How Can Rule 506(c) Help Me Raise Capital?

Raising capital to start a company, fund business opportunities, or expand an ongoing business is a continuing concern for many entrepreneurs, founders, owners, small companies, and start-ups.

While critical, raising capital is among the more difficult business tasks owners and founders must undertake. It is far more time-consuming, stressful, and difficult than most people realize. Plus, if you are selling financial securities to raise money, the process is further complicated by federal and state securities laws. 

For small businesses and start-ups looking to sell financial securities to raise capital, Rule 506(c) of Regulation D (“Reg. D”) can help.  How Rule 506(c) can help you raise capital is something we will discuss in further detail below. 

First, however, let’s look at some options available to start-ups and founders for raising capital in general.

What Are Your Fundraising Options?

When it comes to raising capital, there are plenty of options available to individuals and businesses alike. We won’t go through all of them, but we will touch on some of the more common avenues most entrepreneurs or start-ups use to raise capital.  

Choosing the one that will work best for you will depend entirely on your specific situation. Therefore, it is critical that you consult with experienced securities counsel and other business professionals for assistance and advice along the way.  

Some capital-raising options include (but are not limited to):

Self-funding or Bootstrapping

This option won’t be a realistic one for everyone because it entails using your own money to fund your business idea. 

How you use your own money to fund your business is entirely up to you. Some founders save for years before starting their business. Others use money from their 401(k)-retirement savings to invest in their companies. Still, others don’t take a salary until the company is up and running. Others take side jobs and use that money to fund their budding companies.

However you do it, “bootstrapping” can be the simplest option for raising capital to fund your business. You don’t have to look for investors, you don’t have to ask for a loan, and you don’t have to rely on anyone but yourself to fund your business. 

But, as mentioned, it is not always the most feasible.

Raising Money from Friends and Family 

Another approach to raising capital is simply to receive investments in the business from friends and family.

This can be an easy place to start because your friends and family know you and want to support you. 

While asking friends and family to invest in your business or to loan you money might be fairly easy to do, this option is laden with pitfalls.

First, because this is often a more informal avenue for raising capital and your friends and family know and like you, many entrepreneurs and founders make the mistake of not getting their agreements in writing. 

Not a good idea.

If you are taking loans from friends and family, handle it just as you would any other loan or investment. Consult with knowledgeable counsel and get the terms of your agreement in writing.

Another major mistake many founders and entrepreneurs make when using this option is thinking that they don’t have to register their offerings with the Securities and Exchange Commission (SEC) because they are selling to “friends and family.” 

This is a serious mistake. Getting investments from friends and family does not mean you do not have to comply with the securities laws. You do. 

The SEC does not have a “friends and family” exemption. Friends and family are investors, just like any other investor. You may be able to structure your offering to fit within, for example, a Rule 506(c) exemption, but the sole fact that you are selling to friends and family does not relieve you from having to register your securities. Indeed, if you are making a Rule 506(c) offering to friends and family, you will need to ensure that each investor is an accredited investor. 

In sum, if you raise money from your friends and family, you will either have to register your securities with the SEC or ensure that your offering comes within one of the securities exemptions. 

As always, it is advisable to consult with securities counsel before asking friends and family for investments to ensure that your offering will be in full compliance with all federal securities laws and all “blue sky” laws that may apply to you.

Crowdfunding

Crowdfunding is another way to raise money to fund a business.

Crowdfunding breaks from traditional funding by using social media to raise money through social media by accepting a lot of small donations or investments from a “crowd” of people.

Crowdfunding can take one of 4 different forms. Money can be raised through:

• donations

• loans (debt-based crowdfunding)

• providing equity in the company, or

• providing participants with some type of reward. 

Crowdfunding campaigns that offer equity, convertible notes, or debt are considered securities and must be registered with the SEC. 

In 2016, the SEC began allowing eligible companies to engage in equity-funding or Regulation Crowdfunding. The law provides an exemption from the securities registration requirements for crowdfunding. It allows companies to engage in crowdfunding and seek small investments from a large number of people, but only if the law’s specific requirements are met. 

Small Business Grants

Another way to raise capital is to apply for small business grants. Unlike a loan which has to be paid back, a grant is essentially “free” money. 

Many governmental entities provide small business grants to qualified applicants. In addition to federal, state and local governments, many companies provide grants to start-ups or small businesses.

Although the grant money is free, the application process can be lengthy. Plus, the competition for grant money is intense. 

