Startups, and particularly first-time founders, typically find that raising funds is a significant, challenging and time-consuming process. There are many ways a founder can secure funding, including crowdfunding, bootstrapping, and debt and private offerings, each having its own considerations. Among the many options available, most founders typically elect to hold private offerings (otherwise commonly known as private placements), selling and issuing securities—including convertible notes, SAFEs (simple agreements for future equity), common stock and preferred stock—to investors.
This article focuses on a startup’s compliance with federal securities laws, particularly a startup’s reliance on Regulation D, often referred to as Reg D, and Rule 506 of Reg D, which provides a series of exemptions to the registration requirements under the Securities Act of 1933 that are most commonly relied on by startups for the issuance of securities to investors.1
Registration Requirement and Common Exemptions
Section 5 of the Securities Act requires all offers and sales of securities to be registered with the Securities and Exchange Commission (SEC) unless there is an available exemption from registration. Since most startups are not in a position to register their securities with the SEC, they typically find and rely on an exemption to the registration requirement.
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 Reg D.
Section 4(a)(2) of the Securities Act exempts from registration offers and sales of securities by a startup that do not involve a public offering. This is the most common exemption used by a startup when first issuing stock to its founders. Some startups even rely on this exemption when issuing stock to friends and family, the argument being that because friends and family are close or well known to the founders, the sale of securities to these investors should not constitute a “public offering.”
Rule 506 of Reg D provides “safe harbor” exemptions for private placements that meet certain standards under Section 4(a)(2) of the Securities Act. A startup may rely on either Rule 506(b) or Rule 506(c) of Reg D to conduct a private offering. However, there are key differences between the two rules that should be considered before moving forward.
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 nonaccredited investors. See the discussion below regarding the definitions of accredited and nonaccredited investors. In addition, a startup cannot use any means of general solicitation or advertising to promote a 506(b) offering. In practice, this means that a startup must solicit investments from investors with whom the startup has a prior existing relationship.
While not being able to broadly solicit investors may pose a potential issue for newly minted startups, the biggest advantage of a 506(b) offering is that a startup may rely on potential investors’ self-certification as accredited investors, which is generally done using a questionnaire provided by the startup. Under a 506(b) offering, startups do not have to implement a costly and time-consuming process to verify the accredited investor status for each prospective investor. This removes a significant burden from the fundraising process.
A startup must provide the same information to nonaccredited investors as is made available to accredited investors. In addition, all information provided to investors must not violate the antifraud prohibitions of the federal securities laws (i.e., information must not contain false or misleading statements). If a startup decides to include nonaccredited investors in its 506(b) offering, the startup must provide additional disclosure documents to such investors, which are typically the same as the disclosure requirements under registered offerings. Preparing such disclosures is an expensive endeavor that is rarely justified by the capital raised from nonaccredited investors.
Unlike those relying on Rule 506(b), startups relying on Rule 506(c) to conduct an offering may engage in general solicitation and advertising. The trade-off, however, is that all investors must be accredited investors and the startup must take reasonable steps to verify that the investors are in fact accredited. Self-certification is thereby not allowed. Startups must obtain and review brokerage statements, tax documents and other financial documents to verify accredited investor status before accepting a potential investor’s investment. This is both a time-consuming and costly endeavor. While Rule 506(c) does preclude the “preexisting relationship” requirements of Rule 506(b), 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 engage third-party verification services to carry out the certification process (obtaining and reviewing the information needed from potential investors and verifying each investor’s status) and, in so doing, shift the burden of the verification to the third party.2 Startups remain liable for false or misleading statements under the antifraud provisions of the federal securities laws.
What Is the Difference Between an Accredited Investor and a Nonaccredited Investor?
Securities laws dictate the types of investors that may participate in 506(b) and 506(c) offerings. Startups must carefully consider the individuals whom they solicit or allow to invest in their offerings.
As mentioned above, a 506(b) offering allows a startup to raise funds from an unlimited number of accredited investors and up to 35 nonaccredited investors, and all investors participating in a 506(c) offering must be accredited investors.
So, what is an accredited investor? Generally speaking, an accredited investor is an individual who has a minimum annual income of $200,000 (or $300,000 for joint income) for the past two years or has a net worth of at least $1 million (excluding the value of the investor’s primary residence). On August 26, 2020, the SEC amended the definition of accredited investors, which in turn expands the group of investors permitted to invest in private securities. Our firm issued an article regarding the key changes to the accredited investor definition.
A nonaccredited investor typically does not meet the net worth requirements of an accredited investor. Nonetheless, any nonaccredited investor in a 506(b) offering must still be “sophisticated.” The SEC has described a sophisticated investor as an individual with the requisite knowledge and experience in both financial and business matters that make them capable of understanding and evaluating the merits and risks of the prospective investment.
While founders have a multitude of options for raising capital, 506(b) and 506(c) offerings often prove to be effective means of doing so quickly without the burdens of registering securities with the SEC. Because of its relative ease, many startups opt for the 506(b) offering and target only accredited investors, avoiding the additional disclosure requirements associated with nonaccredited investors.
1 The issuance of securities is governed by both federal and state securities laws. The Securities Act of 1933, as amended, and the regulations promulgated by the Securities and Exchange Commission pursuant to the Securities Act are the main sources of federal law with respect to the issuance of securities. At the state level, each state has its own set of laws that are generally known as “blue sky” laws.
2 Another alternative to the startup carrying out the verification requirements is to rely on an investor’s accountant, lawyer or other professional making written representations to the startup that the professional has taken “reasonable steps” to verify the investor’s net income or net worth.