Private Equity Law Review : New York Private Equity Lawyer & Attorney : Geoffrey Parnass : Corporate & Business Law

A private placement is a process, not a source of funding. A private placement simply means that the stock is sold in the private market, and cannot be resold in any public stock markets. As a practical matter, no private placement can occur without a placement agent, underwriter or direct source of capital, such as a venture capitalist. Although a private placement is not itself a source of capital, the phrase has become a shorthand way of referring to capital that is provided by private investors, rather than the public stock market.

Private placements must be structured to comply with State and federal securities laws. These laws, dating back to the 1930s, say that a stock offering must be registered with or approved by a government agency, unless it meets a specific exemption. An offering or sale of the securities that is conducted privately, without a public offering, will generally be exempt, as long as the offering is made only to sophisticated and wealthy investors. The safe harbor most often relied on for private sales of securities is Regulation D adopted by the Securities and Exchange Commission under the Securities Act of 1933. Many States also incorporate the thinking behind Regulation D in their own regulatory scheme.

"Accredited Investors" under Regulation D

Regulation D includes a number of exemptions from registration, depending on the size of the issuer, the number of investors and the manner in which the offering is conducted. One popular exemption under Regulation D allows a company to offer and sell its securities to an unlimited number of "accredited investors” and up to 35 unaccredited investors. Specific classes of information and financial statements must be furnished to unaccredited investors and no general advertising or solicitation is allowed.

An “accredited investor” includes:

• Any director, executive officer, or general partner of the issuer of the securities being offered or sold, or any director, executive officer or general partner of a general partner of that issuer.

• Any natural person whose individual net worth, or joint net worth with that person's spouse, at the time of his purchase exceeds $1,000,000.

• Any natural person who had individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year.

• Any trust with total assets in excess of $5,000,000, not formed for the specific purpose of acquiring the securities offered, whose purchase of the securities is directed by a person who has such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment.

• Any organization that was not formed for the purpose of acquiring the securities being sold, with total assets in excess of $5,000,000.

• Any entity in which all of the equity owners are Accredited Investors.

The scope of State securities laws has been cut back in recent years. Now, a securities offering under Regulation D that is made only to accredited investors is automatically exempt from State securities laws, as long as notice filings are made with the SEC and the State regulators within prescribed time frames.

In practice, most private placements are offered or sold only to accredited investors. A private placement made only to accredited investors has no specific information requirements. For most purposes, there is no limit on the number of accredited investors that can be involved in the offering. The issuer usually prepares and hands out a private placement memorandum that outlines all of the risks of the offering and the material information about the company. Assuming willing investors are found, the private placement mechanism is a popular way to raise equity capital and one that follows a tried and true procedure and legal requirements.

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Companies that have burned through what cash friends and family have been willing to provide, and still can’t get a bank loan, turn to strangers for money. These strangers go by many names, one being “venture capitalists”. 

Venture capitalists provide money when other sources are not available. Most venture capital financing goes to companies in a narrow band of industries:  technology, information services, life science and telecommunications. Because so many start-up ventures fail, venture capital tends to adopt a collective mentality, flocking toward those deals and industries that are perceived to have the greatest chance of a quick and profitable exit.

A common requirement for venture capital is a founder or CEO who has had previous successful experience with venture capital money. Also, venture capital tends to favor companies that are already far along in the development process and need funding to get a product to market.  Finally, venture capital needs to see that projected revenues will accelerate very quickly, like a hockey stick, once product development and launch are complete. New ventures in mature industries with slower growth prospects, no matter the brilliant the business plan, are not a target of venture capital investors.                                  

Once a decision is made to provide venture capital financing, the venture capitalist typically prepares a term sheet for the investment, setting out the principal terms of the transaction. The term sheet is later reflected in formal legal documents. Whatever negotiations transpire between the company and the venture capitalist occur as the term sheet is circulated. 

Venture Capital Term Sheets

The following provisions are typically covered in venture capital term sheets:

1. Fixing the “pre-money” value of the company in order to determine how much equity the new investors will receive. For example, if the company has a pre-money value of $3 million and the venture capitalist provides $1 million of capital, the company will be worth $4 million after the investment, and the venture capital will receive shares equal to 25% of the outstanding stock.

2. Defining the terms of the security the venture capitalist will receive—generally preferred stock. The term sheet will spell out the rights and preferences of the preferred stock, such as dividends (often payable in more shares of preferred stock), liquidation preference, conversion rights (how the preferred stock is converted into common stock), and anti-dilution protection (in case the common stock is split or additional shares of common stock are issued at a price that is less than the conversion price of the preferred stock).

3. Actions that require the consent of the preferred stock voting separately as a class, such as a merger or sale of the company, amending the terms of the preferred and the issuing securities with rights senior to those of the preferred. Generally, the approval of the venture capitalist will be required in order to undertake any significant event.

4. A right to demand that the company file a registration statement with the Securities and Exchange Commission covering the stock so that it can be sold in the public markets. Also, the right to participate in any registration statements filed by the company on behalf of other investors.