Finally, there are often limitations placed on how you can use grant money.

Angel Investors

Angel investors are individuals who have a high net worth who, use their own money to invest directly in a business or company. They typically invest in exchange for ownership equity in the company or for future equity. Angel investors generally invest on their own behalf. Most angel investors are accredited investors.

Venture Capital Funds

Venture capital (VC) funds are a type of private fund that invests most often in high-growth startups.  

Investors supply the fund with money which the fund invests. Most venture capital funds invest in specific industries, such as healthcare technologies, information technology, and the like. 

Venture capital funds are generally structured to last between 5 to 10 years, with the fund actively investing during the first few years, then monitoring the fund’s investments for a time before “exiting” and returning any profits to the investors. 

Consider All Your Options 

In addition to those mentioned above, there are other ways of raising capital. It is important to consider all of your options before choosing which method, or combination of methods, you intend to use. 

Which funding approach is best for your company or start-up will depend on the facts of your situation and what stage your company is in. 

Raising Capital by Selling Securities: Basic Considerations.

No matter how you slice it, to raise capital, you need investors.

Whether your investors are your friends and family, a crowd of strangers on the internet, or professional investors — you cannot raise money without investors.

But attracting and retaining investors means that you:

1. Must be very aware of the individuals you are soliciting to invest in your company, and

2. How you structure your offering is especially important.

Why?

Because federal and state laws govern how companies can raise capital from investors. And, depending on how your offer is structured, you may be selling securities. 

At the federal level, unless an exemption applies, the Securities Act of 1933 (“Securities Act”) requires all public offerings of securities to be registered with the federal regulatory body, the Securities and Exchange Commission (SEC). 

The SEC registration process is a lengthy, expensive, and arduous one. Additionally, each state has its own set of laws (known as “blue sky laws”) that impose registration requirements that issuers must fulfill before selling securities in that state.. 

So, if you are an “issuer” or “offeror” — an individual or business entity who offers securities for sale to any other person — you will need to fully comply with all federal and state securities laws.

Is Your Offering a Security?

Before you start raising capital through investors, then, you will need to know whether your offering is a “security” that must be registered with the SEC.

How can you tell?

Well, to begin with, the definition of “security” is a very broad one. Securities are more than just notes, stocks, or bonds. They also include (and are not limited to):

• preorganization certificates

• subscriptions

• debt equity

• security equity, or 

• hybrids — securities that have both debt and equity security characteristics.

In addition, financial transactions that qualify as “investment contracts” are considered securities under the Securities Act and must be registered with the SEC.

Whether a transaction constitutes an “investment contract” is determined by the “Howey test.”  

Derived from a Supreme Court decision, the Howey test says that if the transaction involves the investment of money in a common enterprise with the expectation of profit, and that profit is to be derived primarily from the efforts of a third person, then the transaction involves the sale of a security. 

Under the Howey test, any type of investment offering can be a security. The offering does not need to be formalized by means of a contract. If it is an investment of money in something intended to create profit for the investor, which will be achieved through the efforts of another, then the transaction will be considered a security. As one court points out, the concept is a flexible one capable of being adapted to fit “countless and variable schemes” involving the investment of money for profit.

Given the broad definition of securities, and the flexible Howey test, if you are raising capital through investments, it is likely that your offering will be considered a security.

Assuming, then, that your offering is a security, let’s look at how Rule 506(c) can help you raise capital.

How Can Rule 506(c) Help Me Raise Capital?

For new companies looking for investors, Rule 506(c) of Regulation D (“Reg. D”) of the Securities Act is a great way to raise capital.

Why?

Because Rule 506(c) allows you to harness the power of general solicitation without having to go to the time and expense of conducting a public offering, and without having to register your securities with the SEC.

For over 80 years, issuers were not allowed to advertise their offerings without registering them with the SEC. The only legal exemption available for an issuer to sell unregistered securities was to conduct a private placement offering to “sophisticated investors” under Section 4(a)(2) of the Securities Act. This meant that the issuer could not conduct a public offering, could not generally solicit investors, and could not advertise its offerings to the general public. Instead, unregistered offerings had to be private placements only, and the issuer had to have a preexisting relationship with “sophisticated investors.” 

Although Section 4(a)(2) did not define “sophisticated investor” and did not specify how much money an issuer could raise under the exemption, or how many investors could be involved, it was clear that the exemption’s purpose was to allow smaller companies to raise only a limited amount of capital from a limited number of investors. 

