When it comes to the decisions an entrepreneur needs to make, the question of fundraising and how to do that effectively rises near the top. Some of the basic questions that must be answered include: what instrument to use, what terms to provide, what size of offering to make, and who to call to begin the process.
For most private issuers, one of two regulatory options under Regulation D must be chosen as well. The decision made here may determine your overall level of success.
Rule 506(b) and Rule 506(c)
The primary exemption to the Securities Act of 1933 which normally requires registration of securities being offered is Regulation D. This Regulation is comprised of rules that give issuers of private securities an exemption from the requirement to register their securities with the SEC.
Specifically, Rule 506(b) opens the door for issuers to raise capital from accredited investors on an unlimited basis. As well, issuers are permitted to raise capital from as many as 35 unaccredited (but they must be sophisticated) investors. One important restriction however is that issuers may not advertise their fundraising effort publicly – only privately.
In 2013, a new Rule 506(c) was introduced as required by the JOBS Act. Rule 506(c) helps address the new economy and covers the need for accessing capital in today’s environment by expanding opportunities for raising capital. Under 506(c), issuers may use public advertising or general solicitation to market their offering to a wider audience, through both online channels and traditional marketing platforms.
Advantages and Disadvantages
The main advantage of raising funds via Rule 506(c) is the capacity it provides to leverage a larger number of marketing avenues that open up your offering to a much bigger audience. Under 506(b), issuers are restricted to only approaching those investors with whom they already have a substantive, pre-existing relationship. The difference in the potential for fundraising between the two approaches can be vast when you consider how many social media accounts, magazines and outdoor advertising opportunities are available.
The main disadvantage to using 506(c) is the added requirement that before you can accept an investor’s investments, their accreditation status must be verified. Issuers that work under 506(b) only need to demonstrate a reasonable belief that the investors purchasing their securities are indeed accredited or else sophisticated, non-accredited investors.
To fulfill the Rule 506(c) requirements, ‘reasonable steps’ must be taken beyond publicly available information and self-certification to verify a prospective investor. Verification can be based on:
* Income demonstrated through W2’s, tax returns or other governmental filings
* A letter from an attorney, CPA or broker that declares the investor’s qualification status as accredited
* Net worth through a bank, brokerage or other relevant statements
* Other reasonable methods taking into account facts and circumstances and the type of accredited investor being verified
Choosing Between the Options
Each startup is different and has its own schedule for meeting fundraising goals. An issuer may switch from Rule 506(b) to 506(c) during any round. The issuer may also switch from 506(c) to 506(b) during any round provided general solicitation in connection with the offering has not be used. Once general solicitation is chosen, the issuer must begin a brand new 506(c) offering.
With everything said, the 506(c) option provides the issuer a wealth of opportunity in terms of tapping potential hungry investors for your products and/or services.
