Deep Dive into Regulation D; Part 5 Rule 506(c)

As we learned in Part 2 JOBS Act, the formation of Rule 506(c) was the cause of "great celebration" for companies in fundraising mode. The truth of the matter is that it is very difficult to raise capital when you're disallowed to publicly promote your offerings! This was a game changer.

Regulation D, Rule 506(c), adopted by the SEC in 2013, permits companies to raise capital through private offerings while bypassing many of the complex registration requirements with the SEC, provided they meet specific conditions. The key aspects of Rule 506(c) include the following:

1. General Solicitation and Advertising

- Rule 506(c) allows issuers to use general solicitation and advertising to reach potential investors. This is a departure from Rule 506(b), which prohibits public marketing. Under Rule 506(c), issuers can openly promote their offerings through various channels, including media, online platforms, and other public advertising.

2. Accredited Investors Requirement

- All purchasers in a Rule 506(c) offering must be accredited investors. Accredited investors are individuals or entities who meet specific income or net worth thresholds, ensuring they are capable of understanding and bearing the risks associated with private investments. For individuals, this generally means having an annual income of at least $200,000 (or $300,000 jointly with a spouse) in the past two years, or a net worth exceeding $1 million, excluding the value of their primary residence.

3. Verification of Accredited Investor Status

- A significant distinction of Rule 506(c) is the requirement that issuers take “reasonable steps” to verify the accredited status of each investor. Merely relying on self-certification by investors is insufficient. The SEC provides a non-exhaustive list of verification methods, such as (but not limited to): reviewing tax returns, bank statements, credit reports, or obtaining a written confirmation from a registered broker-dealer, attorney, or CPA that the investor qualifies as accredited.

4. No Limit on Capital Raised

- Rule 506(c) does not impose a cap on the amount of capital a company can raise. This unlimited capital-raising potential is particularly attractive to companies seeking substantial funding from high-net-worth investors.

5. Exemption from State Registration

- Although Rule 506(c) offerings must still comply with federal securities laws, they are exempt from most state-level registration requirements. Under the National Securities Markets Improvement Act (NSMIA), Rule 506 offerings are considered “covered securities,” preempting the need for state-by-state registration, which simplifies the compliance process significantly.

6. Form D Filing Requirement

- While Rule 506(c) offerings are exempt from full registration with the SEC, issuers must still file a Form D with the SEC within 15 days after the first sale of securities. Form D provides basic information about the issuer and the offering, including the amount of capital raised and the types of securities issued.

7. Restrictions on Resale

- Securities sold under Rule 506(c) are considered “restricted,” meaning that investors cannot freely sell or transfer them. The securities must comply with Rule 144 or other exemptions from registration to be resold legally, generally requiring a holding period and restrictions on the number of shares that can be sold in a given timeframe.

Summary of Limitations

Rule 506(c) is beneficial for companies seeking to leverage public marketing to reach a broader pool of accredited investors while maintaining regulatory efficiency. However, the rigorous investor verification requirements and the accredited-only stipulation may limit the pool of eligible investors compared to other exemptions.

Rule 506(c) offers advantages, but it also introduces several caveats for companies seeking to promote their offering. These caveats primarily center around investor verification, regulatory compliance, and the limitations on investor eligibility. Here’s a closer look at the primary caveats for companies using Rule 506(c) to raise capital:

1. Strict Accredited Investor Verification

- The company must take “reasonable steps” to verify that all purchasers are accredited investors. This requirement goes beyond self-certification, meaning issuers must review financial documentation, such as tax returns, W-2 forms, and bank statements, or seek verification from third-party professionals (CPAs, attorneys, or broker-dealers). This step introduces additional operational costs, time, and potential administrative complexity.

2. Increased Liability for Inadequate Verification

- If an investor is later found not to be accredited and the company’s verification process is deemed insufficient, the issuer may face serious consequences, including enforcement actions from the SEC. The liability risk increases when using general solicitation and advertising, as the pool of potential investors is more diverse and may include those who are not accredited.

3. Potential Deterrence of Investors Due to Verification Requirements

- The rigorous verification process may discourage some investors who are accredited but unwilling to provide sensitive financial documentation. This could reduce the overall appeal of the offering to qualified investors, especially those concerned about privacy or data security.

4. No Non-Accredited Investors Allowed

- Unlike Rule 506(b), which permits up to 35 non-accredited investors (if they are financially sophisticated), Rule 506(c) is strictly limited to accredited investors. This restricts the pool of eligible investors, particularly for companies targeting a broader or less affluent audience. Companies with networks that include potential investors who do not meet accreditation standards may find Rule 506(c) limiting.

5. Increased Scrutiny from Regulators

- Publicly advertising a securities offering invites more scrutiny from the SEC and other regulatory bodies. The use of general solicitation could prompt questions about how the offering is conducted, the content of promotional materials, and the accuracy of statements made during the campaign. Companies must be diligent about the accuracy of all statements to avoid allegations of fraud or misrepresentation.

6. Risk of Securities Fraud Allegations

- Given the open nature of marketing allowed under Rule 506(c), companies are more exposed to potential allegations of securities fraud if statements or projections are later deemed misleading or overly optimistic. The SEC expects issuers to avoid making exaggerated claims or predictions, even in advertising materials.

7. Ongoing Compliance and Disclosure Requirements

- Although Rule 506(c) offerings are exempt from most state registration requirements, companies must still comply with federal antifraud provisions and submit a Form D to the SEC within 15 days of the first sale of securities. This filing requirement and other federal rules mean that issuers must still maintain detailed records and disclose pertinent information to the SEC, investors, and other regulatory entities if requested.

8. Restrictions on Resale

- The securities sold under Rule 506(c) are restricted and cannot be freely resold without registration or an exemption from registration. This limitation on liquidity can make the investment less appealing to some investors who might otherwise be interested in a quicker exit opportunity.

9. Impact on Brand and Market Perception

- General solicitation under Rule 506(c) can attract both positive and negative attention. A public campaign for private securities might raise questions about why the company is not using traditional financing routes or a private network of accredited investors. Missteps in public marketing could also harm a company’s reputation or deter future investors.

Summary

While Rule 506(c) enables companies to leverage public marketing to expand their reach, the associated caveats introduce complexity, potential regulatory risks, and additional verification and compliance burdens. Companies must weigh these factors against the potential benefits and prepare to implement rigorous compliance practices to maximize the advantages of using Rule 506(c).

From my experience, it is by partnering with team members who understand compliance, who take the time to train their teams, witness the most successful outcomes this strategy can offer.

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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