Old School vs New School Private Placements

After many decades of relying on existing relationships in order to conduct business with private securities, the need for general solicitation was obvious. In order to sell securities privately, companies would only be able to sell to friends and family members or any other personal networks. Fortunately, the US government eventually added Rule 506 of Regulation D in order to allow for solicitation which grew the private investment sector substantially.

When the JOBS Act was passed in 2013, Rule 506 was separated into two different categories. One being Rule 506(b) and the other Rule 506(c). Rule 506(c) is a seemingly innocuous name, however, this is one of the most significant pieces of legislation in the whole world. Almost nowhere else in the world can a private company raise funds essentially in a public matter. Rule 506(c) allows companies to generally solicit for investors rather than rely on existing networks. Rule 506(b) was kept in place as a sort of continuation of the old school private raises. Rule 506(c) on the other hand represents the new way of crowdfunding and allowing smaller companies with fewer resources to raise money and promote new ideas. Here is an infographic explaining the differences.

Rule 506(b) - The Old School Way

Rule 506(b) as stated before is meant for companies used to the old way of raising capital privately. It is a safe harbor, however, the requirements are pretty strict and limiting. Issuers are not permitted to generally solicit, so say goodbye to new investors. Additionally, the Issuer may only allow up to 35 non-accredited investors into the fund. Furthermore, these investors must be financially literate aka “sophisticated investors”. The definition of a “sophisticated investor” is up for debate, so if you are considering this path please consult an attorney. (Don’t try to skirt the system, hire a general counsel with finance law experience people, the consequences of DIYing a private placement can be severe).

Users of Rule 506(b) must prove they have a prior relationship with their investors. This is of course required since general solicitation aka making new friends is out of the question. Using your favorite long-standing investors is well and good, however, in order to expand to more investors that you have not courted yet is where Rule 506(c) comes into play.

Rule 506(c) - The New School Way

Rule 506(c) is the new kid on the block, the key benefit here is the ability to general solicit to any investor. Think of Rule 506(c) as the popular kid in school who has tons of friends. However, once the investors are accepted into the fund each investor must be an “accredited investor”. We have a handy FAQ page that goes over some of the basic requirements of accredited investor status. Needless to say, these standards are meant to protect investors and issuers from catastrophic loss. Think of two individuals investing $100 in their friend’s campaign to finally open a permanent lemonade stand on their street corner. Friend A has a total net worth of $10,000, and Friend B has a total net worth of $200. If the lemonade stand goes under and no longer produces dividends for the investors, Friend A will be just fine, however, Friend B just lost half of all of their money (at least they got some free lemonade while it lasted). As you can see by this simple example the need for an accredited investor is quite necessary and is not just gatekeeping.

Companies must take “reasonable steps” in order to determine if their investors are indeed accredited investors. There are many methods of verification for accredited investor status, the most common ones being: third-party verification, net worth method, and income method. In order to navigate these nuanced laws, it is important to consult a legal advisor familiar with this type of definition or even utilize an accredited investor verification service such as VerifyInvestor.com.

Determining which Rule 506 you use for your private raise is the most important decision in this type of capital raising process. Weigh each option yourself with some advisors familiar with both. Once a decision has been made, be very careful and follow the SEC guidelines in order to avoid negative consequences. Navigating these waters is worth it in the end as private equity in conjunction with general solicitation through Rule 506(c) has proven very lucrative for many Issuers.

Updated 7/14/2023

With the passing of the JOBS Act in 2013, Rule 506 was divided into two distinct categories: Rule 506(b) and Rule 506(c). Rule 506(b) continues to serve as a safe harbor for companies accustomed to traditional private capital raising practices, imposing strict limitations on general solicitation and permitting only up to 35 non-accredited investors. On the other hand, Rule 506(c) has emerged as a groundbreaking piece of legislation, enabling private companies to raise funds in a publicly solicited manner, setting it apart from most other countries worldwide. Rule 506(c) facilitates crowdfunding and empowers smaller companies with limited resources to secure investment and promote innovative ideas.

Rule 506(b) adheres to the established way of raising capital privately, requiring issuers to prove prior relationships with investors and prohibiting general solicitation. This rule necessitates caution and legal counsel to avoid severe consequences associated with do-it-yourself private placements. Conversely, Rule 506(c) provides a fresh approach, allowing issuers to generally solicit any investor. However, each investor must be an accredited investor, ensuring protection for both parties from substantial financial losses. Compliance with this rule requires companies to take "reasonable steps" to verify the accredited investor status, employing methods such as third-party verification, net worth evaluation, or income assessment. Seeking advice from legal experts experienced in this area or utilizing accredited investor verification services has become essential to navigate the nuanced laws surrounding Rule 506(c).