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Rule 501 of Regulation D

Rule 501 of Regulation D

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Rule 501 of Regulation D

Regulation D governs the offering or private placement exemptions. There are several benefits to making an offering under this regulation. However, there are also several rules that you must follow to create a valid offering.

Rule 501 of Regulation D is among the most prominent. This rule provides several definitions for the various components required for a Regulation D offering. It also determines who you can invite to the offering and what’s involved when creating purchasing arrangements. Here, we dig into all of the terms defined in Rule 501 of Regulation D so you can create a legal and valid offering.

What is Regulation D?

As mentioned, Regulation D is enforced when you’re making an offering that falls under a private placement exemption. There are several reasons why you may wish to make an offering under this regulation. Thanks to Regulation D, entrepreneurs can gain access to funding much more quickly than they would through a public offering. Offerings made under Regulation D also cost less than public offerings, making them ideal for start-ups and businesses with little capital.

Under this regulation, a business can sell debt securities or equity without needing to register the sales with the Securities and Exchange Commission (SEC). Regulation D offerings are private transactions, though nothing is preventing you from making the details of such a transaction public.

The regulation also contains several rules that you must follow when making your offering. Rule 501 of Regulation D is just one of several, though it’s among the most important because it defines who can purchase your offer and how they go about doing it.

Definitions for Rule 501 of Regulation D

Rule 501 of Regulation D provides definitions for some of the most important elements of a Regulation D transaction. In brief, these definitions are as follows:

Accredited Investor

This definition covers the types of investors that can purchase your offering. It covers both individuals and organizations that can trade securities without registering themselves with the SEC. An accredited investor is in a privileged position as this lack of registration allows them to make investments quickly and more easily. Typically, these investors achieve their status through a combination of their professional experience, net worth, assets, governance status, and income.

Affiliate

As the term implies, an affiliate is somebody associated with the securities issuer. The issue must specify an affiliate if the individual controls or is controlled by the security issuer.

Aggregate Offering Price

This is the sum of all of the cash and other assets an issuer will provide as part of its debt or equity offering.

Business Combination

This section of Rule 501 of Regulation D covers what happens in the case of a business combination. It’s required if the transaction matches that specified in Rule 145 of the Securities Act of 1933.

Calculation of Number of Purchasers

Here, Rule 501 of Regulation D defines who is excluded from your calculations when you’re determining the number of purchasers for your securities offering. It also tells you who is included and under what conditions. This information is crucial to ensure you don’t exceed the limit of 35 non-accredited investors for a Regulation D securities offering.

Executive Officer

This term applies to the president, vice president, or any other executive officer in charge of forming policy on behalf of the security issuer. In other words, anybody who has helped you to determine the terms behind your offering may fall under this definition.

Final Order

A final order is a written declaration issued by a state or federal agency. This statement provides an opportunity for a hearing related to the transaction, in addition to notice that the transaction will occur. Final orders can be appealed in cases where “bad actor” rules apply.

Purchaser Representative

The purchaser representative definition defines the conditions somebody must meet to represent the buyer in the transaction.

Spousal Equivalent

This term is used to describe somebody who has a similar relationship to one of the parties in the transaction as a spouse would have. For example, somebody who cohabits with the securities issuer but isn’t married to them would be a spousal equivalent.

Digging Into the Key Definitions

Of these definitions, five are crucial to the creation of a Regulation D offering. These are:

  1. Accredited Investors
  2. Aggregate Offering Price
  3. Business Combination
  4. Calculation of Number of Purchasers
  5. Purchaser Representative

To provide you with a better understanding of Rule 501 of Regulation D, let’s dig into the specifics of these definitions.

What is an Accredited Investor?

As mentioned, accredited investors are people or entities that can purchase securities without registration. A person or organization attains accredited status if the SEC determines they are financially sophisticated enough to require fewer protections when making transactions. For Rule 506c of Regulation D offerings, all investors must be accredited investors.

For an individual to become an accredited investor, they must meet at least one of the following criteria:

  • An individual yearly income of $200,000 or a joint income of $300,000. This income must be stable for the previous two years, with the investor also having a reasonable expectation that they will achieve the figure, or higher, for the coming year.
  • Have a net worth of at least $1 million, which they can have as an individual or with their spouse.
  • Be an executive officer, general partner, or director of the company issuing securities under Regulation D.

If an entity wants classification as an accredited investor, it has a different set of criteria to satisfy:

  • It is a private business development firm with assets valued at a minimum of $5 million.
  • The entity has equity owners who are classed as accredited investors themselves. This criterion is interesting because it means the entity does not need to reach the asset value threshold. The thinking behind it is that the presence of the individual accredited investor means the entity has access to the required financial knowledge to make unregistered transactions.

It’s also worth noting that organizations created with the sole purpose of buying an unregistered security cannot be classified as accredited investors. Rule 501 of Regulation D states that the organization must exist beforehand and have other business interests beyond the securities offered under the regulation.

A wide range of organizations and business entities can qualify as accredited investors. These include brokers, banks, trusts, and insurance companies.

What is an Aggregate Offering Price?

