Thanks to the current tech boom, the world is full of aspiring entrepreneurs looking to start the next Uber. And to do so they need capital. That’s where 506(c) comes in.
In the current start-up ecosystem most companies raise capital by selling securities, financial instruments which represent investment as an owner, creditor or for rights to ownership. In the United States, the sale of securities is regulated by the U.S. Securities and Exchange Commission, or the SEC. Under the United States Securities Act of 1933, any offer to sell securities must either be registered with the SEC or qualify under an existing exemption. Regulation D is the SEC regulation which identifies these exemptions for private placements, allowing smaller companies to raise capital through sale of debt or equity securities.
In the past, many companies raised capital under exemption 506(b) of Regulation D. This exemption allows issuers to raise an unlimited amount of capital from an unlimited amount of accredited investors and up to 35 non-accredited investors, provided there was no use of general solicitation, and the issuers made the offering to individuals with prior existing relationships.
Enter the JOBS Act in 2012, and along with it, the addition of exemption 506(c) to Regulation D. With the introduction of this exemption, the SEC established guidelines that allowed companies to raise money using general solicitation.
So what are the key differences between the two?
Marketing & General “Solicitation”
The biggest difference between the two exemptions is that under 506(b), general solicitation is explicitly prohibited.
Under the 506(c) exemption, general solicitation is explicitly allowed.
Under the SEC definition, general solicitation includes advertisements published in newspapers and magazines, public websites, communications broadcasted over television and radio, and seminars where attendees have been invited by general solicitation or general advertising. In addition, the use of an unrestricted, and therefore publicly available, website constitutes general solicitation.
This key difference is game changing from a company perspective because it provides issuers with the ability to tap into capital resources outside of their network of preexisting relationships, broadening the reach of their offering in a way not previously possible. At the same time, from an investor perspective, it allows access to alternative investment opportunities that would never have been available prior to the JOBS Act. In switching from a 506(b) offering to a 506(c) offering, the pool of available early stage investment opportunities automatically expands from personal networks and local exposure to global reach encompassing complete strangers.
Under rule 506(b), issuers are allowed to raise capital from an unlimited amount of accredited investors, and up to 35 non-accredited investors, provided that they meet the sophisticated investor threshold designated by the SEC.
Under rule 506(c), issuers are only allowed to raise capital from accredited investors.
To qualify as an accredited investor, individuals must either have a net worth greater than $1,000,000 excluding their primary residence, or an annual income greater than $200,000 in the past two years, with the expectation to remain at the same level in the current year. In order for an investing entity (LLC, Trust, Partnership, or Corporation) to qualify as an accredited investor, it must either have total net assets in excess of $5,000,000 or all entity owners must be accredited investors on an individual basis.
From the investor standpoint, one of the major distinctions between 506(b) and 506(c) is the process used to verify that investors are accredited.
According to the SEC, an issuer must take “reasonable steps” to verify accreditation.
Under 506(b), issuers are allowed to accept investments from investors with preexisting relationships. Because this exemption is based on an existing relationship with the investors, the SEC has deemed that issuers have taken “reasonable steps” by relying on a self-certification by the investor of their own accredited status.
Under 506(c), issuers are allowed to solicit investments from the general public. Since they lack a formal, pre-existing relationship with the investors, the SEC has created more stringent accreditation guidelines in order to protect the general public.
Because these guidelines are purposefully vague in order to remain flexible, the SEC also published a more specific non-exclusive list of verification methods that are accepted as “reasonable” in their eyes. These methods include:
- verification of individual income by reviewing copies of any IRS form that reports income (W-2, 1099, K-1, 1040) for the prior two years, with a reasonable expectation by the investor to earn the same amount in the current year;
- verification of individual net worth, by reviewing specific documentation dated within the prior three months (i.e. bank statements, brokerage statements, certificates of deposit, tax assessments and a credit report), and a letter from the investor affirming total liabilities;
- a written confirmation from a registered broker-dealer, an SEC-registered investment adviser, a licensed attorney or a certified public accountant stating that such person or entity has taken reasonable steps to verify that the purchaser is an accredited investor within the last three months and has determined that such purchaser is an accredited investor; and
- a method for verifying the accredited investor status of persons who had invested in the issuer’s Rule 506(b) offering as an accredited investor before September 23, 2013 and remain investors of the issuer.
The Bottom Line
At FlashFunders, we believe in the value in 506(c) offerings, and the access to deal flow and capital that general solicitation provides to both companies and investors. While it’s clear that the rigorous guidelines for accreditation seem to create an additional barrier, FlashFunders has developed internal best practices with the assistance of independent legal counsel for verifying accreditation, taking this burden off of the company.
Have additional questions related to 506(b) and 506(c) offerings?
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