Summary of Dr. Sabrina Howell’s Report on the Use of Rule 506(c) Exemption
VerifyInvestor.com
In an October 2024 report developed for the SEC’s Office of the Advocate for Small Business Capital Formation (SEC OASB) and co-authored by Dean T. Powell, (referred to as “the report” or “the Howell report”), Dr. Sabrina Howell researched and examined the efficacy and use of Regulation D’s Rule 506(c) capital raising exemption for venture capital funds (“VC” s).
In this post, we will briefly summarize the findings of the Howell report.
But first…
A Little Background on Rule 506(c)
Under the federal securities laws, unless a securities offering has been registered with the Securities and Exchange Commission (SEC) or comes within an exemption, it cannot be publicly advertised (i.e., “offered”) or sold. To raise money to start a business, expand, or even just operate, most companies (both public and private, as well as investment funds like hedge funds) raise money from investors through “private placements”. In other words, they offer and sell securities that are exempt from SEC registration.
As a result of the passage of the Jumpstart Our Business Startups Act (JOBS Act) in 2012, Regulation D (Reg. D) of the Securities Act of 1933 (“Securities Act”) was amended to ease the longstanding restriction on advertising securities. The main rationale for the law was that providing exemptions for private placements would lessen the capital raising restrictions for smaller companies and startups.
The two main subparts of Reg. D, effective as of 2013, used by most companies and by virtually all venture capital funds (VCs) to not have to register their securities offerings with the SEC are:
These rules — 506(b) and 506(c) — allow issuers to offer and sell unregistered securities. However, they differ in whether or not an issuer can advertise its offering, and who can invest in that offering.
Briefly, Rule 506(b) allows companies to sell to 35 non-accredited investors and an unlimited amount of accredited investors. However, it does not allow issuers to solicit investors or market the offer by general solicitation (i.e., websites, newspapers, t.v. advertisements, etc.).
Rule 506(c) in contrast, allows for general advertising and solicitation, but only if: (1) all investors participating in the offering are accredited investors, and (2) the company takes “reasonable steps” to verify the accredited investor status of every single investor.
Reg. D: Protecting Investors While Still Allowing for Fundraising
As the Howell report puts it, there is an acute tension in the securities regulations (especially in the private markets) between protecting investors and allowing for broad capital raising to increase access to private markets — especially for women, minorities, and entrepreneurs in rural counties — all of whom are underrepresented in private markets.
Traditionally, because private placements have few or no disclosures, the securities laws have protected investors by: (a) not allowing issuers to publicly advertise their offerings, thereby forcing issuers to rely on their personal networks, and (b) restricting participation to “sophisticated” and/or wealthy individuals and institutions.
To expand capital investment opportunities for smaller companies, Reg. D was amended to create two exemptions: Rule 506 (b) and Rule 506(c). Rule 506(c) allowed for general solicitation (i.e., advertising) of an offering, but it restricted the offering to accredited investors only and it required the issuer to verify that every investor was an accredited investor. According to the Howell report, nearly all Reg. D capital raises are conducted by venture capital funds (VC), private equity funds (PE) or hedge funds. The report indicates that in 2023 alone, investment vehicles raised $1.38 trillion as compared to $88 billion raised by non-financial issuers that same year.
The Response of Venture Capital Funds to Rule 506(c)
When Rule 506(c) was enacted, it received a positive response from the industry. Many people expected that because the new law would allow for general solicitation, it would even out the disparity that exists in private capital markets for underrepresented demographic groups. Yet according to the Howell report, this didn’t happen. Instead, Rule 506(c) “failed to gain traction” with VCs, and has had a very low “take up”.
After thoroughly analyzing the data regarding how many VCs have relied on Rule 506(c) and concluding that it has had a low “take up,” the Howell report asserts that one reason why the exemption is underutilized seems to be because VCs rely heavily on personal networks and not general advertising to find investors. According to the report, it is only VCs that have weak or no personal networks that are likely to use 506(c). The report posits that because underrepresented groups in VCs (women and other minorities) tend to have weaker personal networks, Rule 506(c) has not enabled the significant entry of new managers into the market and has not really “moved the needle” that much toward decreasing the demographic disparity seen in private markets.
