The "(c)" Change in Private Offerings
Updated: Sep 7, 2020
The pros and cons of SEC Rule 506(c), general solicitation in private offerings.
By Paul Swegle
The Jumpstart Our Business Startups Act of 2012, or the JOBS Act, spurred big changes in the federal securities laws. The most highly publicized change was the legalization of equity crowdfunding. Less high profile, but equally interesting to many securities practitioners, was the sea change involving “general solicitation.”
The JOBS Act forced the SEC to write rules allowing companies to “generally solicit” accredited investors in private placements. Private placements are offerings that are exempt from registration as public offerings because of their limited nature. The congressional mandate to permit essentially all types of solicitation and public advertising for private offerings overturned an 80 year prohibition that was a core regulatory principle for the SEC.
Despite the JOBS Act’s mandate to move quickly, the SEC dragged its feet in drafting the new rules. It also floated proposals that seemed designed to discourage the use of general solicitation. Ultimately though, to its credit, in 2016 the SEC adopted a fairly straightforward new Rule 506(c) under its Regulation D, or “Reg D,” as it is more commonly known. Rule 506(c) is found at 17 CFR 230.506.
By way of background, virtually all venture capital, and most other private capital raised by smaller companies in recent years, has been raised under the exemption from registration provided by former Rule 506 of Reg D. Former Rule 506 allowed companies to raise unlimited funds from unlimited numbers of “accredited investors,” and also from up to 35 unaccredited investors.
It has always been a point of concern as to whether a company or its placement agent must have a “pre-existing substantive relationship” before approaching an investor, no matter how wealthy. The rules and related guidance have likewise always prohibited public statements or advertisements about an offering, including in the press, at meetings, on websites, in blogs or in any other context.
Startup founders, among others, often stumble badly over this prohibition. Traps for the unwary and unsophisticated abound. It also seems the financial media are forever trying to trip up founders by asking about their current or future financing plans and then publishing responses like “we’re just starting a Series A round” for all the world to see, including securities regulators. This leads to concerns around “blown exemptions from registration,” investor rescission rights and related legal and regulatory contingencies.
Rule 506(c) changes all of this for companies that are willing to comply with the requirement that all investors be accredited and to take “reasonable steps to verify” such status. By simply collecting proper W-2s, 1099s, Form 1040s, or attestations from personal bankers, accountants, brokers or lawyers as described in Rule 506(c), and also keeping out any “bad actors” with prior securities law violations or other specified legal or regulatory blemishes, companies can now advertise their private offerings all they want and essentially “crowdfund” for accredited investors.
No more concerns about errant founder statements to the press or to fellow attendees in tech meetups.
As simple and potentially attractive as this sounds, surprisingly few companies are using Rule 506(c). Most are avoiding general solicitation and relying on the old version of Rule 506, which is now Rule 506(b).
A casual review of the Form D filings streaming into the SEC’s EDGAR system (https://www.sec.gov/edgar/searchedgar/webusers.htm) shows that 506(b) is claimed at least ten times more often than new Rule 506(c).
Informally surveying a number of securities law practitioners on the reasons for Rule 506(c)’s low usage rates yielded these responses, some of which have been paraphrased:
"My clients do not use 506(c) for several reasons. First, the process of verifying accredited status is more time consuming and more costly – the company must either use a verifying firm, or spend additional legal fees to ensure that the standards are met. Second, investors are reluctant to provide the backup needed to verify, and so there is a segment of potential investors that are not available. Third, the clients do not feel a need to undertake general solicitation – they believe they have a pool of potential investors needed to raise the funds."
"Why would you spend more time gathering additional information and prying into the personal finances of investors unless you really have to? Most of my startup clients want to limit the hassle for their investors as much as possible (and limit the ways an investor could choose to back out of the investment)."
"I never use 506(c) because most investors are not interested in divulging this type of information in this type of setting."
Other respondents raised different concerns, such as these two:
"Beyond the administrative and legal issues associated with using 506(c), I think that using it can be viewed as a “tell” that the offering isn't a particularly attractive one. Relying on it essentially signals to the investing public that the offering isn't expected to be appealing to the most desirable sources of funding, for whom a general solicitation isn't necessary."
"If the 506(c) exemption fails, due to an inadvertent unaccredited investor, there is no fallback provision. 4(a)(2) is not available due to the general solicitation."
Lastly, a staff member in the SEC’s Office of Small Business Policy acknowledged in a phone conversation on this topic that the SEC staff is also surprised by the low usage of 506(c). That staffer speculated that some issuers are likely concerned about not having the ability to fall back to a 506(b) offering if a 506(c) offering fails to get traction after general solicitation efforts.
But some issuers are using Rule 506(c). Numerous 506(c) offerings can be found on websites like Crowdfunder (www.crowdfunder.com) and Fundable (www.fundable.com). And a review of recent Form D filings reveals that Rule 506(c) has become popular for financing commercial real estate development deals and oil and gas deals.
So how are these issuers meeting the investor verification requirements? And how difficult, intrusive or expensive are the issuers or investors finding 506(c) compliance?
Interestingly, survey responses from counsel who have successfully used Rule 506(c) indicate fewer concerns about cost, difficulty and investor reluctance, as evidenced by these responses:
"For the one 506(c) offering I did, the company used a combination of internal verification based on tax returns for those investors who were comfortable with this (about one-half of them) and having the other investors' CPAs or brokerage firms provide letters verifying accredited investor status."
"For verification of accredited status we have the investor engage a 3rd party accounting firm to review their assets and liabilities and provide certification of accredited status based on net worth."
"We've done a couple 506(c) deals. We have done some of the investor verifications in house, reviewing docs to fit within the safe harbor (W2s for the income test; or brokerage statements, credit reports under the net assets test). We also have a client who runs a fund with a 506(c) offering and since he's usually these folks' investment advisor, he generally has plenty of info about their financial situation to make a determination, and often they have $1mm+ with him."
"For the 506(c) offerings I have done, the clients contracted with their placement agents (registered brokers) to handle the accredited investor screening. I think this is ideal because investors sometimes balk at providing that much personal information to the offeror directly and because engaging a professional bolsters the argument that the offeror has taken reasonable measures."
In summary, usage of Rule 506(c) is off to a slow start and only time will tell whether or not its popularity will grow. Investors may well get used to being verified, especially through services like www.verifyinvestor.com, and if enough big deals are run through the larger fundraising portals and angel investing platforms, 506(c) offerings might not seem quite so low brow, clunky or risky.
For startups outside of metropolitan areas or founders who are less well connected to wealthy individuals, angels or VCs, 506(c) may well offer their best opportunity for reaching potential investors to fund new businesses – a central goal of the JOBS Act.
Tactically though, for most strong companies with good access to capital it probably makes sense to start a funding round under 506(b) and then switch to 506(c) if the dollars don’t come in.
Paul Swegle has served as general counsel to numerous tech companies and advises a dozen others as outside counsel. He has completed $12+ billion of financings and M&A deals, including growing and selling startups to public companies ING, Capital One, Nortek, and Abbott.
Paul has authored two authoritative and practical business law books, available for preview and purchase here:
"Contract Drafting and Negotiation"