Raising through Reg D 506c
Financing your company is an integral part of its success. It is often the most difficult aspect of running a startup. If you don’t have a large potential investor network, financing is especially challenging. It takes a lot more than a great idea or disruptive technology to get investors on board to invest.
Luckily there are many investor networking resources available to today’s founders. Digital networking tools like LinkedIn allow you to find and connect with a savvy pool of potential investors. There are even targeted platforms that are focused on shining a spotlight on early-stage startups to possible investors.
These tools can effectively attract funding to a startup. However, founders must be aware of the securities laws like Regulation D to ensure they are staying compliant.
What is Regulation D?
Regulation D came from the Securities Act of 1933 and is a set of federal securities laws that are regulated by the Securities and Exchange Commission (SEC). These laws regulate private security offerings. When a company offers securities, it must register with the SEC unless it qualifies for one of the exemptions to registration.
The extensive process and high cost of registering its offerings through an IPO for example are challenging for startups. Luckily, there are exemptions to these rules which allow startups to raise capital without going through this process. The two exemptions fall under Rule 506 (b) and Rule 506 ©.
Rule 506 (b)
Using this exemption, founders can raise an unlimited amount of money from as many accredited investors as they want. Up to 35 non-accredited investors can also finance the startup through the sale of restricted securities. Companies are barred from making general solicitations or advertising to sell their securities.
Under this rule, the startup must demonstrate there’s a prior relationship between the two parties to present the security offering to them. Accredited investors can self-certify their status. Conversely, non-accredited investors have to meet certain criteria that show they have knowledge and experience in business and financial matters to weigh the risks of investing.
Startups must determine what information they provide to accredited investors regarding the securities. It must not violate any antifraud prohibits of federal securities laws when doing so. That means the company can’t make any false or misleading statements or exclude information that could lead to this situation.
Disclosure documents must be given to non-accredited investors. These include financial statements and other documents found with Regulation A or registered offerings. All information provided to accredited investors must also be available to non-accredited investors. The company must also make themselves available to prospective purchasers to answer any questions.
Rule 506 ©
Founders can raise an unlimited amount of money under this exemption. Under Rule 506(c), a startup is allowed to broadly solicit and advertise their offerings as long as it meets the following two requirements:
- All investors in the offerings are accredited investors; The company can have an unlimited number of investors
- Company has taken reasonable steps to verify the accredited investor status of these investors. This may include reviewing documents like W-2s, credit reports, tax returns, and bank statements.
Before providing specific information about the securities, the startup must verify the investor’s accredited investor status.
Founders must also decide what information to provide to investors without violating anti-fraud prohibitions. As with Rule 506 (b), they must also be available to answer questions that investors may have.
Rule 506(C) makes it easier to founders to market their securities to other investors who they don’t have an existing or previous relationship with.
Investors who have “accredited investor” status is an individual who meets one of the four following requirements:
- Earned at least $200,000 ($300,000 if married) in each of the last two years and expects to make that much in the current year
- Has a net worth that totals $1 million dollars or more; This amount excludes the value of their home; Can be with or without their spouse’s assets
- Has a professional certification or credential in good standing that’s designated by the SEC; examples include a Licenses General Securities Representative (Series 7), Licenses Investment Adviser Representative (Series 65), and Licensed Private Securities Offerings Represenative (Series 82)
- Is an entity that satisfies the relevant criteria found in Reg D such as a trust, partnership, non-profit entity, limited liability company, bank, or corporation
Traditional ways of Fundraising
Your business must survive past the early stages to get past the business idea stage. Startup financing through Reg D isn’t a traditional method of raising funds, however. Using the right approach is important and will shape your company’s future. Here are some other options that are traditionally how founders fund their startups:
In the beginning, many entrepreneurs self-fund their startups. Since future investors typically like to see that you have “skin in the game,” this is a viable approach. Other benefits of bootstrapping your startup include keeping more profits for yourself. It’s common for founders not to take a salary as they are getting the startup off the ground. Some entrepreneurs will fund their startup by working side jobs or using money in a 401(K) retirement account.
Friends and Family
Another traditional fundraising option for founders is raising money through friends and family investors. It’s important to confirm whether or not there are securities restrictions that apply when using friends/family to fund your startup. Investments from friends and family are usually in the form of stock purchases or a loan. A clear written agreement is necessary to protect the relationship and outline how the money will be repaid.
Loans, Credit Cards, and other Debt Instruments
Although it’s challenging to get bank loans for a new business, many founders will finance by putting up their personal assets as collateral. Using equity in their house or personal credit cards is a common method. With steady sales, a startup might have the ability to open up a line of credit that goes against its accounts receivables or use business equipment as collateral. There are also several small business loan programs through the Small Business Administration (SBA) that might be options.
