PRIVATE PLACEMENT OF SECURITIES TO FUND A SMALL ACQUISITION

A stock offering in the form of a private placement of securities may be an effective technique for raising capital to fund an acquisition. The private placement may be used in conjunction with, or as a substitute for, the commercial bank loan.



Raising Capital: A Strategy

A privately owned company seeking to acquire the assets or stock of another company -- in the price range of $1 million to $5 million -- may find it difficult to finance the transaction. Commercial bank loans may not be available to a young company. If such loans are available, the bank will require personal guarantees and substantial collateral. Moreover, bank loans involve transactional costs that, over the course of the loan, may be substantially greater than the costs of a private placement of securities.

A popular technique for raising capital is the use of convertible preferred stock, with or without cumulative dividends. Investors favor this security because they have a preferred position if a dividend is authorized, and a senior position in the event of the sale or liquidation of the business. Moreover, the ability to convert the preferred stock to common stock gives the investor the opportunity to participate in the growth of the company.

Convertible preferred is advantageous to the issuing company, since it may postpone or avoid payment of a dividend for a specified period of years. Alternatively, the issuing company may offer common stock with warrants. The warrant allows the issuer to enhance the marketability of the common stock by allowing the investor to purchase additional common shares of the issuer at a later date for a fixed price. The price at which the investor may exercise the warrant is fixed at the time of the offering and may represent a bargain price if the acquisition is successful.

The Private Placement of Securities

A small private stock offering, in order to qualify for exemption from federal registration, must comply with Rule 504, Rule 505, or Rule 506 of SEC Regulation D. In 2007, the SEC issued proposed amendments to these rules, and at least one state (Maryland) has issued proposed amendments to its limited offering exemption. Under Rule 505, an issuer can raise up to $5 million, without SEC registration, provided that the stock offering does not involve a general solicitation or general advertising of securities. The securities may be sold to an unlimited number of “accredited” investors, but to a maximum of 35 “unaccredited” investors.

Unfortunately, under Rule 504 and Rule 505, the issuer must also contend with state regulation. One alternative is for the issuer to qualify under Rule 506 of SEC Regulation D. Rule 506 provides a broad exemption from state regulation (but not with respect to state antifraud rules). However, in complying with SEC Rule 506, the 35 unaccredited investors must be sophisticated or have the benefit of a purchaser representative who is sophisticated. A Rule 506 offering normally involves the use of a disclosure document, known as a private offering memorandum, even if the offering is limited to accredited investors. Either a registered broker-dealer is used in a 506 offering or the issuer utilizes a selling agent who qualifies under state law as an “issuer’s agent”. In some circumstances, the principal of the company may qualify as issuer's agent.

Securities issued pursuant to a private offering exemption are “restricted.” In other words, the securities are not freely transferable and can be resold only in reliance on SEC Rule 144 or upon subsequent registration.

As with any stock offering, the issuance of common stock, warrants, or convertible preferred stock will result in diluting the earnings-per-share. For example, accounting principles and SEC rules require that earnings-per-share be reported on a fully diluted basis to account for all of the equity that may be outstanding after exercise of the outstanding warrants and conversion of convertible securities.

Another disadvantage of a private placement is that shares are typically sold to so-called "accredited" investors, who will follow closely the progress of the company. Accredited investors, by definition, have substantial personal resources and may seek a more active role in the business, particularly if they represent a large block of the outstanding securities. In this connection, principals of the company may want to use two classes of stock so that they preserve voting control of the company.

Moreover, it is essential that the terms of the offering are clear regarding management's ability to reinvest profits in the business. Prospective investors must be informed in the offering memorandum that there will not be dividend distributions during the start-up or development stage of the business.

Finally, initial transaction costs will be higher for a private placement than a traditional commercial loan. Counsel will be needed to perform due diligence and to prepare a prospectus or offering memorandum. Financial projections or forecasts should be prepared by a qualified CPA. In addition, if a broker is required as placement agent, sales commissions and expenses could be in the range of 5% to 15% of the offering proceeds. These placement costs can be avoided if the principals of the company have the ability, time and inclination to assume responsibility for capital formation.

Conclusion

For the entrepreneur of an emerging company with a good business reputation and access to private investors, a private placement of securities may be the most effective method for raising capital to fund an acquisition or finance internal expansion.