Nor, says the report, has 506(c) done much if anything to change the geographic disparity that currently exists that makes New York, California, and Massachusetts the states with the most concentrated VC startups and technological advances — which, in turn, leads to a buildup of wealth in these areas and makes it all but impossible for VCs to thrive outside of these financial hubs.
All of which leads us to the next part of the report’s analysis.
Why hasn’t Rule 506(c) been more effective for VCs?
The Howell Report’s Explanations for Rule 506(c)’s Less than Stellar Results for VCs.
According to the Howell report, there are basically three reasons why Rule 506(c) hasn’t been taken up much by emerging VC managers and hasn’t really helped underrepresented managers. These are:
The need for a strong track record.
Access to the “crowd”.
The costs of verifying accredited investors.
Below, we will summarize each reason found in the report.
The Need for a Strong Track Record.
According to the report, there is almost a “Catch-22” situation that impacts advertising securities offerings under Rule 506(c). The report indicates that Rule 506(c) is generally used by VCs who do not have strong personal contacts with potential investors. For these VCs, general solicitation is necessary. However, investors who don’t have a personal relationship with an issuer (i.e., those who respond to general solicitation) heavily rely on a VC’s track record when deciding whether or not to invest. The problem is that most VCs who use Rule 506(c) don’t have a strong track record — which is why they are using the exemption in the first place.
Since a strong personal network and a strong track record are usually developed at the same time — and those using Rule 506(c) very likely have neither — the exemption is simply not helping emerging managers or underrepresented managers very much.
Access to the “crowd.”
In this part of the report, the authors posit that Rule 506(c) is most useful for VCs who are looking to raise capital from lots of small investors, and that “access to the crowd” is most important for those who do not have personal connections with wealthy individual or institutional investors.
The report points out that the regulatory cap on investors may cause some constraint in using Rule 506(c), however, it also seems to be the case that while public advertising may attract lots of small retail accredited investors, (of which there appear to be plenty) it does not attract institutional or very wealthy individual investors. That’s because institutional and very wealthy investors do not look for advertised investments. So being able to advertise a capital raise isn’t helping VCs.
The Costs of Verifying Investors
The third main reason given for the low take-up of Rule 506(c) by VCs, is the costs of complying with the law. As noted above, Rule 506(c) does not allow securities to be offered or sold to non-accredited investors and it further requires an issuer to take “reasonable steps” to verify the accredited status of every single investor. This is a far more onerous burden than Rule 506(b)’s “reasonable belief” (that every investor is accredited) standard.
For Rule 506(b), an issuer can rely on an investor’s self-certification of accreditation. So long as the issuer has a “reasonable belief” that the investor is an accredited investor, that is all the law requires. Plus, if the issuer of a Rule 506(b) offering is wrong about an investor’s status, there are no serious consequences.
In contrast, to comply with Rule 506(c), VCs have to spend time and money verifying the accredited investor status of every single investor. This has to be done either in-house or through a third-party verification service. While it can be argued that taking “reasonable steps” to verify investors is not really all that burdensome, making mistakes or failing to verify every single investor can have serious consequences — including the failure of the entire offering, or enforcement action.
On top of that, the results of the report’s surveys indicate that many investors are not comfortable providing the level of information required for verification. It also indicates that Rule 506(c) fundraising sends a negative signal to investors that the issuer using the exemption does not have a strong personal network. The belief/bias held by investors is that issuers using Rule 506(c) simply are low-quality managers recruiting unsophisticated retail investors.
The Report’s Conclusion
The Howell report concludes that Rule 506(c) is being underutilized by VCs. It states that the exemption is mostly used by female, Black/Hispanic, and first-time managers with weak personal networks, rather than by elite VC managers.
The authors caution that the SEC is over-protecting investors and suggest its policies could be improved by changing the 506(c) verification requirement from the more onerous “reasonable steps” standard to the less burdensome “reasonable belief” standard found in Rule 506(b). The report also suggests that the SEC allow investors to switch between 506(b) and 506(c) to better accommodate investor demand and the costs and benefits of general solicitation.
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