Deep Dive into Regulation D; Part 4 Rule 506(b)

In Part 4 of our Deep Dive series we take a look into one of the two most popular registration exemptions offered to private companies; Rule 506(b).

Why is this rule one of those widely chosen exemptions? Great question.

Many startups and growing companies do not have any business history - they're brand new. Banks simply cannot lend them money due to their restrictive application processes and requirements. In terms of the required financials, they simply do not exist at these early stages. Most startups rely on investments from friends and family, often referred to as 'seed capital' to launch or grow their startup. The founders may not know many accredited investors who are ready to take a gamble on an unproven business until some benchmarks have been reached. Rule 506(b) is a superb model that allows for a certain number of non-accredited investors to participate in their offering, as well as accredited investors. This exemption is an excellent choice to grow into your capital raise.

For those who think there's no need to register a formal exemption to raise capital from friends and family, you would be wrong. Raising capital - in any capacity is a risk to you and the investors, and requires specific legal registrations, as well as a host of disclosures to keep yourself, your business, and the investors safe.

Rule 506(b) Overview

Regulation D, Rule 506(b) is a key provision under the U.S. Securities and Exchange Commission (SEC) that allows companies to raise capital without having to register their securities with the SEC. Rule 506(b) falls under Regulation D, which governs private placement exemptions, and it offers certain advantages, primarily for small to mid-sized companies, private equity firms, hedge funds, and real estate ventures looking to raise funds from accredited investors. Below are the critical aspects of Rule 506(b):

1. Unlimited Capital: Companies can raise an unlimited amount of money.
2. Accredited Investors: Sales can be made to an ***unlimited number of accredited investors.These are individuals or entities that meet certain income, net worth, or professional criteria. It is stipulated that sponsors can rely on the investor’s representation as to their accreditation status. (***allowing issuers to raise an unlimited amount of money from up to 2,000 investors and up to 35 non-accredited investors, without having to register their securities with the Securities and Exchange Commission (SEC). An issuer with more than 2,000 investors must become a reporting company under the Securities Act of 1934, as amended).
3. Non-Accredited Investors: Up to 35 non-accredited investors can participate, but they must be *financially sophisticated (or represented by a **Purchaser Representative).
4. General Solicitation: General solicitation and advertising are not allowed under Rule 506(b).
5. Disclosure Requirements: If non-accredited investors are involved, issuers must provide them with disclosure documents similar to those used in registered offerings.
6. Resale Restrictions: Securities sold under Rule 506(b) are considered "restricted" and cannot be resold without registration or an exemption.
7. State Laws: While federal registration is not required, companies must comply with state securities laws, often through notice filings and fees.

*Financial Sophistication

Determining if a potential non-accredited investor is financially sophisticated typically involves assessing their financial knowledge and experience. Here are some factors to consider:

1. Investment Experience: Look at their history with similar investments or financial products.
2. Professional Background: Consider careers in finance, investing, or related fields that require financial expertise.
3. Education: Relevant education in finance, economics, or business can indicate sophistication.
4. Advisors: Whether they have access to financial advisors or consultants who can guide them in evaluating investments.
5. Understanding of Risks: Ability to comprehend the risks associated with the investment and articulate them.

These factors help ensure that the investor can make informed decisions without needing extensive disclosures, or a *purchaser representative.

**Purchaser Representative:

The role of the purchaser representative is to ensure that non-accredited investors evaluate the merits and risks of the prospective investment in the acquirer's stock. A common exemption from registration used in these circumstances is available pursuant to Rule 506 under SEC Regulation D.

Notable Caveats

Increased Disclosures

Rule 506(b) is by far one of the most popular exemptions chosen by issuers to raise capital for their offerings. The versatility of recruiting both accredited and non-accredited investors broadens the range of participation. However, taking on even one non-accredited investor significantly increases the level of information an issuer must provide. This is because of Rule 502(b) under Regulation D, which states that issuers selling securities to non-accredited investors must provide audited financial statements, information on resale limitations, and other disclosures.

No Advertising Allowed

Issuers are not permitted to perform any “general solicitation or advertising” for securities offered under Rule 506(b). There is no specific definition of what is and is not general solicitation. Generally, to determine whether a communication will be considered general solicitation, a sponsor (or fund manager) should consider:

• Is the communication to a wide spread and anonymous audience?
• Does the communication contain a cold call to invest?
• Even if there is no call to invest, might the communication prime the market for the securities being offered?
• General solicitation includes advertisements published in newspapers and magazines, public websites, communications broadcasted over television and radio, and seminars where attendees have been invited by general solicitation or general advertising.
• Sponsors must also be able to prove that all investors had a “pre-existing and substantive relationship” with them prior to the offering.

The Unknown Future of Regulation D 506(b) and 506(c)

In an article featured in the Journal of Business & Technology Law, Allen C. Page, JD, CPA writes an interesting forecast of the future of Regulation D exemptions, specifically, rule 506(b) and 506(c). The article is titled: Approaching the Tipping Point for "Public-Private Offerings" : The Current Trajectory of Rule 506(c)

To quote the abstract;

"Rule 506(b) of Regulation D of the Securities Act of 1933 is, without question, the most utilized exemption from registration by securities practitioners in private offerings of equity securities to date by a wide margin. So to say that Rule 506(b) may soon be overtaken in popularity by another exemption would seemingly amount to heresy among securities law practitioners, who almost exclusively rely on this safe harbor in private placements and other corporate transactions. Rule 506(c) has many similarities to Rule 506(b) and affords use of general solicitation (which Rule 506(b) prohibits), but also has a number of weaknesses that limit its use by issuers and practitioners. However, the SEC’s recent enactment of the updated integration framework in Rule 502 in November 2020, viewed in light of the SEC’s recent guidance concerning the use of Rule 506(c), raises the question of whether Rule 506(c) will eventually subsume, or at least overtake, Rule 506(b) as the exemption of choice for securities practitioners."

These forecasts are merely conjecture, as nobody can project what the SEC may revise or impose next. In spite of that, we can review how often the SEC has modified the Regulation D mandates since its inception in 1982.

• 1982: Regulation D was established
• 2012: JOBS Act was implemented (30 years since last revision)
• 2020: Minor adjustments to Accredited Investor status and contemporaneous integration fundraising strategies was amended (8 years since last revision)

From my perspective, there is not enough data to determine when the next revision will be.

Structuring Your Capital Raise

Navigating the formation of your offering can be daunting and expensive -- some law firms and startup incubators charge between $50,000 - $350,000+ depending on which exemption your company files. As investors in companies ourselves, we {Poplar Equity Group} believe these costs are entirely unnecessary, and even unwise for a startup venture to accumulate that much debt -- before you've taken on any capital!

We put our heads together and created a better way. If you've been considering raising capital for your business in a structured, compliant manner, we want to help. Send me a message and let's get to work!

Your best days are ahead! ??

-Blake E. Robbins

Reg CF, Reg D 506(B), Reg D 506(C), Reg A+ Reg S, Equity Crowdfunding, Capital Raising, startup, angel capital, venture capital, private equity hedge funds

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