Created in the 1980s, Regulation D provides entrepreneurs with the opportunity to raise capital privately from a large number of investors. It does this by allowing you to offer securities without having to register the offering with the Securities and Exchange Commission (SEC).
Those issuing securities under Regulation D must do so by following one of the rules within the regulation. Of these rules, Rule 506(c) offers some of the biggest advantages. However, it also has some drawbacks to consider before you move forward. In this article, we examine Rule 506(c) in detail to ensure you understand all of your obligations when creating an offer of securities under this rule. (See https://www.law.cornell.edu/cfr/text/17/230.506 for the full text of Rule 506c.)
What is SEC Rule 506(c)?
Rule 506(c) is one of the two distinct exemptions offered to securities issuers under Rule 506 of Regulation D. It allows you to offer restricted securities to an unlimited number of accredited investors. What’s more, an offering of securities made under Rule 506(c) allows you to raise as much capital as you need for your business venture.
The following are the basic criteria for Rule 506(c):
- You can sell your securities to an unlimited number of accredited investors. However, you cannot sell securities to non-accredited investors.
- Advertising and solicitation of your securities are allowed as long as all of your investors are accredited. If you wish to work with non-accredited investors, you must make your offering under Regulation D Rule 506(b).
- The issuer must take steps to verify the status of an accredited investor that wishes to buy their securities. These steps include, but aren’t limited to, checking tax returns, examining credit reports, and conducting suitable due diligence that involves the collection of relevant documentation.
- An issuer can raise an unlimited amount of money under Rule 506(c).
- The issuer must ensure that investors receive all relevant information to allow them to make a reasonable decision. Much of this information is covered using a Private Placement Memorandum (PPM). However, investors may require further documentation.
- Prospective purchasers must be able to as questions of the issuer. If an issuer makes themselves unavailable, they may get accused of withholding important information.
- The issue cannot withhold or exclude any important information from their offering. They must also make every effort to ensure the information they provide is accurate, up-to-date, and cannot mislead an investor. Failure to follow these rules can lead to prosecution at both the state and federal levels.
While this seems like a lot of criteria that you need to meet, Rule 506(c) offers several benefits that can make offering securities under it more desirable than offering registered securities.
The Benefits of Rule 506(c)
The most obvious benefit of Rule 506(c) comes from the lack of SEC registration required.
With a typical capital raise, the SEC requires public filing before it approves any sales of securities. Creating this filing is time-consuming and requires the company to register itself with the SEC. The slower process can make it more difficult for smaller companies to gain access to funding. This issue is particularly damaging to companies that have an urgent need for capital so they can maintain rapid business growth.
Rule 506(c) allows you to quickly access capital from suitable investors without tying you up in all of the paperwork that comes with a typical capital raise.
Rule 506(c) is also ideal for those who wish to syndicate their business ventures. The rule has no limits on the number of investors you can involve or the amount of money you raise. As a result, Rule 506(c) offerings can allow you to collect small sums from a huge number of investors, which add up to a larger capital raise that enables your business venture.
We often see this in the real estate industry. By creating a syndicate under Rule 506(c), an issuer can invite several investors to a development project that the investors would not be able to fund on their own. Each investor stands to gain if the project succeeds, with the issuer also gaining access to a larger knowledge pool and the funding they require.
Offerings of securities under Rule 506(c) usually cost less than public offerings. Again, this relates to the time saved on registration and other paperwork. More time saved means that an issuer’s employees can focus on other business tasks. It also means the issuer doesn’t have to dedicate as many resources to the completion of paperwork.
Finally, Rule 506(c) is often preferred to Rule 506(b) because it offers issuers the chance to advertise to prospective investors. While this comes at the cost of working with non-accredited investors, the ability to advertise means you can appeal to a wider pool of potential investors.
The Drawbacks of Rule 506(c)
The lack of non-accredited investors is the most significant drawback of Rule 506(c). We’ll dig into what this means a little later, but it essentially cuts out approximately 95% of the potential investors you might attract to your offer of securities.
