Regulation D Offering

The regulatory basis for offering and selling securities is the Securities Act of 1933, including rules (§§ 230.501–230.508) that govern the limited of er and sale of securities without registration. The latter is known as Regulation D. Common securities of Regulation D offerings are equity and convertible bonds.

Besides Regulation D, there are other exempts from registration, such as for the issue of insurance policies and short-term commercial papers or securities issued by governments, nonprofit groups, common carriers, and banks.

According to the Securities Exchange Act of 1934, companies with more than 500 shareholders, $10 million assets, or those listed on national stock exchanges are required to register. An investment strategy based on these issues is also known as Regulation D investment or PIPE investments (private investments in public entities).

Despite its complexity, Regulation D is an easy method of financing for small companies. Rule 501 provides several definitions, which are applied in rules 504, 505, and 506.

According to Rule 501,
  1. accredited investors are typical institutional investors (such as banks, brokers, insurance companies, pension funds, and trusts), private development companies, members of the (top) management of the issuer, and individuals with a net worth of about $1 million or an income of about $200,000 in the two most recent years. 
  2. Companies can be issuers, or in case of reorganization, also the trustee or debtor. 
  3. The calculation of the number of nonaccredited investors is also ruled.

Rule 502 determines general conditions for Regulation D offerings.
  1. The issuer has to inquire whether the purchaser acquires the securities for his own or a third party’s account and the purchaser should not be an underwriter. 
  2. The issuer must notify purchasers that securities are not registered under the Security Act and therefore cannot be resold. 
  3. General solicitation and advertisement are not allowed. 
  4. Just as in registered offerings, documents for nonaccredited investors have to be disclosed. Any information for accredited investors can be made as long as these meet antifraud provisions. All information for accredited investors must be disclosed to nonaccredited investors as well. 
  5. The issuer must be available to answer questions by prospective purchasers. 
  6. For non-accredited investors a certified financial statement must be provided by an independent public accountant (in some cases the company’s balance sheet or the audited financial statements prepared under the federal income tax laws are sufficient).

Rule 503 specii es the filing of notice of sale (505/506). Within 15 days at er the first sale of securities, the issuer has to file Form D to the SEC, which includes names and addresses of the company’s owners and stock promoters. Registration of securities and sending of reports to the SEC are not required.

Three exemptions for limited offerings and sales without registration are named in rules 504, 505, and 506.

Rule 504 exempts offers and sales of securities that do not exceed $1 million in any 12 month period. Before the small business initiatives (August 1992), the general rules 501, 502, and 503 have to be met. Thereafter, under certain conditions there can be a public offering of securities up to $1 million to an unlimited number of investors of any kind, without delivery of disclosure documents.

It is required that the issuer is not a blank check company and does not have to file reports accordingly to the Securities Exchange Act of 1934. In some cases, state security laws may be stricter. Antifraud provisions have to be abided. This means no including or excluding of information that would be false or misleading.

Rule 505 provides the exemption for offers and sales of securities not exceeding $5 million in any 12 month period. An unlimited number of accredited investors and 35 nonaccredited investors are able to buy the offered securities. The definitions (rule 501), the general conditions (rule 502), and the filing of notice of sale (rule 503) have to be met.

Rule 506 provides the exemption for unlimited offers and sales of securities. It is considered as a safe harbor for private offering that arises under Section 4(2) of the Security Act (504 and 505 are small offerings).

An unlimited number of accredited investors and 35 nonaccredited investors are able to buy the offered securities while non-accredited investors have to understand the merits and risks of the investment. Again all definitions (rule 501), general conditions (rule 502), and the filing of notice of sale (rule 503) have to be met.

Compared to full SEC registration, a Regulation D offering has the advantage to be easier, faster, and cheaper. Furthermore the issuer is in safe harbor (legal protection) if all requirements are fulfilled. For small companies, which are fast growing, have large expenses (R&D), or run out of liquidity, Regulation D provides fast new capital.

Under unfavorable market conditions or restructuring, (secondary) public offerings are often not possible for small and unknown companies. In the past, high-tech, Internet, and biotechnology companies used Regulation D intensely. The danger of losing control of the company exists when toxic PIPEs occur.

Toxic PIPE refers to a situation when convertible bonds are issued and the conversion ratio depends on the future equity price. Through short selling of the equity, the purchaser of the convertible bond reduces the equity price and receives more (in some cases the majority) shares.

Investors of Regulation D offerings often receive a discount on the security price due to the restriction on reselling them. Moreover it is possible to invest in growing businesses in early stages. The risks of such an investment are illiquidity, uncertain business model of a small company, and the voluntary nature of information received.

Regulation D Offering
Regulation D Offering