By: Tilden Moschetti, Esq.The SEC offers a collection of rules under Reg D where an individual or entity can offer and sell securities without registering the transactions with the SEC. This regulation makes it easier for small businesses to raise capital without having to worry about all of the paperwork associated with regulation. Plus, the variety of rules that fall under Reg D offers several ways to achieve this exemption, making them suitable to numerous offering types.
Rule 506(b) is one of these rules.
This rule is considered a “safe harbor” according to the Securities Act. However, there are several requirements that you must meet to create a valid securities offering under Rule 506(b). Here, we dig into everything that you need to know about this rule to ensure that you’re offering gets approved. (See https://www.law.cornell.edu/cfr/text/17/230.506 for the full text of Rule 506(b).)
Rule 506(b) is part of the SEC’s Reg D that allows you to sell securities to an unlimited number of accredited investors and up to 35 non-accredited investors without registration. More, a syndicator can raise an unlimited amount of money as long as they do not publicly solicit for those funds.
As mentioned, Rule 506(b) is a safe harbor rule that enables you to offer securities without registering your transactions with the SEC. However, this rule does not apply to all types of businesses. Anybody who receives securities under a Rule 506(b) offering faces restrictions related to selling those securities to others. Typically, these restrictions last for either six months or one year and prevent the resale of securities without registration.
You must meet certain conditions to make an offering under this rule.
Let’s say you’ve developed an offering and want to market it to as many people as possible. This leads to you hiring a marketing company, which creates online ads, television ads, and other media designed to advertise your securities.
This is not allowed under Rule 506(b).
The rule states that your company cannot engage in any form of solicitation, advertising, or marketing for its securities. We’ll examine what this means in practice later in the article.
Rule 506(b) allows you to sell securities to an unlimited number of accredited investors and up to 35 non-accredited investors. What’s more, any non-accredited investor must have a suitable level of sophistication, either from their own knowledge or due to help from an advisor, to make the purchase.
Again, we’ll did into this topic in more detail later in the article.
As the issuer, you’re responsible for disclosing relevant information to any investor who’s interested in buying your securities. In doing so, you must remain mindful of federal and state laws, which require you to provide accurate information without omissions. If you wish to bring non-accredited investors into the offering, further disclosure rules apply.
By making an offering under Rule 506(b), you commit to being available to answer any questions that a potential buyer may have. If you’re not available, investors may believe you’re attempting to withhold information. At best, this can lead to an investor pulling out. At worst, it could result in legal action taken against you because you’re not disclosing the information an investor needs to make their decision.
One of the main benefits of a Rule 506(b) offering is that you don’t have to register your offering with the SEC. However, the SEC stills need notification to tell it that an offering will take place. This is where Form D comes in.
Form D is a simple document that provides the SEC with basic information about the company offering the securities. These details include:
Happily, the SEC doesn’t charge any fees for a Form D filing. However, it is very strict in terms of when the filing takes place. You must submit your Form D within 15 days of the offering’s first confirmed securities sale. The date your first investor signs a contract to buy securities is the starting point of these 15 days. However, if the contract is signed on a Saturday or Sunday, the starting date is moved forward to the next business day.
You must submit your Form D filing online using the SEC’s Electronic Data Gathering, Analysis, and Retrieval (EDGAR) system. To begin filing, your company needs to have a Central Index Key (CIK) and a set of access codes, both of which you obtain after applying for access to the EDGAR system. Make sure you record these details, as you may need them for multiple Form D filings, in addition to other filings made through the system.
Assuming you have access codes and a CIK, you can complete a Form D filing. Note that EDGAR provides you with one hour to complete the filing, with the timer beginning with your first keystroke once you’ve entered the filing system. To prevent delays, have all of the relevant information about your company’s owners and stock promoters ready so that you don’t run out of time and have to complete the form again.
There are two main benefits to a Rule 506(b) offering, especially when compared to the similar Reg D Rule 506(c).
