The two primary ways of getting capital into a business are borrowing (like a traditional bank loan) and selling securities. If borrowing is not desirable or feasible (and for many startups, it isn’t), a startup has the option of selling debt or equity securities to get new capital in the door, assuming it has access to early stage investors.

Running out and selling equity to the first willing buyer, however, could lead to bad results if not done correctly; a startup must take care to avoid the pitfalls in the federal and state securities laws. This is true whether the securities in question are stock or notes of a corporation, units or membership interests of a limited liability company, or a partnership interest in a partnership. The general rule, set forth in Section 5 of the Securities Act of 1933, as amended (Securities Act), is that all offers and sales of securities must be registered with the Securities and Exchange Commission (SEC) (essentially “going public”), or else exempt from registration.

Registration of securities under the Securities Act is a time-consuming, expensive process, making it ill-suited for a startup business with little capital in the first place. Fortunately, several exemptions from the general registration requirement may be available. By far, the most commonly employed exemption from registration used by startup business is the so called “private placement” exemption in Section 4(a)(2) of the Securities Act (previously denoted as § 4(2), and still referred to as such by many practitioners), and Rule 506(b) of Regulation D, which acts as a safe harbor for compliance with the Section 4(a)(2) exemption.

Who Can Use Rule 506(b)? Only the startup itself. Section 4(a)(2) and Rule 506(b) exempt “private placements” by an “issuer.” The issuer is whatever entity is actually selling the securities in question. Because of this, the exemption does not apply to securities being sold by founders or other stockholders.

Are Securities Sold Under Rule 506(b) Permanently Exempt from Registration? No. This exemption is a “transactional” exemption; a particular offer or sale of securities by the issuer is exempt from registration, but the exemption does not stick to or run with the securities after that transaction is concluded. Securities sold under the Section 4(a)(2) exemption are, therefore, “restricted securities,” having restrictions on further transfers or resale.

Is There a Dollar Limit on the Size of a Rule 506(b) Offering? No. As long as the startup complies with the requirements of Rule 506(b), there is no limit to the amount of capital that can be raised.

Can a Startup Advertise its Rule 506(b) Offering? No. Rule 502(c) of Regulation D makes it clear that Rule 506(b) and Section 4(a)(2) offerings may not use “any form of general solicitation or general advertising.” This includes advertisements or notices in newspapers or magazines, as well as on the internet, TV or radio broadcasts, and seminars or meetings where the attendees were invited through any of these forms of general advertising. Note that the new Rule 506(c) does allow general solicitation, as contemplated by the JOBS Act, but which has a very different set of concerns for the start-up.

Who Can the Startup Sell to in a Rule 506(b) Offering? There is no limit on the number of investors who may participate in a Rule 506(b) offering as long as the issuer reasonably believes they are “accredited investors.” A Rule 506(b) offering can include up to 35 investors who are not accredited investors.

Rule 501(a) of Regulation D defines accredited investors as:

  • Institutional investors;
  • Business development companies;
  • Small business investment companies;
  • Private business development companies;
  • Corporations, partnerships, LLCs and tax-exempt entities with total assets in excess of $5 million not formed to make the investment;
  • Directors, officers and general partners of the issuer;
  • Certain high-net-worth individuals (either having over $1 million in assets determined without reference to primary residence, or having income over $200,000 each of the past two years (or $300,000 together with a spouse) and a reasonable expectation of the same income this year); and
  • Any entity in which all of the equity owners are accredited investors.

It is common for the issuer to have any prospective investors complete a questionnaire or to give a contractual representation in purchase documents certifying their status to support the issuer’s belief that they are accredited. Being satisfied as to accredited investor status is important because, in addition to the cap on the number of non-accredited investors that can participate in a Rule 506(b) offering, the non-accredited investors are entitled to additional specific disclosure from the issuer. Plus, private placements can be subject to an analysis by regulators called “integration,” where different offerings are reviewed to see if they were really part of the same plan or scheme of financing; if two offerings are integrated but there are no non-accredited investors, the chances that the safe harbor is still secure increase.

What Information Must an Issuer Provide to Investors? It depends on whether the investor is accredited or not. The key point of an accredited investor is that such an investor thought sophisticated enough not to need the types of information ordinarily provided under Section 5’s registration requirements to make an intelligent investment decision (or to be wealthy enough to afford inattention to due diligence). This rationale doesn’t apply to a non-accredited investor, and so Rule 506(b) (through Rule 502(b)(2)) requires certain information be provided to non-accredited investors.

Generally, non-accredited investors are entitled to the type of information that would be included in a registration statement, as well as certain financial statements, some of which must be audited; the information required becomes greater as the size of the offering increases.

If an issuer provides information about itself to a non-accredited investor, it should, as a best practice, provide the information to the accredited investors involved in the offering as well. Doing so would avoid a perception that the company is only selectively disclosing things and trying to defraud anyone. Generally, many issuers provided a disclosure document, called a “private placement memorandum,” to all potential investors, even if it is not planning on having any non-accredited investors participate at all.

Could Anything Make Rule 506(b) Unavailable for Use by a Startup? Yes, there are certain “bad actor” provisions that could disqualify an issuer from relying on Rule 506(b) for an offering of its securities. The bad actor provisions apply to the issuer and its predecessors, directors, executive officers, general partners or managing members, and equity holders holding 20 percent or more of its voting securities. If any of these parties has been convicted of certain crimes involving securities or is subject to SEC or court orders regarding certain securities matters, then the entire company is barred from relying on Rule 506(b). It is common for issuers of all size to have its officers and directors complete a questionnaire on an annual basis to confirm that none of these disqualifying events exist. Startups must obviously be sensitive to this issue and be certain not to engage any “bad actors” as it seeks to grow.

What Filings are required in a 506(b) Offering? A Form D must be filed with the SEC within 15 days of the first sale of securities. A Form D is a fairly simple notice filing filed electronically with the SEC. It contains some general information about the issuer and the offering and is publicly available on the SEC’s website. The Form D is specifically excluded from being considered general advertising or soliciting materials for the purposes of Rule 506(b).

What State Securities or “Blue Sky” Law Issues Are There? The other advantage of 506(b) offerings is that, if the startup complies with the Federal regulations, state laws requiring registration or qualification do not apply. Generally, a state in which an investor in the startup resides can require filing a copy the Form D and paying a fee. Some states have additional requirements, such as the filing of a consent to service of process or annual updates on the offerings.