What Is a Subscription Agreement?
A subscription agreement is a crucial document in the world of private equity and limited partnerships, serving as an investor's application for joining a limited partnership (LP). More than a simple formality, it operates as a mutual commitment, wherein a company agrees to sell a predetermined number of shares at a specific price, while the subscriber consents to purchase those shares at the agreed-upon price. This agreement thereby lays the foundation for the financial relationship between investors and companies.
Key Takeaways
- Definition: A subscription agreement defines the terms under which a party invests in a private placement offering or a limited partnership.
- Regulatory Framework: They are typically governed by SEC Rule 506(b) and 506(c) under Regulation D, which permits specific types of private placements to raise funds without the need to register securities with the SEC.
- Nature of Investment: These agreements are often used in situations where investors provide capital in exchange for equity while taking on limited risk.
Understanding Subscription Agreements
At its core, a partnership represents a business arrangement where two or more individuals share ownership. In this structure, profits and losses do not attract taxes at the entity level; instead, they “flow through” to each partner based on a partner agreement. This is particularly common in general partnerships, like law or accounting firms.
Limited Partnerships and Their Structure
In a limited partnership (LP), the arrangement comprises general partners who actively manage the business, and limited partners, who are investors that contribute capital but have no control over day-to-day operations. Here’s how it works:
- General Partners: They handle management responsibilities and decision-making. They also play a central role in raising capital via subscription agreements from limited partners.
- Limited Partners: These investors typically make a one-time capital investment. They do not engage in managing the business, which limits their risks. Their liability is capped at the amount they invested, providing a degree of financial safety.
The subscription agreement plays a pivotal role in determining the eligibility of a candidate to participate as a limited partner, examining factors such as investment experience, sophistication, and net worth.
Regulatory Environment for Subscription Agreements
SEC Rules and Regulation D
Subscription agreements are largely governed by SEC Regulation D, specifically Rules 506(b) and 506(c). These rules detail the necessary steps and disclosures a company must make to potential investors when raising capital:
- Rule 506(b): Allows issuers to offer and sell securities to up to 35 non-accredited investors, alongside an unlimited number of accredited investors, without registering with the SEC.
- Rule 506(c): Enables issuers to publicly solicit investors but mandates that all investors be verified as accredited.
As new limited partners are onboarded, the general partner must secure consent from existing partners to amend any existing subscription agreements, thereby fostering transparency within the partnership.
Private Placements and Their Alternatives
When companies look to raise capital, they typically provide shares for purchase either to the general public or through a private placement. In cases involving public offerings, potential investors receive a prospectus, a detailed document that outlines pertinent information about the business and its securities. Conversely, in private placements, prospective investors, generally composed of accredited individuals, receive a private placement memorandum (PPM), which offers less exhaustive information than a prospectus.
A subscription agreement often accompanies the PPM and can specify various terms, such as:
- Rate of Return: Some agreements detail specific returns, such as a percentage of net company income.
- Payment Schedule: Investors often receive their returns before company founders or minority shareholders.
By establishing clear expectations regarding returns and payment dates, these agreements provide a structured investment framework.
Conclusion
A subscription agreement is a fundamental document in the investment landscape, particularly for limited partnerships. It not only delineates the financial commitment of the investor but also establishes a clear framework for how that investment will be managed. Understanding the nuances of subscription agreements, their regulatory environment, and the relationship they forge between investors and companies is essential for anyone looking to engage in private equity or limited partnerships. By investing through these agreements, investors can navigate the complex world of private investments while managing their risk and expectations effectively.