Under Rule 506(b), you can include unaccredited investors in your offering. The result is a wider pool of potential investors, which makes Rule 506(b) ideal for syndication or crowdfunding activities. Furthermore, the rule does not require you to provide verification for its investors. Under Rule 506(c), you must show the SEC that you’ve taken reasonable steps to ensure all of your investors are accredited. This condition does not exist for Rule 506(b).
So, why would anybody choose Rule 506(c) ahead of Rule 506(b)?
Advertising.
Rule 506(b)’s main drawback is that it does not allow you to solicit investors for your offering. Advertising isn’t an issue with Rule 506(c) as long as all solicited investors are accredited and verified. As a result, your choice of which rule to operate under comes down to what types of investors you want to attract and whether you feel like you’ll need to advertise your offering to create sales.
Many of the rules in Reg D limit the amount of capital you can raise during a single offering. Reg D Rule 504 is a good example, as this rule places a $10 million per year limit on your offering.
No such capital restrictions apply for Rule 506(b).
The total value of your offering can reach any number that you desire. What’s more, you can make multiple offerings in a single year with no limitations.
This makes Rule 506(b) ideal for larger businesses that are not registered with the SEC. The rule is also a good choice for startups and entrepreneurs who anticipate rapid growth that will require more than $10 million of capital to fund.
Of course, a lack of capital limitations does not mean that you can create an offering with random figures attached to it. Any potential investor will conduct thorough due diligence to determine if they’re likely to receive a return on their investment. If your securities come with a price tag that doesn’t reflect the revenue your company will likely generate in the future, you may price yourself out of an investment.
Rule 506(b) requires you to create a private placement memorandum (PPM) that you distribute to every investor who considers buying one of your securities. A PPM is a document that outlines all of the relevant facts related to your offer. With a PPM, you generally fulfill most federal requirements for providing accurate information with no omission. However, the document does not absolve you of your responsibility to remain available to your prospective investors to answer any additional questions.
PPMs also protect you as the seller. If an investor chooses to buy your securities only to later claim that you didn’t provide them with the information they needed, you can point to your PPM. Assuming you’ve created a comprehensive PPM, you can prove that you provided the information the investor needed. As such, a PPM ensures that you don’t get into any sticky legal situations.
As a PPM contains information about your company and the investment opportunity it offers, it’s easy to assume that a PPM is the same thing as a business plan.
It isn’t.
These two documents serve very different purposes. Attempting to use your business plan as a PPM may result in you failing to provide all of the information your investors need.
Think of your business plan as a marketing document. It exists to promote your company and talk about how great you, your products, and your business are. As a result, most business plans contain forward-focused information, such as projections and information about the various processes and products you hope to put in place. Business plans outline growth opportunities, market demand, and partnerships in a way that’s designed to make your business seem as attractive as possible to potential investors or lenders.
A PPM is a more formal document.
Its sole focus is to demonstrate the merits of the investment you’re offering. A PPM does not require marketing speak or company promotion, as this information gets in the way of the important things that your potential investors want to know. Instead, a PPM is where you provide factual and more concrete information and data related to the specific offer you’re making.
This isn’t to say a PPM can’t serve a marketing purpose. However, any marketing that occurs is indirect and results from the professionalism evident in the document.
In short, a business plan exists to make your business look good while outlining its plans for the future. A PPM exists to cut to the chase about an investment opportunity that you’re offering.
There is no definitive standard for what a PPM should contain. Every document is a little different depending on the nature of the securities issuer’s business and the information that investors will require. However, some common PPM components usually find their way into every document.
Your introduction offers investors a summary of the opportunity you’re presenting to them. You’ll cover the investment’s basic terms, in addition to providing general information about your company and its main business interests.
The introduction should also include any legends that state or federal law requires. For example, if your business manufactures pharmaceuticals, the introduction should contain the relevant legend that relates to the products you sell.
