Background – Regulatory Scheme and Regulation D

Raising money from investors is a heavily regulated activity. For a company to sell its securities, it must either go through the expensive process of registering them with the SEC, or it must rely on a handful of exemptions aimed at allowing smaller private companies to access capital.

The most popular securities law exemptions arise under Regulation D, which generally restricts sales to wealthy investors or those with a high level of business sophistication. Historically, the Reg D exemptions also prohibited companies from using advertising or general solicitation to attract investors, so these companies have been limited to exploiting preexisting relationships and networks. To overcome the obvious limitations of that model, some specialized networks such as AngelList and Tech Coast Angels formed to help companies and investors leverage existing networks.  They allow companies to raise capital while ostensibly staying within the parameters of Reg D.

Rule 506 is a popular exemption arising under Regulation D. It allows a company to raise an unlimited amount of money from investors whom the company reasonably believes are accredited investors.[1] There are multiple categories of accredited investors. The most relevant for purposes of this discussion are as follows:

• An individual with a net worth of at least $1 million, not including the value of his or her primary residence; and

• An individual with income exceeding $200,000 in each of the two most recent calendar years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year.

Changes – Implementation of The JOBS Act – New Rule 506(c)

Thanks to regulations recently adopted by the SEC to implement the April 2012 JOBS Act, starting on September 23, 2013, companies will be able to use advertising and general solicitation in connection with securities offerings under new Rule 506(c).

Significantly, the form of advertising and solicitation will not be regulated by the SEC. So a person or entity can raise money via numerous mediums, including online and mobile social media, newspapers, specialized investment platforms, direct marketing, and solicitations on a company’s own website.

What’s the catch? Surprisingly, the new regulations are not particularly onerous (at least for now – see here). The major new requirements for Rule 506(c) offerings are:

• Sales may only be made to accredited investors; and

• Rather than the company “forming a reasonable belief” that its investors are accredited, it must take reasonable steps to verify that its investors are accredited.

Reasonable Steps to Verify that Investors Are Accredited

The new Rule 506c) details options for verification:

First, there is a “principles-based method of verification.” Under this, a company should assess a number of factors including “the nature of the purchaser and the type of accredited investor that the purchaser claims to be; the amount and type of information that the issuer has about the purchaser; the nature of the offering, such as the manner in which the purchaser was solicited to participate in the offering; and the terms of the offering, such as a minimum investment amount.”

If you don’t want to figure out what all of that means or how to implement it, you’re in luck. The SEC also adopted a non-exclusive list of methods that comply with the verification requirement.

Income Test

If an individual claims to be an accredited investor under the income test, the company cans review any IRS form that states the investor’s income for the two most recent years and then have the investor represent, in writing, that he or she has a reasonable expectation of reaching the income level needed to qualify as an accredited investor for the current year.

Net Worth Test

If an individual claims to be an accredited investor under the net worth method, the company can review certain documentation, including bank and brokerage statements and a consumer credit report. The investor must also represent, in writing, that he or she has disclosed all liabilities necessary to determine net worth.

The Easy Way Out

Failing to satisfy Rule 506(c)’s verification requirement could jeopardize the availability of the exemption, putting the company at risk of securities violations after it has already taken money from investors. But the SEC also provided a safe harbor that allows companies to rely on a written confirmation from a registered or licensed broker-dealer, investment adviser, attorney, or CPA, that such person has verified the purchaser as an accredited investor. This option will allow companies to eliminate some uncertainty and risk associated with complying with these new rules.

Takeaway

Under Rule 506(c), companies will soon be able to use Twitter, Facebook, and any other public communication to find investors. The main difference is that companies will have to take reasonable steps to verify that potential purchasers are actually accredited investors. While the SEC left this standard very flexible, it also detailed several methods that will satisfy the verification requirement. Companies wanting to publicly advertise their offering should seriously consider relying on one of these safe harbors to minimize the chance of any inadvertent securities law violation. Companies should also consider relying on third party professionals, who will likely be able to offer companies and investors a cost-effective compliance mechanism while eliminating a significant legal risk for the companies.