Regulation D Stock Sales (#89)
/In this podcast episode, we discuss why a business might want to sell shares using the Regulation D exemption, and what that entails. Key points made are noted below.
When to Use Regulation D
At some point, you may be working with a public company, and you’ll be asked to help it raise money by selling stock. If you do, you absolutely want to avoid filing a stock registration document with the Securities and Exchange Commission. I’ll get into stock registrations in another episode, but trust me on this one, don’t do it if you can possibly avoid it. There are major auditor and legal fees involved, and a registration takes up a lot of your time, and the SEC will pick it to death and keep making you modify it. So, you don’t want to go there.
Instead, you want to use one of several SEC regulations that provide exemptions from the main stock registration laws. A good way out is Regulation D, which provides an exemption from the normal stock registration requirement. Regulation D requires that you only sell securities to accredited investors.
The Accredited Investor
There are a couple of definitions for an accredited investor, but the one used the most is that it’s a person having individual income of at least $200,000 per year, or a joint income with a spouse that exceeds $300,000 per year. And that’s in each of the last two years, by the way, and there has to be a reasonable expectation that they’ll reach the same income level in the current year. It can also be anyone with an individual net worth of at least $1 million, or it can be a director or executive officer of the company. It can also be an entity, like a bank, or a trust, or an investment company. These guidelines keep going up over time, but those are the minimums that the SEC has established so far for accredited investors. The main point with the accredited investor is that it’s someone who’s wealthy enough and therefore presumably smart enough to make informed investment decisions.
How to Find Accredited Investors
So, your first task is to round up a group of these accredited investors. Under Regulation D, you can’t pull in these investors by using a general solicitation. That means no advertisements, and no free seminars for the investing public. What you do instead is either use personal contacts or use an investment banker who can contact a short list of accredited investors on your behalf. This means you’ll need an investment banker most of the time, since they know who the most likely investors will be.
Another question is, how do you know if someone is really an accredited investor? What if they don’t really have the financial resources required by Regulation D? Actually, it’s not your problem. Have your attorney create a questionnaire for the investors, which they have to sign. The questionnaire asks them about all of the criteria that I just mentioned for an accredited investor, and if they say they are, and you have a copy of the signed questionnaire, then you’re covered.
The Stock Restriction
Now, the problem with Regulation D stock sales is that they are not registered, so when you issue the stock certificates, there’s a big restriction paragraph on the back of the certificate. And that restriction means they cannot sell the shares. The restriction says something like “These securities may not be sold, offered for sale, or pledged in the absence of a registration statement.”
Investor Motivations
Tt’s fairly obvious why a company wants to use Regulation D; it has far less reporting to do, and it still gets the money from investors. But why would an investor agree to do it, since the shares can’t be sold? Well, there’s a certain type of investor who’s willing to take restricted stock, and that’s the long-term investor. They’re assuming they’ll be holding onto those shares for a number of years, and they expect to cash out when the company is sold.
Or, they may be expecting to have their shares registered whenever the company eventually registers other stock. This is called having piggyback rights, and it means that the company is obligated to list their shares in any registration statement that the company eventually files with the SEC. Piggyback rights are very common in a Regulation D stock sale.
The investors realize that they’re doing the company a favor by accepting unregistered stock, so they can also extract some other favors. One common item is warrants, which is a right to buy the company’s stock at a certain exercise price. If they get one warrant for every share they buy, that’s called having 100% warrant coverage. If they get one warrant for every two shares they buy, then that’s called having 50% warrant coverage, and so on. A canny investor is very likely going to want warrants so he’ll be able to grab additional profits from any upside on the stock price that may occur over the term of the warrants, which is usually five years.
Now if you’re really desperate for cash, the investors can get even more onerous. They may demand preferred stock instead of the usual common stock, which may give them really favorably conversion rights into common stock, or dividends, or even super-voting privileges over the common shareholders.
Parting Thoughts
So, it’s a great idea to use an exemption like Regulation D to avoid a stock registration statement, but use it when the company is in fairly good financial condition and isn’t overly desperate for cash. Otherwise, you may be stuck with some really rapacious investor who will take the restricted stock, but will also gain quite a financial advantage over the company.
A final issue is, what if a stock sale occurs over several months, which may happen if some investors are straggling in ways after everyone else. Do all of the stock sales in that period fall under Regulation D? There are a couple of guidelines for figuring that out. First, are the sales all part of a single documented financing plan? Also, does it involve the sale of the same type of stock? And, are sales being made for the same type of consideration? And finally, are the sales being made for the same general purpose. If the stock sales in the time period all conform to those rules, then you’re covered by the Regulation D exemption.