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- Rule 506 of Regulation D allows fund managers to raise money without having to file an offering with the SEC. They may choose to raise money under Rule 506(b) or Rule 506(c).
- Only Rule 506(c) allows an issuer to publicly advertise an offering, but 506(c) also requires the issuer to take reasonable steps to verify the investor's accredited status.
- Determining whether a fund manager prefers a Rule 506(b) or 506(c) offering may come down to 1) whether it can achieve its fundraising goals without advertising and 2) whether it has procedures in place to properly vet potential investors. accreditation status.
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By default, all securities offerings in the United States must be registered with the SEC. Registration can be a complex, expensive and time-consuming process. Fortunately, the SEC offers several exemptions from registration, the most common of which are listed belowRegulation D Rule 506Consistent with the requirements of Rule 506, VCs may offer securities to certain investors without the need to register the offering with the SEC.
Two different offers are allowed under Rule 506: Rule 506(b) and Rule 506(c). Each has different requirements for what a VC can and must do in terms of marketing and accepting investments.
In this guide, we examine the provisions and implications of Rule 506(b) versus 506(c), their pros and cons, and give venture capital funds some things to consider when making the best decision for their fund.
What are Regulation D offerings?
Before we delve deeper into Rule 506(b) and Rule 506(c), let's take a quick look at Regulation D itself. Regulation D was passed by the SEC in 1982 to provide issuers with certain exemptions fromregistration requirements set forth in the Securities Act of 1933.
Compliance with such registration requirements would require a level of disclosure equivalent to that of publicly traded companies. This would mean detailed prospectuses with audited financial statements, risk factors, management details and more. And this is exactly what should be made available to investors after the offering. They would also be subject to ongoing quarterly and annual disclosure requirements.
So it comes as no surprise that most business offers take place under Rule 506 of Regulation D, which exempts the offer from registration. Not only venture capital funds benefit from this exemption. Many private placements of securities (even publicly traded securities) are also conducted under Rule 506.
Offering securities under Regulation D also exempts issuers from the need to register with state securities agencies. However, publishers may still need to do thisThe Blue Sky message, depending on the country.
What can VCs do under Rule 506(b) of Regulation D?
Rule 506(b) allows an issuer to raise an unlimited amount of capital from a theoretically unlimited number of investors, provided the issuer is not engaged in general fundraising. Let's take a closer look at each element of Section 506(b).
How Much Capital Can VCs Raise?
Under Section 506(b), there is no limit on the amount of moneyfund controllerscan increase In entrepreneurship, this means that the size of the fund is limited only by market demand and the placement of beneficial ownership in the fund. There are no restrictions on the amount each investor can contribute to the fund.
How many investors can VCs accept – and what kind of investors should they be?
Technically, there is also no limit to the numberauthorized investorsto whom issuers may offer securities. But in the enterprise, the numberlimited partnersthe individual fund can have is limited by the structure of the fund itself. For example, 3(c)(1) funds can typically only accept a maximum of 100 investors (or 250 investors if the fund is less than $10 million); while 3(c)(7) funds can hold up to 2,000. Anything over that amount requires the fund to register with the SEC.
Rule 506(b) also allows fund managers to offer their securities to up to 35 non-accredited investors. However, taking on even one non-accredited investor significantly increases the level of information the issuer must provide. It is like that becauseRule 502(b) under Regulation D, which requires issuers selling securities to non-accredited investors to provide audited financial statements, resale restriction information, and other disclosures. In addition, portfolio companies often require their investors to be accredited themselves. One way to onerisk fundcan meet this requirement is to have only accredited investors as LPs. By not seeking investments from non-accredited investors, although this is technically allowed, venture capital funds often find it easier to invest in companies.
For this reason, venture capital funds that practice Rule 506(b) generally still limit their fund to accredited investors. Note, however, that Rule 506(b) also states that fund managers may rely on investor representations regarding their accreditation status.