With the basic introduction out of the way, investors will want to know more about the company and how it’s structured. Use this section to discuss the following:
This is the part of a PPM that most closely resembles a business plan. Again, keep marketing speak to a minimum. A PPM is not for selling your company to the investor. Only state the facts in this section, providing data wherever you can to back up whatever information you share.
Any information about your management structure and the people involved in executive decisions goes into this section. In addition to a basic chart showing how the managerial hierarchy works, aim to provide a biography for each member of the management team. Share any special skills each manager has. Plus, include background information that demonstrates why the individual in question is in their current position.
This information allows an investor to follow up with their own research so they can determine if they want to work with your management team. In many cases, demonstrating a sold structure containing competent managers acts as a selling point because it raises investor confidence.
This is a collection of terms that apply to your offering. It’s usually written as a term sheet that covers the following details:
For example, Rule 506(b) has a limitation in place that restricts the securities offered under the rule. This limitation prevents the sale of the securities you offer unless you register those securities with the SEC. You’ll use this section of your PPM to inform investors about these restrictions because they have a direct impact on the liquidity of the securities.
Risk is an issue for every investment. It’s often the first thing that an investor will look for when determining if they should dedicate their money to your offering. As such, your PPM needs to include a page where you detail the risks specific to your offering.
Include both general risks related to your industry and any specific risks concerning your company. For example, if your company depends on strategic partnerships to stay operational, you need to declare the nature of these partnerships. They represent risks because the end of the partnership could have an impact on your company’s ability to provide its services, which affects the revenue it generates.
It’s best to be safer than sorry when creating this section. If you believe something could constitute a risk, include it here. Failure to do so could lead to investors accusing you of withholding information, which creates legal issues on the state and federal levels.
You answer a simple question in this part of the PPM:
How will you use the money that your offering raises?
Outline specific plans for every dollar the offering should generate. You should have an aggregate offering price to hand, which you can break down into specific business actions and the money you’ll spend on each. Your goal here is to show an investor that your business has a plan for the raised capital beyond simply hoarding it.
Use this section of the PPM to outline the types of securities you’re offering to your investors. Provide information about the rights the investors have and any restrictions they face once they’ve bought your securities.
Furthermore, include any information relating to the company’s ability to alter is capitalization. For example, you can use this section to discuss the distribution of dividends and how that may change if you change the classification of the securities in the offering.
Generally speaking, those raising capital under Rule 506(b) offer either equity or debt securities.
With equity securities, you essentially sell a portion of your company to an investor. They get a controlling stake, often with voting rights, that depends on the percentage of equity you provide in exchange for the investor’s money.
A debt security works similarly to a bank loan. The investor commits to lending you a set sum of money with agreed repayment, interest, and other loan terms. These terms vary depending on the investor’s assessment of the opportunity you’re presenting to them.
Make sure that there’s no doubt about which type of securities you’re offering.
Interested investors need to know how to start the buying procedure. This section of the PPM should provide step-by-step instructions that cover the whole process. Aim to make things as easy as possible for the investor by giving them a specific point of contact and informing them of what happens during the process.
This section is particularly important if you aim to attract unaccredited investors who may not know about buying securities. Though these investors typically have advisors, anything you can do to make the process simpler improves their confidence in your offering. It also ensures that you’re not stuck answering a lot of questions later on.
There’s a lot of information that an investor may need access to but that doesn’t fit into the general framework of a PPM. Examples include your standard investment contracts, your company’s financial statements, license, and the issuer’s organizational documents.
All of this information can be stored in an appendix or exhibits section. You may also refer an investor to this section throughout the PPM to ensure they know they have access to relevant documentation.
Rule 506(b) allows you to include up to 35 non-accredited investors in your offering. These investors are often unsophisticated, which means that they have little experience with investing or the industry you operate in. Approximately 95% of the investors in the United States are non-accredited. Some refer to non-accredited investors as retail investors.
Beyond their lack of investing knowledge, non-accredited investors also do not meet the SECs limits for net worth and income. Because of this, the SEC places limitations on the types of investments a non-accredited investor can make, as much for their safety as anybody else.