Rule 506(c) also places limitations on the resale of the securities you offer. This may be a concern to investors if they need access to liquid capital but can’t sell the securities they purchased from you. Again, we’ll discuss this topic in more detail later in the article.
Rule 506(c) also requires you to verify every accredited investor who wants to purchase your securities. The verification process adds time to the sale, though there are third-party companies that can complete the process on your behalf.
Filing Form D
Though the SEC does not require you to register your offer with them, it does ask you to notify them of your offering and its exempt status under Rule 506(c). You do this using Form D, which is a fairly simple form that asks you for key details about the transaction. Using Form D, you’ll provide your name and address, along with the names and addresses of other key personnel who are part of the offer of securities. This personnel includes directors, promoters, and executive officers. The form also asks you to provide basic details about the offer, though you don’t have to go into a lot of detail about it or your company.
You must file Form D within 15 days of making your first sale using the SEC’s Electronic Data Gathering, Analysis, and Retrieval (EDGAR) system.
Upon creating an account on this system, you receive various access codes and a Central Index Key that applies to your company. Using these details, you can complete Form D on EDGAR. The platform gives you an hour to complete the form, meaning you should have all of the appropriate details to hand before you start the process.
Form D is a necessity if you offer securities under Rule 506(c). Thankfully, the process, including registering your business on the EDGAR system, takes no more than a couple of hours.
How Much Capital Can You Raise Under Rule 506(c)?
As mentioned, one of Rule 506(c)’s biggest advantages is that it allows you to raise an unlimited amount of capital. This means it differs from many of the other rules in Regulation D. For example, Rule 504 of Regulation D only allows you to raise up to $10 million.
However, having no limit on the amount of capital you raise does not mean you can ask for any amount of money. You must ensure that you offer securities at a reasonable price to ensure that investors can see the potential for returns. Furthermore, you need to define exactly what you’re going to do with the money you raise to ensure investors feel confident about your company.
For example, let’s say you want to syndicate a real estate development project using multiple accredited investors. You’ve decided to offer securities and your research shows you that the project should cost approximately $15 million. However, you decide to use your capital raise under Rule 506(c) to try and raise $25 million.
Rule 506(c) will not stop you from making an offer of securities with a total value of $25 million.
Still, you may find that asking for $10 million more than you need will worry many of your investors. In addition to potentially raising the price of your securities, asking for more money than you need could make investors think you’re irresponsible. Many will also feel wary about what you intend to do with the extra money and will not invest if you plan to simply stockpile the extra cash.
As such, “unlimited” does not mean there are no limits to how much money you can raise using Rule 506(c). It simply means the SEC doesn’t impose a limit. You still have to consider your business, the nature of the offering, and what you’re going to do with the money so you can set a suitable limit for your offering.
Private Placement Memorandums Under Rule 506(c)
As part of your Rule 506(c), you must create a Private Placement Memorandum (PPM) that you distribute to all potential investors. This document has some similarities to a business plan. You use a PPM to dig into the details about the opportunity you’re offering, as well as to provide information about your business and the relevant parties involved in the offer of securities.
However, a PPM is not a business plan.
Business plans predominantly serve a marketing purpose. They contain projections and marketing lingo, all of which are designed to sell your company as an attractive opportunity.
A PPM is a completely fact-based document that should provide the information an investor needs to make an informed decision about the opportunity that you prevent to them. While a PPM can still serve a marketing purpose by demonstrating your professionalism, the language you use and the nature of the document differ markedly from a business plan. These differences mean you can’t just transplant your business plan into a PPM and call it a day. You have to take great care to ensure you’re offering factual information that does not mislead investors or misrepresent the opportunity you’re offering to them.
The Elements of a Good PPM For Investors
Unfortunately, the SEC does not provide a set template for the PPM required for Rule 506(c). It leaves you to your own devices in creating your PPM, meaning you have to take care to ensure you’re providing all of the information your investors require. Furthermore, certain PPM elements apply to some offers and not to others.
Still, most PPMs include the following elements as a bare minimum.
