Startup Financing – Private Placements 101

Startups need cash, no doubt about it.  One of the ways to go about getting it is through a private placement.  This post will give an overview of how such a placement works.

For the sale of any stock in a startup corporation, the federal and state securities regulations require registration of such securities prior to the sale, unless there is an exemption from registration that is available to the company.  One of the exemptions from the registration requirements is when the securities are sold in a private placement.  This is a federal exemption which preempts state regulation, save for certain notification filings and fees to be paid wherever to whatever state the company and investors are located in.

In a private placement the securities are only offered to investors that the company or a broker acting on behalf of the company has a relationship with.  The key is that there is no solicitation of the public to buy any of the securities offered.  This is very important and must be pointed out early in the process to ensure there are no Twitter posts or other Internet or social media feeds doing any solicitation.  Even one post, which has the ability to reach everyone on the Internet or World Wide Web depending on what platform you are using, can cause a company to lose its private placement exemption.  If that’s the case then the sale of the securities will be in violation of the federal and likely state securities laws and the investors can seek their money back.  There are also can be criminal penalties involved for the founders.

Now how does the private placement work?   Well, generally, by drafting a private placement memorandum (commonly referred to as a “PPM”), distributing it to certain likely potential investors and having them subscribe to the offering.

The private placement memorandum is usually drafted by an attorney and is in essence a business plan on steroids – executive summary, normal business plan components and a projected cash flow section.  The PPM contains the details of the investment – describing the current ownership of the company, how many shares are offered for sale, the per share purchase price and the minimum investment that will be accepted. The PPM also, and importantly, details all of the risks involved in the investment.  At times, founders do not like the specific detail that the PPM has to go into describing the types of risks that are involved, how each risk could manifest itself, etc.  However, it is important they are in there, as the securities laws require that the company give full disclosure to investors of these possible risks.  The company does not want to risk losing its exemption just to make the investment sound more attractive.  If an investor agrees to invest, they will return a subscription agreement signed by them with a check.  The company will hold all subscriptions and all funds in an escrow account, until the minimum amount it was trying to raise is reached.  Then it can issue the shares and access the funds.

There are many different ways things can be structured and set up but this is the standard way for a company to do a private placement.  Attorneys can usually assist in your private placement process for a flat fee, which will vary based on the type of industry, and importantly if you will seek investment only from accredited investors, or also from those that are not accredited.  Contact me to find out how much any PPM would run.

The PPM model of investment is in contrast to the Silicon Valley model, which is usually done by the initial signing of a Term Sheet between the investor and the company.  After which the company shares its information and then the investor purchases equity through a stock purchase agreement.  Each subsequent investment is called a “round”, as in Angel round, Series A, B, C rounds, etc.  This is generally the same concept as a Private Placement, and uses similar exemptions from registration as well, but has its own caveats to watch out for.