Rule 506(b) Offerings Continue to Dominate Small Business and Real Estate Equity Offerings

Whitman Legal Solutions, LLC

Whitman Legal Solutions, LLC

Beginning violinists frequently rent their violins, which may be valued at only a few hundred dollars. As violinists advance, they may purchase an instrument at a cost ranging from several hundred to a few thousand dollars. However, hand-made instruments and particularly those that are made by a famous luthier can range from tens of thousands up to millions of dollars for a Stradivarius.

A few lucky musicians may find a patron willing to loan them an instrument to support their career development. However, most advanced student violinists and professionals don’t have patrons, and most don’t have the financial wherewithal to pay tens of thousands of dollars for the instrument they need to succeed. Their only option is to finance their purchase.

Some luthiers or dealers might sell an instrument on an installment plan. However, most require that the violinist pay 100% of the purchase price when they acquire the instrument. Fortunately, instrument finance companies have developed to help musicians with this important purchase.

Some dealers may partner with a finance company to offer financing to their customers. Synchrony Financial has an entire division dedicated to instrument finance. NoteWorthy Federal Credit Union, which serves the arts and entertainment community, also has a musical instrument finance program.

Most start-up businesses and real estate funds are in the same position as professional violinists–they don’t have sufficient capital to finance their business plans or real estate acquisitions. They may have access to some debt financing, such as mortgage loans for real estate acquisitions. However, they also need equity. As discussed in my previous article, Orange Groves, Pay Phones, Visas, and Violins: Why Your Real Estate or Business Investment May Be Subject to Securities Laws most business equity constitute securities under federal securities laws.

Securities Law Compliance for Equity Offerings

Under the Securities Act of 1933 (1933 Act), all securities offerings must be registered with the Securities and Exchange Commission (SEC)–unless there is an exemption. Registering securities is a costly and time-consuming process because it requires SEC review and approval. Most small businesses and real estate funds offer securities under a registration exemption that permits them to sell securities without prior SEC review.

Traditionally, most real estate securities have been sold under an exemption from registration under Rule 506(b) of Regulation D, which was adopted under Section 4(2) of the 1933 Act. Because Section 4(2) is a private placement exemption, Rule 506(b) requires there be no general advertising relating to the offering and general solicitation of investors.

It’s easy to see why Rule 506(b) became popular. Rule 504 offers another exemption under Regulation D but imposes strict dollar limitations on offering amounts, which are too low to meet the needs of many startups and most real estate sponsors.

The Jumpstart Our Business Startups Act (JOBS Act) of 2012, directed the SEC to create an exemption that permitted general advertising and general solicitation. In response, the SEC added Rule 506(c) to Regulation D, which allows publicly advertised securities offerings. However, Rule 506(c) also limits sales to accredited investors who meet net worth, asset, or income requirements. Plus, Rule 506(c) requires more intense scrutiny into investors’ financial situations than Rule 506(b), which may be a deterrent for high net worth individuals to invest.

The SEC also recently adopted Regulation CF, which allows equity crowdfunding. Regulation CF can be used only to raise equity for operating companies. It can’t be used like Rule 506(b) and 506(c) to raise funds for real estate funds. Like Rule 504, Regulation CF limits how much the issuer can raise ($1 million in a 12-month period). And unlike Rule 506(b) or Rule 506(c), Regulation CF also restricts how much investors can invest ($2,000 per issuer unless the investor’s net worth and annual income both exceed $100,000).

Regulation A+, adopted in 2015, was touted as a great opportunity for small business. However, Regulation A+ provides a faster track for securities registration, rather than an exemption from registration. As I discussed in An A Isn’t the Same for Everyone–Why Regulation A+ Might be a B or C for Real Estate Funds, due to the cost, time, ongoing reporting requirements, and limitations on investor net worth and income, Regulation A+ also doesn’t meet the needs of many small businesses.