Element No. 1 – Introduction
This section provides some basic information about your company and its core business. Keep this section brief and factual, ensuring you don’t veer into using the marketing language that you may use in a business plan. It’s also worth including any registrations of federal legends your business has here. This registration information demonstrates that your business can operate legally in its chosen industry.
Element No. 2 – The Offering’s Terms
Here, you cover the basics of the offering and the terms attached to it. Most use a term sheet to make this information easier to digest, though it isn’t a set requirement.
Include the company’s current capitalization and the capitalization it should have when your offering concludes. You can also include any details related to the securities you’re offering, such as any voting rights that they bestow and how the investor can liquidate their securities.
Finally, discuss any protections that are in place for the investor.
Element No. 3 – Risk Factors
Most investors want to understand the risk involved in an investment before they start digging into the potential profit they can generate. For some, the presence of certain types of risk may lead to them choosing not to invest before they consider the possible financial gain.
As such, it’s best to include this section as early as possible in your PPM.
Keeping in mind that you’re obligated to provide as much information as possible to your investors, include as many potential risks as you can think of.
Start with a list of general risks that pertain to your company, the industry, and the market. For example, you may discuss competitors and their movements here, as well as any information that may suggest a shift in market tastes over time. Any risks that are common to the type of investment you’re offering, which will usually be equity or debt securities under Rule 506(c), go here.
From there, focus on more specific risks that could affect your business venture. Company size is a good example. If you’re going to use the capital raised to grow the company, yet you currently only have a small number of employees, you create some risks. A vital employee may leave, which slows down your growth. Or, your growth may lead to some much work that your current employees become overwhelmed. In either case, you need to demonstrate that you’ve considered these risks and have contingencies in place to deal with them.
Element No. 4 – Description of the Company
Use this section to go into more depth about the company and its management structure. You can discuss your company’s products and services here, as well as its history, goals, and the strategies you’ve created to compete with others in your industry. It’s also worth including details about any intellectual property (IP) you own here. If you have any patents, trademarks, or copyrights, provide details of them so your investors can conduct research. All of these IPs are assets that make your company more appealing to an investor. Again, it’s important to note that you have to stick to factual language.
In terms of management, discuss the structure of the company and provide a brief biography for each member of the management team. Include any relevant accreditations and memberships so the investor understands as much as possible about each member of the team.
Element No. 5 – Securities Description
Describe the types of securities you’ll offer to the investor. Usually, you’ll offer either debt or equity securities. A debt security works similarly to a loan in the sense that it has a term attached to it with an interest rate. This is ideal if you need a quick influx of cash but don’t want to give away an ownership stake in your business.
Equity securities typically involve offering a percentage of your company’s equity in exchange for the capital received. Though you lose some of the ownership, you may gain valuable advisors who can help the business grow faster.
You should also use this section to talk about changes to capitalization, liquidity, restrictions, and any possibility of the equity shares getting diluted over time.
Element No. 6 – Using the Proceeds
We mentioned earlier that investors want to know how you’re going to use their money once they’ve bought securities from you.
This is where you tell them.
Ideally, the use of proceeds section will include an itemized list of everything that you expect to spend the capital raised on. These amounts don’t have to be exact, though they must be reasonable approximations based on your own figures.
Element No. 7 – How to Buy
If an investor believes your offer is right for them, they’ll need to know what they have to do to purchase your securities. Provide a step-by-step guide in this section that covers what they need to do and who they need to contact or work with for each step. In addition to making the purchasing process as simple as possible for the investor, this section also means you don’t have to spend time fielding inquiries about how to buy.
Element No. 8 – An Appendix
Any documents that aren’t shared naturally as part of the PPM but are important to investors can go here. Good examples include your company’s financial statements, a copy of the contract an investor will sign when they buy your securities, and any important licenses or declarations that relate to your business. Again, aim to make this section as substantial as possible. If the investor has all of these documents they need, they’re less likely to ask questions. Plus, including this documentation in your PPM ensures you’re not withholding important information.