The aggregate offering price is the sum of all of the cash, assets, and other financial vehicles made available through the offering. Most use a simple sum to determine the aggregate offering:

Price Per Security x Number of Securities Offered

Several elements can go into this aggregate calculation, including:

  • Cash
  • Property
  • Notes
  • Debt Cancellations
  • Services

In traditional securities transactions, the maximum aggregate offering price also determines the fees paid to the SEC for overseeing the transaction. However, this is not a concern under Rule 501 of Regulation D as the transaction isn’t registered with the SEC.

Securities Offered for Both Cash and Non-Cash Consideration

If you’re offering securities with a non-cash component, the aggregate offering price is calculated using the cash price you’re offering the securities for. This means you can offer a non-cash consideration that’s worth a different amount than the cash consideration. Either way, it will not affect the aggregate price offering as long as a cash component is in place.

What Happens if Cash is Received in a Different Currency?

If the transaction requires the use of any other currency aside from U.S. dollars, the foreign currency is converted into dollars. The exchange rate that applies either on the date of the sale or for a reasonable time beforehand is used for the conversion. As such, your aggregate offering price can change depending on when the transaction takes place and the state of the currency exchange market at that time.

How is the Aggregate Offering Price Determined When Securities Aren’t Offered for Cash?

If you’re not offering your securities for cash, the aggregate offering price is calculated based on reasonable sales of whatever you’re asking for in return. These sales must have occurred within a reasonable time frame, which means sales that occurred years ago aren’t used.

If there is no recent sales data to draw from, the issuer must use an accepted standard to determine a fair price for the non-cash component. This standard varies depending on the component, meaning it’s recommended to work with a professional if you’re unsure about the calculation required.

What is Business Combination?

This section of Rule 501 of Regulation D defines what happens if a business combination will occur as part of the securities exchange. In other words, if the exchange requires the merger of two entities or the acquisition of one by another, it’s classed as a business combination.

A business combination applies in the following circumstances:

  • The transaction falls under the remit of Rule 145 of the Securities Act of 1933.
  • Any transaction where the acquiring issuer gains control over the other issuer involved. This applies even if the acquiring issuer did not have control beforehand.

Simply put, this part of Rule 501 of Regulation D tends to apply if there will be a change of ownership or company structure as a result of the exchange. The most obvious example is the offering of equity securities that provide the security holder with more control over a company than the security issuer.

Explaining Rule 145

Much like Regulation D, Rule 145 of the Securities Act of 1933 allows businesses to sell securities without having to register the sales with the SEC. However, this rule specifically covers any stocks that the seller receives as a result of an acquisition, merger, or securities reclassification.

However, transactions made under this rule must meet various criteria to remain unregistered. Existing securities owners can vote for registration in the following circumstances:

  • A merger or acquisition is about to occur that involves one company exchanging securities with another company.
  • The security in question is going to be reclassified as part of the transaction. For example, a debt security may get reclassified as an equity one, which could prompt a vote from other security owners for registration.
  • If a company is going to purchase another company and then give securities to the shareholders of the purchased organization.

If existing securities owners vote for registration under Rule 145, it’s unlikely that an unregistered transaction can take place.

What is the Calculation of the Number of Purchasers?

With this element of Rule 501 of Regulation D, we must also take Rule 506(b) of the same regulation into account. By combining these two rules, you can calculate the number of purchasers to ensure that the number of individuals or entities purchasing securities does not exceed the maximum.

Explaining Rule 506(b)

Rule 506(b) of Regulation D states what a securities issuer can and can’t do when making its offering. The rule covers a lot of ground, including the following:

  • It bands the use of advertising or general solicitation used to market your securities to investors.
  • The rule ensures that the securities issuer makes themselves available to answer any questions a potential buyer may have.
  • It places the onus on the offeror to determine what information to provide to accredited investors. This information must be free of misleading or false statements. It also cannot omit any important information that a buyer may use to make their decision.

However, the most important part of Rule 506(b) for the purposes of calculating the number of purchasers comes from the limits it sets on investors. Under this rule, your company may sell to as many accredited investors as you want. However, you can only sell to up to a maximum of 35 non-accredited investors.

To ensure you follow this rule, you need to know who you can exclude and who you must include when making your calculations.

Who is Excluded From the Calculation?

There are several types of purchasers that you can exclude from your calculation without running afoul of Rule 506(b) of Regulation D.

Accredited investors are the most obvious, as the rule states that you can have as many of these types of buyers as you like. As such, if your transactions only involved accredited investors, you don’t need to worry about calculating the number of purchasers.

Other exclusions include relatives of the purchaser, in certain circumstances. A relative, spouse, or relative of a spouse can be excluded from the calculation if they share the same primary residence as the security purchaser. This mention of “primary residence” is critical. It means that a relative is counted if they live in a property owned by the securities purchaser if the purchaser does not class that property as their main residence.

An exclusion also applies if the purchaser, or any of their relatives who meet the above criteria, has over 50% of the equity in a trust or estate. Finally, there is a similar exemption in place for purchasers and their relatives if they collectively own more than 50% of the equity in a partnership, corporation, or similar business entity. This 50% can include equity interests and equity securities. However, it excludes any director’s qualifying shares the purchaser or their relatives own.