If you wish to include non-accredited investors in your Rule 506(b) offering, there are a few additional considerations to keep in mind.
Most importantly, the SEC obligates you to provide full disclosure documents to any non-accredited investors. Much of the information required for these documents can get placed into a PPM. However, you must make every effort to be transparent while providing as much information as possible. What’s more, any financial information you provide to accredited investors must also go to your non-accredited investors.
Furthermore, you must establish that the investor is “sophisticated”. This means that they either have direct investment knowledge or they’re receiving advice from somebody who understands the type of investment you’re offering.
Finally, you have to be accessible to your non-accredited investors at all times so you can answer any questions they may have.
As long as you’re willing to provide the additional paperwork and make yourself available to answer questions, there’s no reason not to include non-accredited investors.
However, remember that these investors typically don’t have the same financial muscle as accredited investors. They’re non-accredited specifically because they don’t earn as much or have as high a net worth as an accredited investor.
As such, many use crowdfunding to attract large volumes of non-accredited investors to their offerings. With crowdfunding, many non-accredited investors can offer smaller amounts of money to generate funding for a business venture. Unfortunately, crowdfunding using non-accredited investors isn’t an option for Rule 506(b) due to the 35-investor limit.
Investors become accredited by the SEC if they meet at least one of the following three requirements:
As long as the investor meets one of these criteria, the SEC can reasonably expect the individual to have sound investment and financial knowledge. The result is that the SEC lifts some of the protections and limitations it has in place for non-accredited investors. Accredited investors have more freedom to choose what they invest in and how much money they dedicate to each investment. As such, your accredited investors are likely to provide the bulk of your funding for a Rule 506(b) offering.
The SEC places no limits on the number of accredited investors you can include in a Rule 506(b) offering.
In theory, this means that crowdfunding is back on the table. You could aim to attract a large number of accredited investors, each of whom takes a small slice of equity in your business in return for the securities you offer.
In practice, it’s more likely that accredited investors will want to take on a larger share of the business because they’re aiming to achieve high returns. Still, the lack of limitations on both the number of accredited investors and the amount of money you can raise under Rule 506(b) means your unregistered offerings can generate substantial amounts of capital.
Some of the investors who take part in your offering may wish to resell their securities at a later date.
Unfortunately, Rule 506(b) places limits on resales. Every security issued under a Rule 506(b) offering carries the “restricted” tag. This tag indicates that the issuer provided that security in a private and non-registered offering. The restrictions applied to Rule 506(b) securities typically last for either six or 12 months, depending on the nature of the offering.
Restrictions prevent your investors from reselling their securities unless you choose to register them with the SEC. You’re obligated to inform your investors about these restrictions before a sale takes place. As mentioned previously, your PPM is usually the best place to do this. However, it’s not a bad idea to inform the investor using separate documentation as well. Doing so protects you if an investor claims they were unaware of the restricted nature of their securities.
Under Rule 506(b), you cannot advertise your offering or solicit investors for the offering. Of course, this leads to the question of how you can attract investors if you can’t use traditional marketing channels to talk about your securities.
The SEC answers this when it states that you must have a “substantive pre-existing relationship” with any investor who purchases your securities.
While the SEC doesn’t provide strict guidelines on what constitutes this type of relationship, it has issued several “no-action” letters that give us a good indication.
According to these letters, the correct relationship requires you to know enough about your investor that you understand their financial position and know they’re able to take on the investment. Furthermore, you must have a recordkeeping system in place that demonstrates that you knew the investor before you made your offer of securities.
Finally, the SEC mentions a “passage of time” that must elapse before you can make an offer.
Based on the SEC’s “no-action” letters, there are two things you need to think about when developing substantive relationships.
Before you make any sort of offer, create a list of investors that you believe could be a useful part of your syndication. Send a prequalification questionnaire to each investor that asks them to describe that status. Specifically, you’re trying to discover if they’re an accredited investor while asking them to describe their financial position and experience as an investor.