Quick Tips for a PPM
Beyond including the elements mentioned above, these quick tips will help you to create a professional PPM:
- Pay attention to formatting throughout the document. Keep color schemes and fonts consistent throughout to show that you’ve paid due care and attention to creating a good document.
- Have several people read through the PPM to find spelling mistakes, grammatical issues, and any passages that don’t make sense. While you’re appealing to accredited investors with this document, meaning they’ll typically be able to decipher jargon, you still want to ensure the PPM is as understandable as possible.
- Consider using a PPM template as a base for your document while adding any other information that you believe is relevant.
- Speak to a legal professional to ensure your PPM contains all of the sections it needs to contain and that it does a good job of relaying all of the appropriate information. The small fee spent on this check is dwarfed by the potential fines that can occur if you fail to provide the required information.
- Use tables whenever you share financial information or any other data that could be difficult to decipher if shared in standard paragraphs. Again, this helps investors to get to the important information quickly so they can make their decision.
Accredited Investors and Third-Party Verification
Under Rule 506(c), you can only make your offering to accredited investors. This differs from Rule 506(b), which allows you to offer securities to both accredited investors and up to 35 sophisticated non-investors. As mentioned, the trade-off here gets balanced out by Rule 506(c) allowing you to solicit investors.
The SEC chooses which investors carry the accredited status. As a general rule, an accredited investor will meet at least one of the following criteria:
- The investor has a net worth of at least $1 million. This net worth can’t include the investor’s primary residence. However, they can share the net worth with their spouse.
- An investor can be accredited if they earn at least $200,000 per year and can verify this income for the last two years. The investor may also have to show they expect to earn the same amount or more for the coming year. This figure rises to $300,000 if the investor has a joint income with a spouse.
- The investor must have an adequate amount of knowledge to ensure they don’t need the same level of protection as non-accredited investors. This knowledge can come from their job, such as somebody who is a knowledgeable employee of a fund that deals in private securities. People who have SEC or state registration for their role are also likely to fall into the knowledgeable category.
Happily, you can include as many accredited investors in your securities offering as you like. The SEC places no limitations, which opens up the possibility of syndication or crowdfunding. In both cases, you rely on a large volume of investors to make small contributions that total up to the required whole. Syndications and crowdfunding allow both the issuer and their investors to access opportunities they might not otherwise have access to.
Verifying Accredited Investors
Unlike Rule 506(b), Rule 506(c) requires you to verify that every investor who buys from you carries the accredited status. The SEC will not do this on your behalf. It’s your responsibility and it is a requirement because demonstrating that you’ve verified every investor in the deal makes all investors more confident.
There are three ways to manually verify an accredited investor:
- The Income Method
- The Net Worth Method
- The Insider Method
Method No. 1 – The Income Method
You’ll use this method to verify that your investor meets the previously stated income threshold and can expect to continue receiving that income for at least one year.
Typically, you complete this verification using documents the investor provides to you. These may include:
- A tax documentation form, such as a W-2 or 1099, that verifies the amount of tax the investor pays on their income.
- Pay stubs or tax filings the investor receives from their employer.
- A verified letter from the investor’s employer or account that confirms the investor’s income.
Method No. 2 – The Net Worth Method
If the investor achieved accredited status because of their net worth, you require different documents to ensure they have assets totaling at least $1 million. Such documents include:
- A credit report that lists all of their assets and liabilities.
- IRS forms to demonstrate their tax status.
- Deed to demonstrate that they own any real estate that contributes to their net worth. Note that deeds relating to the investor’s primary residence aren’t included here as that property does not count towards their net worth for Rule 506(c).
- Proof of the ownership of any vehicle the investor classes as an asset.
- A valuation of any privately-held securities the investor owns. You can verify public securities via the SEC.
- Valuation documents from a third party that verifies the value of the assets the investor presents to you.
This method becomes more complex if the investor incorporates several assets into their overall net worth. Alternatively, it can be extremely simple if the investor can point you towards a bank account that has at least $1 million in it.
