Raising money is one of the formative parts in the life of a growing business. Whether a business needs start-up capital to get an operation formed and off the ground, operating money to scale up while it is pre-revenue, or an influx of cash to fund a major project or acquisition, many small and growing businesses will find themselves at some point wanting to raise capital from outside investors.
Financings are exciting – they represent powerful opportunities to stabilize, scale, and evolve. Financings also come with risks and should be intentionally managed by your team and your legal counsel to make sure that you raise money in a way that keeps the company in compliance with all applicable law. When you consider raising money, it’s important to loop in your lawyers early so you can sort out which options make the most sense for your business.
Securities Law Framework
One important set of laws that are critical for any business looking to raise capital to consider are the securities laws. For purposes of this blog, we’ll assume the way you want to raise money is through the sale of securities[1] (for example, through the sale of preferred stock to outside investors).
Let’s level set on how the law treats this process – Congress passed the Securities Act of 1933 and the Securities and Exchange Act of 1934 because they were animated by the goal of protecting investors after so many ordinary folks lost their shirts in the stock market crash of 1929. These laws and the regulations that followed were aimed at supporting investors to make smart, informed investment decisions in part by requiring the companies offering securities to provide those investors with information about their business and formalizing consequences for misinformation.
As a result of these laws, all securities must be registered with the Securities and Exchange Commission (SEC) unless those securities or the transaction qualify for an exemption. Any sale of unregistered, non-exempt securities is illegal. Most of our clients are best-suited for exemptions given their growth stage, needs, and resources. The exemptions from registration are an important way that companies can raise money without taking on that heavy registration burden.
Regulation D
The SEC has detailed a host of exemptions from registration, but the ones we’ll focus on here (and that are most often used in the marketplace) are through the Regulation D safe harbors under Section 4(a)(2) of the Securities Act. Section 4(a)(2) is sometimes referred to as the “private placement” exemption. Section 4(a)(2) exempts from registration transactions by a company not involving a public offering. This exemption is still used in certain situations, but it doesn’t provide clear steps for how to ensure an offering is within the exemption and so the SEC adopted Regulation D in the 1980s to provide clear guideposts on how to conduct a Section 4(a)(2) exempt offering. Below is a discussion of the exemptions under Rule 506(b) and Rule 506(c) of Regulation D. Rule 506(b) and Rule 506(c) are two options to fit your financing under Regulation D to complete private offerings of securities and raise money without needing to register the offerings.
Rule 506(b) vs Rule 506(c): A Snapshot[2]
| Rule 506(b) | Rule 506(c) | |
| Offering Size Cap? | None. | None. |
| Types of Companies That Can Use This | Any, whether reporting[3] or not. | Any, whether reporting or not. |
| Who Can Invest? | An unlimited number of “accredited investors” and up to 35 non-accredited investors (see below). | An unlimited number of “accredited investors”. |
| Company Required to Provide Certain Information to Investors? | Yes, for non-accredited investors. | No. |
| Company Allowed to Generally Solicit/Advertise for Investors? | No. | Yes. |
| Disqualification for “Bad Actor” under Rule 506 | Yes. | Yes. |
What do these differences between Rule 506(b) and Rule 506(c) mean?
As you can see, there is a lot of overlap in the requirements of Rule 506(b) and Rule 506(c) exempt offerings. Below are the three most significant ways they differ – companies should look to these differences to determine which exemption is a better fit for their financing plans.
- Differences in who can invest in the offering:
Rule 506(c) offerings are limited to “accredited investors”[4]. Accredited investors are either individuals who meet certain wealth/income thresholds or other measures of financial sophistication or entities who meet certain parameters based on their structure or assets.[5] There is no limit on how many investors can participate in a Rule 506(c) offering, but each investor must qualify as an accredited investor.
In contrast, in addition to an unlimited number of accredited investors, Rule 506(b) offerings may also include up to thirty-five (35) non-accredited investors so long as those non-accredited investors (either on their own or with a purchaser representative) qualify as sophisticated. A “sophisticated”[6] non-accredited investor is one who can fend for themselves in the offering; this is typically documented by the company through a questionnaire and some investor representations.
Although both Rule 506(b) and Rule 506(c) offerings may include accredited investors, there is a difference in the burden on the company to verify that an accredited investor is, in fact, accredited. In a Rule 506(b) offering, the company may rely on self-certification by the investors. In a Rule 506(c) offering, the company must take reasonable steps to verify that an investor is accredited. The steps a company can take to perform such verification aren’t specified in the rule, but Rule 506(c)(2)(ii) includes a non-exclusive list of methods that a company could use to verify the status of a natural person.
- Information Requirement for Non-Accredited Investors:
Given the nature of non-accredited investors, Rule 506(b) requires that companies provide them with certain information related to the business and the investment. The information that the company must provide is fairly extensive, and includes details on the business’ plans and history (including financial) and the specific securities being offered. If a company has both accredited and non-accredited investors in the same offering, care must be taken to ensure that all have the same or similar access to information about the company. Preparing this prescribed information for non-accredited investors can dramatically change a company’s budget options when preparing for a financing and should be discussed with the company’s management team and lawyers at the onset.
- General Solicitation/Advertisement:
In a Rule 506(b) offering, companies may not engage in general solicitation or advertising. One way for a company to demonstrate that it has not engaged in general solicitation or advertising is by establishing that the company had a pre-existing, substantive relationship with its investors in the offering. Rule 506(c) offerings are not subject to limitations on general solicitation and advertising.
A Note on Integration
Offerings under both Rule 506(b) and Rule 506(c) are subject to the integration framework. The SEC developed the integration framework to prevent companies from artificially dividing offerings into separate offerings simply to avoid the burdens of registering them if they were combined. Integration analysis examines whether two private offerings need to be integrated with each other for the purposes of securities compliance. If you are conducting simultaneous offerings or have conducted other exempt offerings in the past, you should perform an analysis of the integration rule set forth in Rule 152 to ensure your offerings won’t be integrated or that there aren’t issues if they are integrated.
Filings
For either a Rule 506(b) or Rule 506(c) offering, the company must file a Form D with the SEC within fifteen (15) days of the first sale of securities. Offerings under Rule 506 are considered “covered securities” under Section 18(b)(4) of the Securities Act and so are exempt from registering on the state level. However, depending on the state, companies may still be required to make state-level notice filings and pay associated fees.
The information provided on this website does not, and is not intended to, constitute legal advice; instead, all information available on this site is for general informational purposes only. Information on this website may not constitute the most up-to-date legal or other information as laws and regulations may have evolved since it was posted. No reader of this site should act or refrain from acting on the basis of information on this site without first seeking legal advice from counsel. This website contains links to other third-party websites. Such links are only for the convenience of the reader and JWPC does not recommend or endorse the contents of the third-party sites.
[1] The definition of a “security” is rooted in the law and case law and is fairly nuanced. If you aren’t sure if what your company is doing would be considered offering a “security”, reach out to us for particularized guidance.
[2] Blue rows indicate differences between Rule 506(b) and Rule 506(c).
[3] A reporting company is one subject to the periodic reporting requirements of the Securities and Exchange Act of 1934.
[4] 17 CFR § 230.501(a).
[5] SEC Resources on Accredited Investors.
[6] “Each purchaser who is not an accredited investor either alone or with his purchaser representative(s) has such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment, or the issuer reasonably believes immediately prior to making any sale that such purchaser comes within this description.” 17 CFR § 230.506 Note to paragraph (B)(2)(i).