Ask the individual to sign and date the questionnaire so you can log it in your record to have a definitive starting date for the relationship.
Follow up on this questionnaire with phone calls can face-to-face meetings that allow you to get to know more about the investor. Use these meetings to ask more questions about the investor’s financial position and goals. If possible, create dated minutes for each meeting that you can keep in your records to show the relationship’s progression.
Your overall goal here is to create a paper trail that shows when you met the investor and how much effort you placed into getting to know them so you could form a substantive relationship.
The obvious answer is that you need to establish the relationship before you offer securities to the investor. As a result, any offer you make upon meeting a new investor won’t meet the SEC’s “passage of time” requirement for a substantive relationship.
As a general rule, aim to have a relationship with a prospective investor for at least two or three months before you contemplate making an offering. During this time, you also need to demonstrate that you’ve built a relationship. This means you can’t meet somebody, place them in your database, and then not talk to them for three months before making your offer.
If you’ve already formed a deal with an investor that you don’t have a substantive relationship with, this usually means a Rule 506(b) offering isn’t possible. However, there is a way to validate the deal. If you have a team member or a relationship with somebody who does have a substantive relationship with the investor, you can invite them to become part of the issuer.
With this person on board, you can leverage their relationship with the investor to validate the deal. However, doing this means you must take the time to ensure the new issuer is not a Bad Actor.
In 2013, the SEC implemented Bad Actor disqualification rules into Rule 506(b) offerings. These rules disqualify you from making the offering if any “covered person” in the issuer team is a Bad Actor.
The term covered person relates to the following:
Covered persons also include anybody that you pay to solicit investors, though this isn’t relevant to Rule 506(b) as you’re not able to solicit your offering.
All covered persons involved in your offering are subject to “disqualifying events”. These events include any of the following:
If the SEC discovers a Bad Actor as part of the issuer’s team, it will likely cancel the Rule 506(b) offering. At best, this means you go back to the drawing board and expel the concerned person before creating a new offer of securities.
At worst, this cancellation can result in legal action from investors who have already signed a contract to purchase your securities. The presence of a Bad Actor, whether you knew they were a Bad Actor or not, can constitute misleading your investors. You may face either civil or criminal court action for failing to identify a Bad Actor in your offering.
Importantly, the onus is on you as the issuer to ensure there are no Bad Actors in your offer. The SEC will not do this for you, meaning you must conduct rigorous due diligence on anybody who you wish to make a covered person in your offer of securities.
Happily, you may be able to exercise a reasonable care exemption under Rule 506(b) if your offer has a Bad Actor. This exemption only applies if you did not know the covered person was a Bad Actor and, crucially, that you can demonstrate that you took reasonable care to find out as much as you could about the covered person before including them.
Reasonable care relates to the due diligence process you undertake when making anybody a part of your issuing team. If the SEC discovers that a Bad Actor managed to hide their status from you, despite you taking all of the necessary precautions to prevent the presence of a Bad Action, you may benefit from this exemption. Again, it’s your responsibility to document any efforts you make to determine if a covered person has a disqualifying event.
With all of the above knowledge, you can now create some general steps to follow when creating a Rule 506(b) offer. This general structure applies to all offers under this rule:
An offer of securities made under Rule 506(b) is right for your syndicate if you have substantive relationships with the investors involved and you want to raise a large amount of capital. Rule 506(b) creates the opportunity for a crowdfunding situation, though you must take care to ensure that every investor qualifies based on their accreditation status and your relationship to them. What about Reg D Rule 506(b) vs Rule 506(c)?
While Rule 506(b) allows you to raise capital without registering your securities offering with the SEC, some restrictions apply. You also need to consider Bad Actor rules and your relationships with each investor. If you believe Rule 506(b) is right for your syndicate, Moschetti Law Group can help you to create a valid offering. Call us today on (888) 606-0990 to arrange a consultation with a member of our team.
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