money you need to raise, how you intend to use the capital, how much creative control you want to negotiate to retain, the stage or round of funding, who your prospective investors are, what your potential investors’ past behavior (as investors) is like (such as expectations of potential investors regarding PPMs), the Blue Sky law of each state in which your potential investors reside, and who is selling your securities for you if not yourself (such as a broker-dealer).
The decision of whether you need to use a PPM to raise money is rarely simple. But regardless of whether you use a PPM or not, you should prepare detailed disclosure documents in order to avoid liability for misstatements or securities fraud, especially if the nature and operations of your business and/or the terms of the investment offering are very complex.
Whether or not a PPM is used, each transaction and offering of securities should be carefully reviewed by legal counsel to determine the minimum level of disclosure that must be provided to prospective investors under applicable federal and state securities laws, and to catch and correct any compliance issues. Call us for more information.