Private Placement Sweeteners for Connecticut Development Stage Issuers
| Pages | 422 |
| Publication year | 2021 |
70 CBJ 422. PRIVATE PLACEMENT SWEETENERS FOR CONNECTICUT DEVELOPMENT STAGE ISSUERS
This article addresses the legal, strategic and practical concerns for a Connecticut development stage business ("NewCo")(fn1) that desires to finance its growth through a private placement of
its securities,(fn2) and, ultimately, to reinvest its earnings for expansion, rather than distribute them to shareholders. It also considers several "sweeteners" that may be used by NewCo's promoters and advisors in structuring an attractive deal for prospective private offering investors Finally, this article will examine regulatory issues affecting a private offering under Connecticut law, particularly in light of the recently enacted federal de-regulatory legislation known as the National Securities Markets Improvement Act of 1996 ("NSMIA").(fn3)
For the purposes of this discussion, NewCo is a closely held Connecticut company with three shareholders who are not related parties.(fn4) It was capitalized in reliance on the section 4(2) exemption from the 1933 Act's requirements that securities publicly offered by a company, or by those who control it, be registered with the Securities and Exchange Commission and sold by
use of a prospectus.(fn5) NewCo was formed four years ago to manufacture and distribute new technology. It has an established niche market at present and, management believes minimal competition, with significant opportunity for new applications of existing technology and for creation of new and related technology. NewCo's earnings have been insubstantial to date; they have been paid as salaries and otherwise reinvested to fund research and development expenditures and equipment acquisitions needed for operations. NewCo was formed as a Connecticut corporation because of its intention to create a public market for its stock in the future.(fn6) It falls within the letter of NASAA's definition of a development stage company, but the duration of its operating history is similar to that of many issuers that commence an initial public offering ("IPO") by registering their securities with the SEC as "Small Business Issuers,"(fn7) or in reliance on a federal transactional exemption, by qualifying either with the SEC, pursuant to Regulation A of the
1933 Act,(fn8) or registering with state securities commissions, such as Connecticut's Department of Banking ("DOB"), pursuant to Rule 504 or 505 of Regulation D of the 1933 Act.(fn9) However, NewCo's product line is unconventional, its customer base is geographically limited, and its executive management team is small.(fn10) A careful evaluation of the availability and requirements of all financing alternatives available to NewCo under each of Regulation A, section 4(2), and any of Rules 504, 505 and 506 of Regulation D,(fn11) as well as the integration issues affecting its long-range financing plans,(fn12) led to its determination that it is not yet sufficiently evolved to offer its s
ecurities in an IPO and thus should raise capital in a Rule 506 private offering to fund the expansion of its operations.
In addition to the perception that its business characteristics, such as an unconventional product line and limited market penetration, are unsuitable for an IPO, there are other compelling reasons for the selection of a private placement as the superior financing vehicle for NewCo. These include the prohibitive cost of going public for an issuer whose working capital reserves are limited, (fn13) its inability to secure the confidence of an under
writer, and its inability to meet exchange requirements.(fn14) The NSMIA, which preempts state regulation of certain types of offerings without substituting federal regulation, makes it easier for development stage companies like NewCo to raise private placement capital to fund expansion of operations. Thus, NewCo, in continued reliance upon section 4(2) of the 1933 Act and, in particular, in reliance upon the safe harbor, Rule 506,(fn15) may raise capital without registration or qualification of its securities with the SEC, the DOB (fn16) or any state securities commission.(fn17) Thus,
the DOB should expect an increase in the number of post NSMIA Rule 506 filings from issuers like NewCo."
It is customary for boards of directors of development companies such as NewCo to adopt a policy that earnings be reinvested to support future growth of the company, rather than paid out to their shareholders,(fn20) who typically seek capital appreciation rather than current income.(fn21) Boards of directors of companies with established operating histories and profitability, on the other hand, establish dividend payment policies (frequency and amount) that competitively satisfy their investor demand for current income.(fn22) Despite the expectation that NewCo will accu
mulate retained earnings, management optimism about the prospect of capital appreciation, and the existence of favorable assumptions underlying NewCo's financial projections, the decision to defer payments of dividends and the resulting reduction in liquidity of its securities will adversely affect the marketing of NewCo's securities. Even the assumption, or covenant, of future liquidity, A 4th offering document disclosure of plans to commence an IPO or another type of rights offering anywhere from two to five years from the closing date of the private placement,(fn23) is unlikely to attract investors. While expecting a lack of liquidity, prospective investors exact a premium for its absence; one or more of the following "sweeteners" will attract these investors to NewCo. As explained below, the flavor of most sweeteners will be enhanced by NewCo's plan to go public within a stated period after the closing of the private placement.(fn24)
As prospective payment of a "cumulative" dividend, NEWCO might agree to issue its stock to investors of record as of the IPO Date.(fn25) Whether this transaction is characterized as a stock dividend or a stock split depends primarily on whether the number of new shares issued is small in relation to the number of shares held (a dividend), or large (a split). However, whether characterized as a dividend or a split, this option, like the stock rights discussed in part B, infra, is usually an artificial sweetener. Stock dividends and stock splits, which usually involve stock of the same exact class, do not alter the value of NewCo's underlying assets, or increase a shareholder's interest in those assets. The only benefit to this device is that it provides investors the opportunity to receive cash for the capital gain on their investments, because the shares issued as a dividend or split may be sold easily.
If, however, the stock to be issued in a dividend or split is stock in a company other than NewCo, or if NewCo stock were convertible into shares of IPO stock of a NewCo affiliate, value might be present. Thus, a genuine sweetener would be the right to either: (i) convert or exchange NewCo stock for shares of stock of an affiliated IPO issuer, at a predetermined exchange rate; or (ii) receive a cash dividend. If NewCo issued either convertible securities or a cash dividend it could obtain the desired sweetness by adjustment of the conversion formula, or exchange rate.
B. Stock Rights
In search of the ideal sweetener, NewCo might issue the right to buy additional shares of its common stock at a price below the per share IPO price for a relatively short period of time after the IPO. The purchase price for those additional shares would establish the sweetness. if, for example, the stock rights price was a modest fixed dollar amount below the IPO price, such as $ 10, or a percentage below that price, such as 5%, chances are that, by the time the right was exercised, the IPO per share price would have adjusted to take into account the dilution created by this right, and profit from the stock right would be eliminated. In other words, if information about this stock right were
reflected in a downward adjustment in the IPO per share price, a recipient...
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