So, we can see that a large number of potential purchasers are excluded from your calculation. These exclusions make it fairly straightforward to find a large number of purchasers for your securities offering under Rule 501 of Regulation D.

Who is Included in the Calculation?

Now that you know who to exclude, it’s important to understand who you must include in your calculations.

Let’s look at corporations, partnerships, and other entities first.

In most cases, these are counted as one purchaser per entity. So, if you have three businesses that are interested in purchasing your securities, that means you have three purchasers. You don’t usually have to account for individuals within the entities.

However, this changes if the entity you’re doing business with was created with the sole purpose of buying your securities and it is not classified as an accredited investor. In this situation, all beneficial owners of equity interests or securities in this entity are classified as individual investors. For example, if the entity has 10 beneficial owners, that amounts to 10 purchasers that you have to include, leaving you with 25 more before you hit the limit. As such, you must understand the nature of the entity that you’re doing business with to ensure you don’t make a mistake when calculating the number of purchasers.

Finally, any non-contributory employee benefit plan involved in the transaction counts as a single purchaser. That means you don’t have to include every member of the plan as an individual investor, assuming the trustee of the plan makes all of its investment decisions.

What is an Employee Benefit Plan?

An employee benefit plan is designed for employees, directors, general partners, officers, and trustees. It can also apply to advisors and consultants assuming they provide a bona fide service to the plan registrant, are natural persons, and their services aren’t related to offering or selling securities.

Employee benefit plans come in many forms, including:

  • Written purchases
  • Bonuses
  • Savings
  • Profit-sharing
  • Appreciation plans
  • Options
  • Pensions
  • Incentive schemes

The key for Rule 501 of Regulation D is that the employees who benefit from the plan do not contribute to it. If they do, the plan is no longer classed as a single purchaser.

What is a Purchaser Representative?

Purchaser representatives of individuals or entities who are in place to protect the buyer’s interests. The term is wide-ranging and can apply to anybody that a non-accredited investor brings on board to help them to evaluate the purchase they’re thinking of making. Typically, purchaser representatives help the buyer to understand the merits and potential drawbacks of a transaction.

You will usually find that accredited investors don’t use purchaser representatives. Instead, they rely on their own knowledge to determine whether they wish to be involved in a transaction. Non-accredited investors may use a purchaser representative as long as they meet all of the below criteria:

Criterion No. 1 – The 10% Plus Rule

The representative cannot be a director, officer, employee, or affiliate of the issuer who owns 10% or more of the issuer’s equity interest. The same percentage applies to equity securities. Furthermore, a combination of equity interest and securities can breach this 10% limit. For example, somebody who owns 5% of the equity securities and 7% of the equity interest has a 12% total beneficial stake and can’t be a purchaser representative.

There are some exclusions to this criterion:

  • If the buyer is a relative of the representative by blood, adoption, or marriage. This rule extends only as far as first cousins.
  • The purchaser representative is the owner of more than 50% of the equity interest and securities in a company or similar organization. This 50% can include any interests or securities owned by a relative of the purchaser representative.
  • The representative serves as an executor or trustee for a trust in which they have over 50% of the beneficial interest. Again, this includes relatives of the purchaser representative.

Criterion No. 2 – Appropriate Knowledge

The representative must have enough knowledge of business and financial matters to provide appropriate advice to the buyer. This knowledge is combinable with knowledge from other representatives. As such, an individual who may not qualify as a purchaser representative alone may qualify if their experience covers an area that another representative doesn’t cover.

Criterion No. 3 – It’s Put in Writing

The buyer must provide written notice of their use of a purchaser representative at some point during the transaction. This document should detail how the representative will help the buyer, allowing the securities seller to conduct research.

Criterion No. 4 – The Representative’s Statement of Disclosure

All purchaser representatives must put any material relationships that they have with the issuer, the issuer’s affiliates, and their own affiliates into writing before the purchase goes through. This disclosure must cover any relevant relationship the representative has had over the previous two years, as well as information about any compensation they received due to these relationships. This condition exists to protect non-accredited investors by ensuring they’re not working with representatives who are trying to force a purchase that they have a vested interest in.

Understand Rule 501 of Regulation D

By understanding the key definitions of Rule 501 of Section D, you ensure that your securities transaction can go ahead without registration. Failure to follow these rules could lead to the cancellation of the transaction, meaning your business can’t raise the capital it needs to move forward.

The information in this article helps you to prevent that from happening. But if you require any help with understanding or implementing the definitions provided in Rule 501 of Section D, Moschetti Law is here. We help entrepreneurs to use syndication and similar techniques to raise capital. If you have any questions about Rule 501 of Section D, contact us today to arrange a free consultation.

Tilden Moschetti, Esq.

Tilden Moschetti, Esq.

Tilden is a Regulation D syndication attorney specializing in 506b and 506c private placement memorandums and offerings. He is a syndicator himself and General Counsel to 2 private equity firms.

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