Method No. 3 – The Insider Method
An insider is a general partner, director, or executive officer who is a part of the securities issuer. These people are automatically considered as knowledgeable about the investment, meaning they’re typically granted accredited status.
You should already have all of the information you need about your insiders from the research you conducted into them before including them in your issuing team. However, further verification may lead to you examining their own securities filings, resolutions, certificates, and governing documents to confirm they are who they say they are. Furthermore, this verification should help you determine if the insider is a Bad Actor.
While manual verification is manageable for a small securities offering, it can become a major burden for a Rule 506(c) offering. The ability to include an unlimited number of accredited investors can lead to hundreds, or even thousands, of people buying your securities. Conducting this verification process on each person is time-consuming and requires a lot of repetitive work. What’s more, this work does not carry over to future offers of securities. For every new offering, you must complete the verification process again.
Thankfully, the SEC allows the use of third-party verification services to take most of the work off your plate. In addition to conducting the research for you, a third-party accreditation service provides you with a letter stating the accredited status of each investor in the deal. This letter allows you to take advantage of Rule 506(c) “safe harbor” status, which essentially means you’re not held responsible if the third party is incorrect about the investor’s status.
Of course, there are limitations in place for who the SEC classes as an appropriate third party for verification purposes. Any of the following can offer third-party verification:
- A suitable attorney
- Registered brokers and dealers
- Certified public accountants
- Registered investment advisors
If you a third-party verification service, the letter you receive should tell you which of the accreditation criteria the investor meets. The validator should also sign and date the letter to confirm that they conducted the review on your behalf.
Engaging one of these services requires the payment of upfront fees. However, they save significant amounts of time while ensuring that you’re not liable if an investor turns out to not have accredited status.
Securities Resale Limitations
Under Rule 144(a)(3) of the Securities Act, offers of securities conducted under Rule 506(c) are restricted. This means that somebody who buys your securities is not able to resell them freely. Instead, they must wait for you to register the securities if you choose to do so. Or, that can resell if they obtain an effective registration statement.
This issue is crucial because it affects the liquidity of the securities you offer. Use your PPM to inform investors that any securities they buy from you under a Rule 506(c) offer carry restrictions. Failure to do so could constitute withholding or misrepresenting important information, which may result in federal or state prosecution.
Advertising and Soliciting Under Rule 506(c)
The ability to advertise your offer of securities is one of the most important advantages of the Rule 506(c) offering. The rule allows you to use any marketing channel you wish to advertise your offer. You can also commission solicitors to act on your behalf to increase sales. It’s a good idea to discuss your use of solicitors in your PPM. Your solicitors are also considered covered persons under Bad Actor rules.
The SEC does levy conditions for this ability to advertise. The previously noted rule that all investors in a Rule 506(c) offering must be accredited directly applies here. So too do the verification steps that you take to confirm the accredited status of your investors. Failure to verify an investor’s accreditation could mean that your offering falls apart or that you’re unable to perform it under Rule 506(c).
What Constitutes Advertising and Solicitation?
Influence is the keyword here.
The SEC generally focuses on the ability of your materials to influence an investor’s decision. For example, let’s assume you’ve distributed written materials to your potential investors. If these materials contain any information issuer information or a substantial analysis of the opportunity you’re presenting, they’re classed as general solicitation. If they only contain facts and figures that come from pre-existing and public sources, it’s likely that the materials can’t sway an investor’s opinions. As a result, those materials are likely not classed as general solicitation.
When it comes to advertising, influence obviously plays a role here. An advert of any type is designed to influence a consumer into buying a product. As such, any advert that you put out to the general public falls under the SEC’s definition of general advertising.
Thankfully, this is all allowed under Rule 506(c) as long as you only accept accredited investors that you’ve verified.
Bad Actor Rules Apply to Rule 506(c)
Rule 506(c)’s status as a safe harbor rule allows you to offer securities without registering them with the SEC. However, that safe harbor status disappears if one of the key members of the issuer’s team is a Bad Actor. Such members include the issuer, any of the issuer’s affiliates, directors, certain stockholders, and officers, plus any compensated solicitors.