5. The right to elect one or more members to the board of directors.

6. Who will serve as CEO and chief technology officer of the company.

7. How much stock management will own, generally through incentive stock options, including lock up provisions prohibiting the sale or transfer of such stock except in connection with a transaction in which all shareholders participate.

8. Rights of first refusal and preemptive rights with respect to new shares offered by the company.

9. The right of the investors to participate in any sale of stock by the original founders of the company.

Venture capital generally comes in stages. Each round of capital is designed to get the company to the next stage of development. As the stages proceed, different venture capitalists may become involved, as the industry has firms that specialize in different stages of development.

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A company with stable growth, revenues and cash flow and assets to serve as collateral can usually get bank financing. This is the least expensive form of capital. Banks charge interest rates keyed to various indexes. Interest costs have been low recently, and look to remain that way for the foreseeable future.

Bank financing documents can appear lengthy and complex, although the lending relationship is quite simple. After providing the funding, the lender is primarily concerned with receiving scheduled payments of interest and principal. The many protective clauses in the loan agreement are designed to maximize the lender’s chances of getting repaid in the event of a default and giving it an early warning if financial problems start to develop before an actual payment default occurs.

Asset Based Financing

Companies often seek “asset based financing” from lenders. In this financing, a company borrows against its tangible assets, such as fixed assets, receivables and inventory. The amount available to loan is tied to the appraised value of assets or the amount of eligible receivables and inventory a company has at the end of a measurement period.  The availability of funds for fixed assets is determined at the start of the loan, and the loan amount remains constant, subject to repayment through amortization. The availability of funds for liquid assets such as inventory and receivables is constantly changing. A formula is used to determine the exact amount of funds available to borrow. These borrowing limits are the critical measures of credit availability. Typically, borrowing limits don’t exceed 80% of the eligible receivables and 50 to 60% of eligible inventory. 

A typical definition of an eligible receivable is one that arises in the ordinary course of business; is not disputed or subject to any right of set off, allowance or adjustment by the customer; is not more than 60 days old; and is owed by a customer whose financial condition is satisfactory to the lender in its sole discretion.

Eligible inventory has similar contractual limitations as to the quality, age and condition of the goods. Generally, a borrower must have a perpetual inventory system that keeps close track of inventory levels. The inventory may be subject to a fair market valuation if that measurement is lower than cost. Although these definitions and the discretion given to the lender to cancel the loan raise concerns, in practice the lender is subject to an obligation of good faith and fair dealing which tempers arbitrary lending practices.

Receivables Financing and Factoring

The financing of accounts receivable is the linchpin of asset-based lending. Receivables are popular with lenders because they are self-liquidating and provide short-term sources of cash. The assets cannot be stolen, lost or damaged. However, problems can arise when the account debtor (the customer) has offsets or counterclaims against the borrower. These can compromise the collection of the receivable and reduce the lender’s collateral base. Lenders typically perform some due diligence on account debtors to make sure there are no hidden defenses to collection of the receivables.

Receivables financing is structured so that the account is immediately assigned to the lender without notifying the customer. The borrower merely acts as a conduit for the collection from the customer, and payments are applied directly to repayment of the loan. The lender monitors the collection of accounts daily and bases it’s lending on the amount of outstanding accounts. Another form of receivables financing is "factoring", where the receivable is actually sold to the factor at a discount to face value. The customer is notified that an invoice has been sold and the seller must repurchase the receivable if non-payment is due to a manufacturing problem. The credit risk is absorbed by the factor.

Customary Terms of Loan Agreements

A typical loan agreement will cover the following topics, in a fashion that strongly favors the rights of the lender:

1. The interest rate, how interest is computed and how often interest is paid.

2. The schedule for repaying principal.

3. Any fees payable to the lender at the closing or during the term of the loan.

4. Affirmative covenants such as delivery of financial statements and other reports on a periodic basis; allowing inspections of major facilities and assets; payment of other obligations and taxes when due; compliance with applicable laws and maintenance of net worth and other financial ratios.

5. Restrictive covenants prohibiting the borrower from entering into merger or acquisition transactions; incurring other obligations for borrowed money; paying dividends or making distributions to shareholders; making loans to third parties or selling assets other than in the ordinary course of business.

6. Defining the events of default such as failure to pay interest or principal when due; breach of representations or covenants; and becoming insolvent or declaring bankruptcy.

Security Interests and Guarantees

To secure a bank financing, the borrower must provide credit supports, such as pledging specific assets or providing guaranties of third parties. A pledge of assets simply means the lender has a preferential right to be repaid out of the proceeds of the asset in the event borrower fails to repay the loan. The pledge is accomplished by granting a security interest in the assets, if they are personal property such as accounts receivable, inventory or equipment, or by granting a mortgage if the assets are land or buildings.

A guaranty is the promise of another party to make good on the loan if the primary obligor defaults. The guarantor may be a stockholder or subsidiary of borrower or some other company under common control with borrower. Most guaranties give the secured lender the right to pursue the obligation directly against the guarantor if the borrower defaults. There is usually adequate consideration for a guaranty if it is required by the lender as a condition of making the loan.

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