Small Business Grants
The SBA and other organizations offer grants to small businesses. Typically these grants are offered to small businesses that are run by minorities, veterans, or women. The local SBA chapter or Chamber of Commerce are good places to start looking for potential grant money. Some grants have stipulations such as the money must be repaid or conditions in the future, so make sure you’re aware of what you agree to.
Regulation D Opportunities for Founders
Why would founders use Regulation D to finance their startup instead of other options? There are many benefits to using the exemptions to raise money. It is a viable choice for startups that want to raise money fast to fund its operations.
It also has a favorable legal framework that enables founders to move outside of its network of family, friends, and acquaintances to a pool of potential investors. Regulation D allows the possibility for founders to solicit and advertise its securities to accredited investors.
Registering your securities through the SEC is a time-consuming and expensive process. The exemptions found in Regulation D enable startups to avoid this process and access unlimited funding (depending on your investors).
For privately-funded startups, using Regulation D has become the norm. All in all, Regulation D is a cost-effective and efficient way for early-stage startups to secure funding. Founders looking to use Regulation D to fund their company should note that due to its specific requirements and timeline, they must carefully plan using this tool.
Who should use Regulation D?
Using Regulation D for startup financing is not meant for everyone. Increasingly, startups are raising funds by using equity crowdfunding which is allowed under Reg CF and Reg A+ exemptions.
Filing Regulation D might not make sense if privacy is an issue. Every filing is made public through EDGAR. Competitors, the press, and others who have an interest in your company can get access to your startup’s information by using the search tool. Information that’s publicly available as part of your filing includes:
- Your startup’s business structure
- Amount and type of securities that you’re issuing
- Year the startup was formed
- How many people invested in the financing for your filing
- Identities and locations of all your executives, directors, and promoters
Since your Regulation D filing is public, your competitors and others in the industry will know that you’re issuing securities. So if you want to raise funds under the radar, that’s not going to happen by filing Regulation D. This could have repercussions on your overall marketing strategy as well.
Consider whether your startup will benefit from the general solicitation. For example, a company that offers a complicated biotech solution would likely not want to use this method to raise funds. Regulation D works better for companies that have a savvy social media team or flashy products to sell.
Another key consideration that founders should make before filing Regulation D is whether they will reach their ideal Investor pool. The potential investors should be ideal for your company since you’ll be dealing with them for a long time.
If you’re considering using Rule 506 © to raise funds, you must be willing to vet your investors on their accredited investor status. It can be uncomfortable to ask investors for their financial information and documents. You must be prepared to ask the appropriate questions and willing to reject investors who don’t qualify.
Limitations of Regulation D
Rule 506(b) and 506 © both have certain limitations that founders should consider before filing. Both of these rules require most investors to be accredited. There are between 12.5 million and 13.5 million accredited investor households in the U.S., according to verifyinvestor.com. You may need to have an existing relationship with these investors to receive funding from them.
Additionally, issuers of Rule 506 © must also take additional steps to verify the accreditation status of potential investors. Marketing your offerings online is allowed under 506 ©, which allows you to have a wider reach. With 506 (B), you don’t have this ability.
Although you can market under general solicitation under Rule 506 ©, the actual selling of securities must be completed by a representative of a registered broker-deal.
Finally, you must comply with various federal and state regulatory compliance. The federal rules generally require complying with the anti-fraud provisions in the Securities and Exchange act, maintaining accurate books and records, verifying the accreditation status of an accredited investor, and others.
Blue Sky Laws exist within state laws that startups must comply with. There are state securities laws in the states where the securities are sold. Thus, you must understand the state’s rules and keep up with requirements and timelines. Large fines and sanctions can occur if you aren’t properly following state and federal rules.
How to Start the Process of Regulation D
After weighing your options, you’ve determined that filing for Regulation D makes the most for your startup. To get the process started, you or a representative will need to register for EDGAR (Exchange Commission Electronic Data Gathering, Analysis, and Retrieval).
Follow these steps to register for EDGAR:
- From the registration page, begin a new registration
- Choose an EDGAR filing type (Regular filer, filing agent, investment company, etc.)
- Fill out your FORM ID application. You will need to input your full name, contact information, Tax Identification Number (TIN), and provide a signature.
- Print out a copy of your application and sign it. The application must also be notarized.
- Scan and upload the signed and notarized application
- Use EDGAR to complete your application process
Remember that EDGAR is open for filings on Monday through Friday, between 6 am and 10 pm EST. Once you’ve completed this process, you will receive a central index (CIK) number. That number will be used for all your dealings with the SEC that are through EDGAR.
Now that you are registered with EDGAR, you’ll need to complete and file Form D. Although filing Form D is more streamlined than an S-1, it’s still a complicated document. Working with an attorney is recommended.
Any securities you sell using a Reg D filing are due 15 days after it is sold. Due dates on the weekend are extended to the next business day.
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