There are many ways for startups to raise capital. At the outset, entrepreneurs use their own funds and perhaps ask friends and family members to contribute or lend them money. As the startup grows, the startup might well decide to raise money by soliciting investment. This alternative requires compliance with Regulation D issued by the Securities Exchange Commission (“SEC”) if the amount sought is large, and possibly with state securities laws. For smaller amounts, compliance only with state securities laws is required. These laws and regulations are designed to protect investors and prevent fraud.
Unless an exemption applies, the federal Securities Act of 1933 requires a business that wants to offer stock for sale to raise capital to register the offering with the SEC. The registration forms require four categories of information:
The company must describe its properties and business.
The securities to be sold must be described, in detail.
The company should set forth so-called “risk factors” to disclose risks phased generally with all start-up and early phase companies.
The business must provide information about its management.
Financial statements must be provided. Independent accountants must certify the financial statements.
The registration materials, together with prospectuses, are made available for public inspection on the SEC’s EDGAR database.
Securities registration is an expensive and cumbersome process. To ease the burdens of registration on both startups and established businesses, the SEC promulgated Regulation D. This regulation allows a business to avoid registration if it complies with one of the exemptions from registration set out in the regulation.
There are three exemptions from registration, contained in two rules, Rule 504 and Rule 506. There used to be a Rule 505, but in 2016 the SEC repealed it and folded its provisions into Rule 504 and amended that rule.
Under Rule 504 of Regulation D, a security offering is exempt from registration with the SEC if the business raises no more than $5,000,000 over any twelve-month period. The securities offered must be restricted, meaning that the purchasers may not sell them for six months or one year, depending on the circumstances. In lieu of registration, this exemption requires the issuer to file a Form D with the SEC. Form D lists the names and addresses of the issuer’s promoters, executive officers and directors, but it includes little other information.
Rule 506 of Regulation D encompasses two exemptions from registration with the SEC. Unlike Rule 504 offerings, there is no limit to the amount of money that can be raised under Rule 506. Registrations exempt under Rule 506 also include the requirement of filing a Form D with the SEC.
The Rule 506(b) exemption has several requirements for exemption under Regulation D. They are:
General solicitation or advertising of the securities is forbidden.
There is no limit on the number of “accredited investors” who may buy the securities. The term “accredited investor” is defined in Rule 501(a). There are many definitions. Generally speaking, accredited investors consist of certain institutions and wealthy or high-income individuals.
The issuer may sell to no more than thirty-five unaccredited investors, but they must be “sophisticated” investors, able to evaluate the proposed investment.
The business must not give investors false or misleading information about the investment or exclude any information the investors should know.
Rule 506(c) exemption from registration under Regulation D applies only to accredited investors. It has a major advantage over Rule 506(b). General advertising of the investment is permitted. But that advantage comes with a disadvantage. When a business uses Rule 506(c) to raise money, the business has the burden of taking reasonable steps to make sure that the investors are, in fact, accredited investors. This may be done by reviewing financial documents such as W-2s, tax returns, bank and brokerage statements and credit reports.
Depending on how far along a startup is in its development, the entrepreneur is in the position of choosing which of Regulation D’s exemptions would be best to raise money for the startup. If less than $5,000,000 is needed over a twelve-month period, and the investors do not object to their securities being restricted from sale for six months to one year, the Rule 504 exemption is superior. The other two exemptions allow raising unlimited amounts. But under Rule 506(b), which can include unaccredited investors, there can be no advertising and accountant-certified financials are required. Rule 506(c) allows advertising, but all the investors must be accredited. Accordingly, the Rule 506 exemptions from registration under Regulation D will be more expensive to use than the Rule 504 exemption. The entrepreneur should consult with experienced counsel to make, and properly implement, the best choice of exemption.