What types of marketing activities can VCs undertake under Rule 506(b)
Issuers are not permitted to engage in any "general solicitation or advertising" for securities offered under Rule 506(b). There is no specific definition of what is and what is not a general request. In determining whether a communication is considered a general solicitation, the fund manager should generally consider the following:
- Is the communication aimed at a broad and anonymous audience?
- Does the communication contain an invitation to invest?
- Even if there is no invitation to invest, can the communication prepare the market for the securities being offered?
This means that a VC cannot advertise that it is fundraising on social networks such as Twitter or LinkedIn. In addition, they must also be able to prove that all investors had a “prior and significant relationship” with them prior to the offer.
Please note that general search restrictions only apply to specific offers. So, for example, a hedge fund could advertise its “brand” under Rule 506(b) – they simply cannot ask investors to invest in a particular fund. Given the nuances here, many fund managers work with outside consultants to develop their marketing strategy.
What can VCs do under Rule 506(c) of Regulation D?
Rule 506(c) allows an issuer to raise an unlimited amount of capital from a theoretically unlimited number of investors using a general invitation. However, the issuer must then take reasonable steps to verify the accreditation status of each investor. Let's take a closer look at each element of Section 506(b).
How Much Capital Can VCs Raise?
Under Rule 506(c)there are no limits to how much money fund managers can raise or how much each investor can invest. It simply depends on how much VCs can (and want to) raise. This is no different than Section 506(b).
How many investors can VCs accept – and what kind of investors should they be?
As with Rule 506(b), there is no limit on the number of accredited investors to whom fund managers may offer securities. However, unlike Rule 506(b), all investors in a 506(c) offering must be accredited investors without exception.
In addition, fund managers must take "reasonable steps" to verify the investor's accreditation status. Unlike Section 506(b), they cannot rely on investor self-examination. Such steps may include looking for evidence of:
- Income to investors in the form of tax returns or W-2s
- Investor assets based on brokerage or bank statements
- Professional licenses from investors
You can see the type of documentation AngelList requiresproof of accredited status here. As with determining whether something is a general request, there can be nuance in what "reasonable steps" might be. Many fund managers also work with external advisors on this subject.
What types of marketing activities can VCs undertake under Rule 506(c)?
Fund managers may advertise broadly under Rule 506(c). Fund managers can advertise on Twitter that they are raising money, and online platforms can prominently display relevant funds all over their site. Many Angel ListOngoing funds are collected pursuant to Rule 506(c), meaning fund managers can promote their funds online or in person.
Of course, the general rules for advertising apply; advertising must not be false or misleading in any way.
Rule 506(b) versus 506(c) Concessions
The following table summarizes the main differences between Section 506(b) and Section 506(c).
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Do I need to have a Regulation D 506(b) or 506(c) offering?
Which waiver is best for your fund ultimately depends on the facts and circumstances surrounding your fundraising, including how much you want to raise, the depth of your professional network, your track record, and many other factors. Here are two simple questions that can help you make the best decision:
How confident are you that you can get the money you need from your private networks?
If you are confident that you can achieve your goal without any advertising, a 506(b) may make more sense since you are not required to confirm the investor's accreditation status. It also makes it easier for investors who prefer self-monitoring.
Are you willing and able to check the accreditation status of your investors?
If you want to promote your fund to the public, ask yourself if you have the resources to properly verify the accreditation status of potential investors. If you don't have the right processes and procedures in place, this process can become too difficult for you. Some fund managers outsource the responsibility for verifying accreditation to an attorney or other external service.
When you raise your funds through AngelList, we handle the entire authentication process on your behalf.
Rule 506(b) versus Rule 506(c) in the Summary
Rule 506 has been very positive for the venture capital ecosystem and plays a huge role in ensuring that startups get the capital they need to grow. Since virtually all venture capital funds are raised under Rule 506, it is important for venture capital funds to understand the differences between 506(b) and 506(c). There is no one-size-fits-all answer, but hopefully you now have a better idea of how to determine the right course of action for your fund.