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The mechanical framework begins with the basic axiom — any offer and sale of a security must either be registered or exempt from registration under applicable securities laws. Exemptions from registration generally come in two forms — either the securities themselves are exempt or the transaction is exempt.
Most types of exempt securities are not relevant or are of little utility to the entrepreneur (except securities offered entirely intrastate. Therefore, this initial column focuses on exempt transactions.
The simplest and least expensive form of exempt transaction is based solely on a federal statutory exemption for “transactions by an issuer not involving any public offering”.
The parameters of this exemption have been defined over the past forty years through rigorous case law and SEC interpretation. Unlike other exemptions — which are based on so-called “safe harbor” SEC rules — which tend to be objectively applied — the availability of this exemption is predicated on satisfying rather subjective criteria.
Almost 48 years ago, the Supreme Court established the basic principle that the non-public offering exemption will be available in offerings made exclusively to investors who are able to “fend for themselves”. In the wisdom of the court, certain investors, such as wealthy individuals (with their superior bargaining power) or persons with a prior business relationship with the entrepreneur, do not need the protections afforded by full registration under the securities laws.
To sustain a showing that investors could “fend for themselves”, the entrepreneur must demonstrate that (a) investors were granted access to the same kind of information that they would have received in a registered offering, and (b) the investors were sophisticated.
The requirement that access be granted, as opposed to physical delivery of the requisite disclosures, is a critical distinction for the entrepreneur. It translates into a much more simplified subscription process.
No formal offering document, such as a prospectus or private placement memorandum, must be prepared and delivered to satisfy the exemption. Instead, a “long form” subscription agreement can be used to accomplish the transaction. This subscription agreement should contain representations establishing compliance with the various legal criteria for the exemption.
For example, the access to information requirement can be evidenced by a representation by the investor that he has reviewed all financial and non-financial information necessary to make an informed decision and has been afforded the opportunity to ask questions and receive answers concerning the investment.
The investor “sophistication” requirement for a non-public offering means, according to the SEC, that investors must have the capacity to properly evaluate the merits and risks of the proposed investment. Generally, this requires a showing of substantial business and investing experience and/or particular investment experience in the entrepreneur’s type of business.
The entrepreneur should, therefore, obtain background information, such as personal financial statements and an investment track record, to gain assurances as to a prospective investor’s “sophistication”. The subscription agreement related to the investment should also contain a representation by the investor regarding his “sophistication”.
Under the non-public offering exemption, the entrepreneur is prohibited from engaging in a “general solicitation”. i.e., a broadly-focused sales effort. Instead, his communications must be confined to only those prospective investors expected to satisfy the sophistication criteria described above. On the mechanics side, the subscription agreement should acknowledge the nonexistence of any general solicitation in connection with the offering.
Investors in a non-public offering are not permitted to resell or transfer their securities except under very limited circumstances. The purpose of this restriction is to ensure that privately placed securities are not publicly redistributed.
Accordingly, the subscription agreement should impose a prohibition on the transfer or resale of the private securities unless the transfer can be accomplished, in the opinion of an attorney, pursuant to an exemption from registration. Also, the subscription agreement should contain a representation by the investor that his purchase of the securities is made NOT with a view towards distribution or resale.
In summary, the non-public offering exemption allows the entrepreneur to approach certain kinds of sophisticated investors without the requirement of delivering a formal offering document. However, to be protected, the entrepreneur should enlist an attorney’s assistance to carefully draft a subscription agreement which contains representations and other legal assurances that the non-public offering exemption has been satisfied.