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Choosing a Public or Private Offering.
Section 5 of the Securities Act mandates that every time a security is sold, it either must be registered with the SEC or exempt from registration with the SEC. Securities registered for sale with the SEC are often referred to as being publicly offered and those sold under certain exemptions from registration are often referred to as being privately offered or placed.
There are advantages and disadvantages to both public and private offerings, although some of the disadvantages previously associated with private offerings were eliminated by Rule 506(c), the private placement exemption that permits the use of general advertising and general solicitation in certain offerings.
In public offerings, a company has access to an open trading market in which it can freely solicit investors. Securities issued in a public offering can be resold freely and therefore are more attractive to potential investors. But, particularly for a small business, the costs of undertaking a public offering can outweigh the benefits. The registration process is expensive and there are significant costs associated with SEC periodic filing requirements, such as the filing of annual and quarterly reports. In addition, detailed disclosure required in certain SEC filings, such as information on executive compensation, director and officer biographies and doing business in politically troubled countries, could cause discomfort for some companies. Further, the implementation of the Sarbanes-Oxley Act of 2002 (SOX), as well as the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act), has added a layer of governance and compliance considerations.
It is important to note, however, that the JOBS Act reduced the burdens of conducting a public offering for emerging growth companies (EGCs) by temporarily exempting EGCs from various ongoing reporting and compliance obligations associated with being a public company. Among other things, EGCs do not need to provide the auditor’s attestation of internal controls otherwise required of public companies under Section 404(b) of SOX. The provisions of the JOBS Act relating to EGCs took effect on April 5, 2012. Despite fewer burdens, however, the costs of conducting a public offering are still likely to exceed the costs of conducting a private placement for companies electing to be treated as EGCs.
In private offerings, a company can meet its capital raising needs while avoiding the registration requirements of the Securities Act and the associated costs. To qualify for a private offering exemption, however, companies must comply with various limitations on the manner in which they make the offering, including requiring the qualification of investors to whom offers are made or who can participate in the offering or limiting the amount of capital that can be raised.
Historically, one of the principal benefits of a public offering was the ability to attract investors through the use of general advertising and general solicitation without being subject to limitations on the size of the offering. However, with the adoption of Rule 506(c), issuers are now permitted to conduct general advertising and general solicitation in connection with a private placement, as long as:
• The issuer takes “reasonable steps” to verify that all purchasers are accredited investors.
• At the time of the sale of the securities, all purchasers are accredited investors or the issuer reasonably believes they are accredited investors.
• All of the terms and conditions in Rule 501 and Rule 502(a) and 502(d) are satisfied. Securities issued in private placements under Rule 506(c) are subject to resale limitations under Rule 502(d) and therefore are “restricted securities” as defined in Rules 144(a)(3)(i) and (ii).
The first two requirements are separate conditions. Therefore, the failure to take “reasonable steps” may not be excused, even if it turns out that all investors are, in fact, accredited. However, the SEC has stated that no additional verification steps are necessary where an issuer has actual knowledge that a purchaser is an accredited investor. The SEC has outlined a principles-based approach for determining what constitutes “reasonable steps” when verifying that all purchasers are accredited investors (Eliminating the Prohibition Against General Solicitation and General Advertising in Rule 506 and Rule 144A Offerings, SEC Release No. 33-9415 (July 10, 2013)). It has also supplemented this approach by providing four non-exclusive methods for verifying the accredited investor status of natural persons (see Confirming the Accredited Investor Definition).
Each company must assess its needs and whether a public or private offering is appropriate.