The Securities Act of 1933 (Act) requires that every offer and sale of a security be registered with the U.S. Securities and Exchange Commission (SEC). However, the Act provides exemptions from registration in certain situations. The good news - most start-up companies who want to raise capital will fall within one of the SEC exemptions and therefore, don’t need to register with the SEC. However, all of the SEC exemptions contain strict disclosure and anti-fraud rules. There is potential for severe civil and even criminal liability if the SEC or state securities commission determines that securities fraud has occurred. Additionally, the members of a company can be sued individually if the company fails to make material and truthful disclosures. Therefore, it is crucial that a company raising money gets this right. So, what is the best approach?
PPM vs. Subscription Package
The traditional approach to satisfying the SEC disclosure requirements is a private placement memorandum (PPM). A PPM is very long (often hundreds of pages) and prohibitively expensive for many start-ups. Law firms have been known to charge upwards of $100,000 to prepare PPMs. At Stock Legal, we work to meet the SEC disclosure requirements by preparing a comprehensive subscription package. The subscription package contains many of the same elements as a PPM, but we are able to provide it at a more reasonable cost by working collaboratively with our clients. We provide the format for information, but allow our clients to do the heavy lifting of providing all of the necessary company specific information. By doing this, we’re able to provide our subscription packages for a fixed fee so that our clients know, up front, the cost of preparing the necessary documents for their capital raise.
What do we include in a subscription package? Our subscription package consists of three documents: (1) a confidentiality agreement; (2) a term sheet; and (3) a subscription agreement.
The confidentiality agreement is between the company and a potential investor whereby the potential investor agrees to keep confidential all information provided to the potential investor by the company. For obvious reasons, it’s important for a company to put a confidentiality agreement in place before sharing important and confidential information with a potential investor.
The term sheet is a brief document setting forth the basic terms and conditions of the capital raise. A term sheet may change based on the feedback a company receives from early potential investors. So, subsequent revisions to a term sheet are common.
The last document in our subscription package is the subscription agreement. Once a potential investor is ready to become an actual investor, he or she will sign a subscription agreement with the company. At Stock Legal, our subscription agreement has 7 parts:
- Subscription Agreement - The Subscription Agreement is the agreement that governs the transaction of the investor agreeing to invest at a certain price. The remaining parts (outlined below) are exhibits to the subscription agreement, many of which are included to satisfy the SEC disclosure requirements.
- Joinder Agreement/Convertible Note - If the capital raise is for equity in the company, each investor must agree to become a member of the company, which is done by executing a joinder agreement. Alternatively, if the capital raise is for a convertible note, the template convertible note is attached to the subscription agreement and executed by the company.
- Investment Considerations and Risk Factors - This exhibit contains wide-ranging risk factors that the investor must be made aware of prior to investing in the company. This is a very important exhibit because, as noted above, if the company fails to make necessary disclosures to its potential investors, it is subject to civil and criminal penalties. Therefore, every single risk factor must be included. At Stock Legal, we provide our clients with risk factors that are generally applicable and then work with our clients to supplement with the risk factors specific to their industry and business.
- Investor Questionnaire - In this exhibit, each investor represents that he or she is an “accredited investor.” An accredited investor is a defined term under the Act and is a person or entity that meets certain criteria regarding income, net worth, asset size and professional experience. For example, an individual having an annual income of at least $200,000 (or $300,000 for a married couple) in each of the past two years is considered an accredited investor. An individual who has a net worth of $1,000,000 is also considered an accredited investor. Although it’s not required for every SEC exemption for investors to be “accredited investors,” for a whole host of reasons (including fitting into the “easier” exemptions to registration) it’s good practice to only sell securities to accredited investors.
- Business Plan and Projected Financials - We ask our client, together with their advisors, to prepare a professional business plan and projected financials. These documents and figures are important disclosures. But by allowing our clients, who are best suited to prepare these documents, to provide them allows us to substantially reduce our fixed fee price for the subscription package. The business plan should disclose all material information about the company, including things like any potential litigation, material contracts, material vendors, etc.
- Sources and Uses of Funds - Similar to the business plan and projected financials, this document outlines how the company will use the money from the capital raise. Again, this is an important disclosure that is provided by our clients, who have the expertise and knowledge of their business to prepare this document with little input from us.
- Organizational Documents - The organizational documents of the company are the last set of documents we attach to the subscription agreement. Investors must have the opportunity to review and understand the organizational documents so that they are aware of the rights and obligations of the equity they are purchasing.
A PPM is one way to ensure that a company satisfies the SEC disclosure requirements and anti-fraud rules. However, PPMs are not a good option for most start-up companies because of their prohibitive cost. A subscription package is a well-designed alternative to a PPM that can be prepared for a more reasonable cost. By working collaboratively with our clients to complete subscription packages, Stock Legal is able to substantially reduce cost which enables us to offer these subscription packages for a fixed fee.
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