Manatt resource for entrepreneurs
Startups, and especially early-stage founders, typically find fundraising an important, challenging, and time-consuming process. There are many ways a founder can secure funding, including crowdfunding, bootstrapping, and debt and private offerings, each with its own considerations. Of the many options available, most founders typically choose to hold private offerings (also known as private placements), and sell and liquidate securities (including convertible bonds, SAFEs (simple forward contracts), common stock, and preferred stock). give to investors.
This article focuses on startups' compliance with federal securities laws, specifically startups' reliance on Regulation D, often referred to as Reg D, and Rule 506 of Regulation D, which provides some exemptions from the registration requirements of the Securities Act of 1933. .which startups most often rely on when issuing securities to investors.1
Registration requirements and common exceptions
Section 5 of the Securities Act requires all offers and sales of securities to be registered with the Securities and Exchange Commission (SEC) unless an exemption from registration is available. Because most startups are unable to register their securities with the SEC, they typically find and rely on exemptions from registration requirements.
The most commonly used exemptions from the registration requirement are the private placement exemptions provided by Section 4(a)(2) of the Securities Act and Rule 506 of Regulation D.
Section 4(a)(2) of the Securities Act exempts offers for registration and sale of securities by startups that do not constitute a public offering. This is the most common exemption a startup uses when it first issues stock to its founders. Some startups even rely on this exemption when issuing stock to friends and family, arguing that because friends and family are close or well known to the founders, selling securities to these investors shouldn't be a "public offering."
Rule 506 Reg D provides for "safe harbor" exemptions for private placements that meet certain standards under Section 4(a)(2) of the Securities Act. A startup can rely on Rule 506(b) or Rule 506(c) Reg D to conduct a private offering. However, there are important differences between the two rules that should be considered before proceeding.
A 506(b) offering allows a startup to raise an unlimited amount of money from an unlimited number of accredited investors and up to 35 non-accredited investors. See the discussion below on the definitions of accredited and non-accredited investors. In addition, the startup may not use any form of general solicitation or advertising to promote the 506(b) offering. In practice, this means that the startup must seek investment from investors with whom the startup already has an existing relationship.
While the inability to broadly attract investors can be a potential problem for emerging startups, the biggest benefit of a 506(b) offering is that startups can trust potential investors to self-certify as accredited investors, which is usually done by of a questionnaire that is provided. by startup. Under the 506(b) offering, startups do not have to go through the costly and time-consuming process of verifying accredited investor status for each potential investor. This removes a significant burden from the fundraising process.
The startup must provide non-accredited investors with the same information available to accredited investors. In addition, the information provided to investors must not violate the anti-fraud prohibitions of the federal securities laws (ie, the information must not contain false or misleading statements). If a startup chooses to include non-accredited investors in its 506(b) offering, the startup must provide additional disclosure documents to such investors, which are generally the same as the disclosure requirements for registered offerings. Preparing for such announcements is an expensive endeavor rarely justified by capital raised from unaccredited investors.
Unlike those that rely on Rule 506(b), startups that rely on Rule 506(c) to make an offering can engage in general solicitation and advertising. However, the trade-off is that all investors must be accredited investors, and the startup must take reasonable steps to verify that the investors are indeed accredited. Self-verification is therefore not allowed. Startups must obtain and review brokerage statements, tax documents, and other financial documents to verify accredited investor status before accepting an investment from a potential investor. This is a lengthy and expensive undertaking. While Rule 506(c) excludes the requirements of Rule 506(b) regarding a prior relationship, the startup is solely responsible for verifying that each investor meets the definition of an accredited investor. In practice, startups relying on Rule 506(c) often hire third-party verification services to perform the certification process (obtaining and reviewing necessary information from potential investors and verifying the status of each investor), reducing the burden of the verification is shifted to the third party.2Startups remain liable for false or misleading statements under the provisions of federal securities fraud laws.
What is the difference between an accredited and non-accredited investor?
Securities laws dictate the types of investors who can participate in 506(b) and 506(c) offerings. Startups should think carefully about the individuals they invite or allow to invest in their offerings.
As mentioned above, a 506(b) offering allows a startup to raise money from an unlimited number of accredited investors and up to 35 non-accredited investors, and all investors participating in a 506(c) offering must be accredited investors are.
So what is an authorized investor? Generally, an authorized investor is an individual who has a minimum annual income of $200,000 (or $300,000 for joint income) or a net worth of at least $1 million (excluding the value of the investor's primary residence) for the past two years. On August 26, 2020, the SEC changed the definition of authorized investors, expanding the group of investors allowed to invest in private securities. Our company issuedarticlein connection with significant changes to the definition of an authorized investor.
A non-accredited investor generally does not meet the capital requirements for an accredited investor. Regardless, any non-accredited investor in a 506(b) offering still needs to be "advanced." The SEC has defined an experienced investor as an individual with the necessary financial and business knowledge and experience to understand and evaluate the benefits and risks of a future investment.
While founders have ample opportunities to raise capital, 506(b) and 506(c) offerings often prove to be effective ways to do so quickly, without the burden of filing securities with the SEC. Because of its relative simplicity, many startups choose a 506(b) offering and target only accredited investors, avoiding the additional disclosure requirements associated with non-accredited investors.
1The issuance of securities is regulated by federal and state securities laws. The Securities Act of 1933, as amended, and regulations issued by the Securities and Exchange Commission under the Securities Act are the primary sources of federal law governing the issuance of securities. At the state level, each state has its own set of laws, commonly known as "blue sky" laws.
2Another alternative for a startup that enforces verification requirements is to rely on the investor's accountant, attorney, or other expert to provide a written statement to the startup that the expert has taken "reasonable steps" to verify the investor's net income or assets. investor verification.