The SEC refers to these individuals collectively as covered persons.
As the securities issuer, you’re responsible for ensuring that nobody involved in your offering is a Bad Actor. Again, failure to do so can lead to accusations of misleading or misrepresenting your offer of securities, resulting in prosecution.
What is a Bad Actor?
A Bad Actor is any covered person in your issuing team that has engaged in a “disqualifying event”. These events typically involve the breaking of SEC regulations and sanctions taken against the covered person in response.
Disqualifying events include the following:
- Criminal convictions related to buying and selling securities or making false filings with the SEC. Certain investment professionals, such as brokers and investment advisers, may also get disqualified if their conviction relates to the field they work in.
- Any restraining orders or court injunctions issued against the covered person. These typically relate directly to the criminal convictions mentioned above.
- Final orders at the federal or state level that bar the covered person from engaging in securities or similar financial vehicles.
- Some SEC disciplinary orders can qualify as disqualifying events. For example, an order that revoked a previously qualified professional’s status may fall under this category.
- Some cease-and-desist orders are also disqualifying events. These orders typically relate to certain sections of the Securities Act, Investment Advisers Act, or Securities Exchange Act.
- If the covered person has filed a registration statement or Regulation A offering statement that the SEC places a stop order on within the last five years, they’re likely a Bad Actor.
- The expulsion or suspension of a covered person from a professional organization, such as FINRA, is often a disqualifying event.
- Any false representation order that the U.S. Postal Service issues can disqualify a covered person.
Bad Actor rules exist to protect your potential investors against fraud and other unscrupulous practices. If your Rule 506(c) offering involves a Bad Actor, the SEC won’t allow it to go through unregistered. If you or the Bad Actor hides a disqualifying event, you may face legal repercussions for withholding important information from your investors.
The General Structure of a Rule 506(c) Offer of Securities
With the above information, you’re equipped to create an offer of securities under Rule 506(c). We can distill the information in this article down to some general steps that apply to almost all Rule 506(c) offerings:
- Before you consider making an offer of securities, build an issuing team around yourself. Make sure that you conduct all appropriate due diligence to confirm nobody on the team is a Bad Actor.
- Set your intended capital raise and decide what types of securities you’ll offer to investors.
- Create your PPM to outline all of the facts related to the offering. If you do not have all of the details required to complete a PPM, you’re not ready to offer securities.
- Assuming you can complete a PPM, consider hiring a solicitor to advertise your offer. You should also create a general marketing strategy to ensure you reach as many accredited investors as possible in the states you’ll make the offer in.
- If an investor shows an interest in buying securities, validate them either manually or by using a third-party validator. Never skip this step. Make a reasonable effort to confirm that you’re selling to an accredited investor in every case.
- Make your first securities sale.
- Complete and submit Form D within 15 days of making your first sale.
- Continue to sell securities until you achieve your intended capital raise.
- Invest the money you receive according to the estimates in your PPM.
The SEC does not require ongoing reporting for a Rule 506(c) offering. As such, you’re under no obligation to provide the SEC with any more information after you’ve completed your Form D filing.
Is Rule 506(c) Right for You?
How do you know if an offer of securities under Rule 506(c) is right for you and your syndication? What about Regulation D Rule 506(b) vs Rule 506(c)?
Generally speaking, if you want the freedom to advertise your offer and you’re happy to work only with accredited investors, Rule 506(c) is a good choice. The lack of limits on the amount of capital you can raise and the number of investors you can sell to also makes Rule 506(c) ideal for syndicates and crowdfunding activities. Rule 506(c) is also ideal for entrepreneurs and start-ups that don’t want to incur the costs that registering with the SEC requires.
Making an offer of securities under Rule 506(c) requires you to meet various criteria, most of which are covered in this article. But if you have more questions about any of the information shared here, or you simply want to talk to a professional about Rule 506(c) syndication, Moschetti Law is here to help. Call (888) 606-0990 today to speak to a member of our team and arrange a consultation to discuss your Rule 506(c) offering.