Until now, unless a company complied with the (quite expensive) rules for a registered offering, advertising an offering was prohibited. Prohibited advertisements included cold calling investors, advertisements in trade publications, website solicitation and distributing brochures (including at a horse auction). As of today, companies will be able to advertise to potential investors, provided that sales of the securities are made only to “accredited investors” whose status as such is “verified.”
While it has been possible to raise funds from “accredited investors” (e.g., individuals with income in excess of $200,000 for each of the previous two years, with that amount reasonably expected in the current year, or individuals with a net worth, excluding their primary residence and related debt, exceeding $1 million), finding enough interested accredited investors has been difficult for many businesses, especially for start-ups and small businesses. Under the old rule, a company could receive investments from accredited investors, but it was not allowed to advertise its offering or call on potential investors with whom the company’s representatives did not have a prior relationship. Placing an advertisement in the paper, “cold calling,” or soliciting investors on your website were effectively prohibited. While, subject to certain limitations, accredited investors could be identified through brokers, that route has been cumbersome and expensive.
Taking advantage of the new rule may greatly increase the chance of success of an offering. For example, a manufacturer needs an additional $2 million to expand its business, but after two months of calling on all its investor contacts, the manufacturer has commitments for only $500,000. Traditionally, its offering would have likely failed. However, under the new rule, the manufacturer may advertise its offering in a trade publication, making the opportunity known to potential investors located in California, Texas and wherever else that trade publication is distributed, and pitch the opportunity to potential investors anywhere and everywhere. Both of these alternatives would greatly expand the chance of the offering having success.
The new rule is not industry restricted – service provides as well as physical product businesses may use it. To that end both the software developer and the film producer may advertise the offering of securities. For instance, the new rule presents significant opportunities for raising funds for equine ventures, including stallion syndication.
There is no ceiling under the new rule on either the number of investors or the maximum amount that may be raised in the offering. That being said, there remain a number of particular requirements:
1. The issuer must “verify” the status of each investor as an “accredited investor.” There are numerous avenues through which verification may take place, including confirmation from a CPA, a lawyer, a securities broker-dealer or an investment advisor that he or she has taken steps to review an investor’s financial statements and determined that the income or the $1 million net worth requirement is satisfied. Third-party verification companies are already up and running.
2. Beware of Integration. Consequent to the “integration” rules, it will be important to clearly separate investments made by “friends and family” who are not accredited investors from the 506(c) advertised offering. If the offerings are “integrated,” which requires a technical legal analysis, the sales to non-accredited friends and family will taint the 506(c) offering, rendering the exemption unavailable.
3. Nothing about the new rule eliminates or limits the anti-fraud rules of the securities laws. Companies and their management still need to disclose all material information about the company and the risks of the investment. While there is no set formula, this most frequently takes the form of an offering circular that sets forth all company history, its prospects, biographies of directors and management, business plan, anticipated use of the funds, financials (either audited or reviewed) and pro-formas. Disclosure of risks is a defense to later suits charging fraud in the sale of the securities.
Raising needed capital will always be a difficult task for most businesses, but new Rule 506(c) should open new avenues for start-ups and growing companies. The above is a summary of the very detailed and technical rules regarding the Regulation D exemption from registration of securities. Advice of legal counsel should be sought before commencing any offering of securities. If you have any questions about the new rule, please contact Allison Donovan, Rich Mains or Tom Rutledge.