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Blog

Embracing Rule 506(c)

JL Law

Entrepreneurs who seek startup capital through crowdfunding and the private placement investors who provide that funding now have more than three years of experience with new Rule 506(c) under SEC Regulation D. The 2012 JOBS Act created that Rule to facilitate general solicitations from qualified investors. In 2015 alone, private placement issuers raised roughly $38 billion in startup capital under the Rule.  The figures for 2016 are expected to be double that. Despite this clear growing trend, some prospective issuers have expressed reluctance to jump into the general solicitation crowdfunding arena, presumably out of compliance concerns that are common among private placement issuers. New technology and services along with better educated service providers may help reverse this initial reluctance by giving issuers better assurances that the Rule's fundraising requirements are being properly complied with.

Previously, Rule 506(b) under Regulation D allowed startups to issue securities to accredited investors and other buyers without verifying the investors' accredited statuses. That rule did not, however, allow issuers to general solicit or advertise, and it limited them to dealing with investors that they believed to be "accredited".  Technically, they could have admitted up to 35 non-accredited, but sophisticated purchasers, but few issuers did that in practice due to the additional compliance burdens associated with accepting non-accredited investors.  These limitations confined private placements to networks of individuals who knew investors that were accredited and that might be interested in private placements.

New Rule 506(c) changed the world. Under this Rule, issuers are allowed to generally solicit and to advertise a private placement offering, but they must then verify the accreditation status of any investor who does provide capital and investors are obligated to prove that status in order to participate in a private placement. Allowing general solicitations democratized the world of private placements by opening them up to startups and entrepreneurs who had connections to high net worth money sources. The verification requirements, however, are perceived to be a roadblock that is preventing broader acceptance of Rule 506(c). Entrepreneurs remain concerned that they will not have the ability or resources to verify an investor's accredited status.

Entrepreneurs and private placement issuers have always operated under an obligation to know their investors, and the new Rule is more of an enhancement of this obligation than it is a paradigm shift in the philosophy of private placements. New technology platforms, like the one provided by VerifyInvestor.com, are building on historical experience with private placement to deliver this knowledge to entrepreneurs. These platforms do the investor research and background checks for business startups to remove the layer of concern that they may have when dealing with unknown investors who claim to be accredited but whose legitimacy is difficult to verify.

Rule 506(c) offerings are distinct from pure crowdfunding offerings, but they provide a more flexible environment for both investors and issuers. The Rule, for example, imposes no upper limits on the amount of investment capital that a company can raise unlike all the other securities exemptions commonly used for crowdfunding. It allows an offering to be published on multiple different platforms, including social media, rather than just through a funding portal as is required by Title III, Regulation CF. Disclosures under Rule 506(c) are a function of market and liability concerns, rather than of strict rule-based disclosure obligations. Persons who make untrue statements in a Rule 506(c) offering are still liable under the anti-fraud provisions of Rule 10b-5, but Rule 506(c) does not extend Section 12(a)(2) liability to the issuer, its officers and directors, and to anyone else who participates in selling the offering.

Raising startup capital will always be a challenge, even for a business that is based on a stellar idea or a killer new product. With Rule 506(c) the regulatory community has balanced the interests of issuers and investors with a more open process that connects startups with a significantly larger pool of potential investors. Services that verify the accredited status of those investors provide the last link to complete that connection.

Over 90% of exempt securities offerings rely on Rule 506, and an increasing number of them are Rule 506(c) offerings.  Stay ahead of the curve and seriously consider Rule 506(c) for your company’s capital raise.