Small Business Capital Formation Advocate’s Report

In 2018, the SEC established the position of Advocate for Small Business Capital Formation (SBCF) to support small businesses’ capital formation needs. SBCF was charged with several initiatives ranging from public outreach to proposing recommendations for regulatory and legislative reform to promote small business's interests.

Recently, SBCF issued its 2019 annual report (2019 Report) describing its activities and findings during its first year. In the 2019 Report’s section on the state of small business capital formation, SBCF compiles data from public SEC filings analyzed by the SEC and third party data

This data reveals that Rule 506(b) remains the overwhelming choice for capital raises among small businesses, with a total offering of $1.4 trillion from July 1, 2018 to July 30, 2019. The next most popular exemption, Rule 506(c), was used to raise only $210 billion in the same time period. The remaining options lagged far behind with $800 million, $260 million, and $54 million for Regulation A+, Rule 504, and Regulation CF, respectively. Total Rule 506(b) offerings even edged out public offerings, which totaled $1.25 trillion.

The 2019 Report’s examination of the companies using various offering types helps explain Rule 506(b)’s dominance. The 2019 Report divides companies into three categories–small, emerging businesses (Small Biz), mature and later-stage businesses (Established Biz), and small public companies (Public Companies). The 2019 Report then analyzes the securities offerings used by each of these business types.

Rule 504 and Regulation CF, which limit how much can be raised, were popular with Small Biz but not with Established Biz or Public Companies. Regulation A+, the mini-public offering, was popular with Established Biz, which might someday become Public Companies. Regulation A+ wasn’t popular with Small Biz and isn’t used by Public Companies. Public Offerings were used only by Public Companies.

Rule 506(c) appealed to both Small Biz and to Established Biz. But Rule 506(b) rules the roost because it was popular among all business types. Further explaining Rule 506(b)’s dominance, the 2019 Report notes that “[c]ompanies are increasingly going public at a later stage in their lifecycle after raising more capital from private markets.”

Flexible and Easily Accessible Equity

When most people purchase a car, they do something that’s easy and reasonably priced. They either use financing offered by the dealer or go to their bank or a credit union offered by their employment. It appears the same is true of professional violinists–they use a program offered by the dealer, the union, or friends, but cost is a factor too. Businesses and real estate investments also appear to be drawn to the most accessible and reasonably priced offerings.

It shouldn’t be a surprise that Rule 506(b) is popular among all sizes of businesses. Although Rule 506(b) offerings can’t be advertised, they are among the least expensive. Best practices require a private placement memorandum, and there are notice filing requirements. Still, the cost for these services and filing fees frequently totals only $25,000-$50,000.

Unlike Rule 506(c) offerings, there is no cost associated with verification of accredited status in a Rule 506(b) offering. Plus, there are no advertising costs for a Rule 506(b) offering. And, unlike Regulation A+ and public offerings, there are no SEC review or ongoing reporting requirements for Rule 506 offerings.

According to the 2019 Report, 94% of Rule 506 offerings were sold only to accredited investors. That may be because Rule 506(b) imposes additional requirements on sales to unaccredited investors. However, it also could be because due to inflation and a strong stock market, there is an abundance of accredited investors.

Although the SEC recently proposed amendments to the definition of accredited investor, the definition hasn’t changed significantly since 1982, when 1.8% of US households were accredited. During that time, both salaries and retirement fund account balances have increased. According to the 2019 Report, 13% of US households now are accredited.

What’s most important to a violinist is to obtain a professional level violin so they can perform at a higher level. What’s most important to a business is that it obtain the equity it needs to move the business forward.

Although no securities offering is simple, compared to other options, Rule 506(b) offerings are akin pushing the “easy” button in instrument financing–provided the business has sufficient relationships, so it doesn’t need to advertise or engage in general solicitation to sell its offering. There are no dollar limits on the amount that can be raised. The process is well-established and relatively inexpensive when compared to public offerings. And it’s often the best way to obtain much-needed funds so the business can focus on its goals.

This series draws from Elizabeth Whitman’s background in and passion for classical music to illustrate creative solutions for legal challenges experienced by businesses and real estate investors.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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