Many people think securities laws are only relevant to big companies in their billion dollar public offerings. Securities laws, however, are also relevant to your startup.
The general rule in the Securities Act of 1933 prohibits selling securities other than by means of a registration statement. Fortunately, the statue also provides certain registration exemptions for transactions that are not public offerings.
One critical concept under Regulation D is the general solicitation rule. Failing to comply with the general solicitation rule may cause a start-up to lose the exemption status. Under some circumstances, pitching your company could be deemed a general solicitation. Therefore, it’s critical for founders to pay attention to the Regulation D and the general solicitation requirements before pitching your company.
Safe harbors in Regulation D
Most startups rely on Regulation D, promulgated by the SEC as the exemption from the registration requirements of the securities laws. There are three main safe harbors in Regulation D – Rule 504, 505, and 506. Rule 504 and Rule 505 are less popular because the issuers have to comply with the securities laws in each state where they are selling securities (see previous post for more information of Rule 504 and 505).
The most commonly used exemption is Rule 506, which allows a company to raise an unlimited amount of capital from an unlimited number of accredited investors (see previous post for information of accredited investors). Rule 506 has two separate but related exemptions—Rule 506(b) and Rule 506(c). Rule 506(b) prohibits general solicitation while the new Rule 506(c), subject to a variety of conditions, allows offering through public advertising and general solicitation.
What is General Solicitation?
Regulation D doesn’t define general solicitation, but gives some examples of prohibited solicitations, including any advertisement published in any media (e.g., television, newspapers, magazines, Internet, radio, public seminars, or cold calls), and any meeting whose attendees have been invited by a general advertising.
When is a solicitation not general? The SEC interpreted the prohibition as requiring that the issuer (or a person acting on its behalf) has a “pre-existing relationship” with each offeree. Examples of pre-existing relationship including:
- Use an outside agent, such as a broker, to serve as an intermediary
- Use questionnaire to request investors providing self-verification regarding their financial status
- Use password protection to prevent general public from accessing investment information on the website
The New Rule 506(c) Under the JOBS Act
On July 10, 2013, the SEC revised Regulation D to remove prohibition on general solicitation and general advertising in offerings and sales under Rule 506(c), provided that all purchasers of the securities sold in these offerings are accredited investors. The major differences between Rule 506(b) and Rule 506(c) are summarized in the chart below.
|Rule 506(b)||Rule 506(c)|
|Limitation on amount of capital raising||Unlimited||Unlimited|
|Type of investors||Accredited investors and up to 35 non-accredited sophisticated investors||Only accredited investors.|
|Accreditation process||Allow Self-certification||Take reasonable steps to verify accredited investor status|
Although Rule 506(c) allows general solicitation, which seems to be a huge advantage, there are several reasons an issuer may prefer to rely on Rule 506(b).
First, Rule 506(c) requires an issuer to take “reasonable steps” to verify that all investors in the offering are accredited investors. According to the SEC guidance, self-certification by investors, for instance questionnaires in which investors self-report their income or net worth, does not satisfy Rule 506(c)’s standard. Instead, issuers must generally request investors to provide tax returns, bank statements, or credit reports to demonstrate their income or net worth. Not only will this requirement add an additional administrative burden on an issuer, it may also alienate some investors.
More importantly, Rule 506(b) is a non-exclusive safe harbor. This means that an issuer can still use the general Section 4(a)(2) exemption under the Security Act if the offering fails to satisfy Rule 506(b)’s requirements. However, an issuer using general solicitation in reliance on Rule 506(c) does not have this fall-back option as general solicitation is prohibited by the Section 4(a)(2) exemption.
Finally, the SEC has also proposed to add new disclosure requirements to Rule 506 and Form D, which may offset Rule 506(c)’s Advantages. For example, the proposed rule requires a Rule 506(c) issuer to file an advance Form D at least 15 days before any general solicitation (instead of the current requirement, 15 days after the first sale). The proposed rule also requires an issuer to file the general solicitation materials, which must have specific mandated legends, with the SEC on or before the date of the general solicitation. These requirements may be difficult or impossible to comply with in practice.
If you do decide to rely on Rule 506(b), here are some tips to help avoid running into the general solicitation trap.
- Limit offers and solicitations to persons with whom you have a “preexisting substantive relationship.”
- When attending a pitch event, make sure the attendees are limited to persons with whom the event organizer has a pre-existing relationship or who have been contacted through a network that the event organizer can rely upon to create that relationship.
- Avoid making “offer” to people you do not have a preexisting relationship.
- To avoid making offer, only provide factual business information and do not include projections.
- Monitor the activities of any agents or representatives to ensure that they are not performing general solicitations.
- Prepare a list of likely investor targets as early in the process as possible and stick to it.
- Be very circumspect in any interactions with the press.
- Keep strict control over the dissemination of offering materials.
- Use password protection and online questionnaires to prevent nonaccredited investors from accessing investment information on a website.
- Review your website content.