For issuers, Section 4(a)(2) left a lot to chance while at the same time putting the onus on the issuer to prove its investors had sufficient knowledge and experience to evaluate the risks of investment. 

Raising capital this way was a difficult and slow process for many small companies.

The enactment of the Jumpstart Our Business Act (“JOBS Act”) in 2012 changed all this. It required the SEC to amend the Securities Act to allow for new exemptions for small businesses so that they could sell securities without having to register them with the SEC.

In accordance with the JOBS Act mandate, the SEC amended Rule 506 of Reg. D to create 506(b) and 506(c). These subsections finally lifted the ban on general solicitation — with the caveat that the offering had to meet all the specific requirements of either exemption.

At last, issuers could publicly advertise their offerings — getting the word out more quickly, attracting more investors, and making the fundraising process move more quickly. 

Rule 506(c) Helps You Raise Capital by Letting You Advertise.

Rule 506(c) — the more commonly used exemption — is an absolute game-changer when it comes to raising capital. The exemption allows issuers to find investors by using general solicitation, including the internet and social media, to solicit investments from large groups of investors. 

Remember our discussion about crowdfunding? Because Rule 506(c) allows issuers to widely advertise their offerings and does not limit the number of accredited investors that can participate in an offering, it enables issuers to use crowdfunding to raise capital.  

So long as an issuer does not commit fraud, sells only to accredited investors, and meets all the other requirements/restrictions of the exemption (i.e., no “bad actors” etc.), Rule 506(c) provides significant freedom for advertising a 506(c) offering.

Rule 506(c) Helps You Raise Capital by Not Restricting How Much Money You Can Raise. 

The other way that Rule 506(c) helps you to raise capital is by not limiting the dollar amount you can seek. 

So long as you sell only to accredited investors, Rule 506(c) does not limit how much money you can raise.

Rule 506(c) Helps You Raise Capital by not Limiting the Number of Accredited Investors You Can Solicit to Invest. 

Unlike Rule 506(b), which places a limit on how many non-accredited investors can participate in an offering, under Rule 506(c) so long as every single investor is an accredited investor, there is no limit on how many investors can participate in the offering.

In addition, in 2020, the SEC expanded the definition of “accredited investor” further expanding who can participate in a Rule 506(c) offering. 

But, as with all good things, there’s generally a catch — or two. 

WARNING: Rule 506(c) Can Help You Raise Capital, but it Has a Few Very Critical Limitations.

Rule 506(c) helps you raise capital by removing barriers to advertisements, dollar limitations, and accredited investor limits. 

BUT…

The exemption has certain restrictions that an issuer cannot avoid or ignore. The failure to comply with the restrictions and requirements of Rule 506(c) can result in serious penalties and even the loss of the entire offering. 

In addition, it is necessary to comply with both state and federal securities laws. Even if you are fully compliant with all federal securities laws, you still have to comply with all state securities laws in each state where you intend to sell securities. 

Rule 506(c)’s Limitations

The rule does not limit the number of investors you may solicit, but it mandates that every single investor in a Rule 506(c) offering must be an accredited investor.

A Rule 506(c) offering cannot be made to non-accredited investors. 

Period.

Your right to use general solicitation to advertise your offer depends on it. If any investor is not an accredited investor, you lose the right to solicit under Rule 506(c). 

Also, it is up to the issuer to take “reasonable steps to verify” that every single investor is an accredited investor.

That means that every single investor must be verified as an accredited investor. If an issuer fails to do this for even one investor, the exemption for the entire offering may be lost.

Finally, all other terms described in the regulation, such as restrictions on resale, or participation of “bad actors” etc., must be strictly complied with.

While the restrictions imposed by Rule 506(c) may be strict, they are far outweighed by the benefits the exemption confers on an issuer looking to raise capital.  

Rule 506(c) Helps You Raise Capital by Making it Easy for You to Verify Accredited Investor Status.  

Finally, one of the most time-consuming and expensive aspects of qualifying for a Rule 506(c) exemption is the time it takes to verify that every single investor is an accredited investor.

Fortunately, however, the law allows an issuer to fulfill its requirement to take “reasonable steps” to verify the status of each investor by using a third-party service to verify accredited investor status. This makes the entire process faster, less costly, and less time-consuming. 

At VerifyInvestor.com, we offer world-class accredited investor verification service. Our services are fast, efficient, cost-effective, confidential, and reliable. We help companies raising capital pursuant to Rule 506(c) comply with their legal obligations to verify investors as accredited investors.