Crowdfunding Lawyers

Understanding the Key Differences Between Rule 506b and 506c for Savvy Investors

July 24, 2024
Understanding the Key Differences Between Rule 506b and 506c for Savvy Investors

When raising capital, it’s essential for issuers to understand the key differences between Regulation D Rules 506b and 506c. The primary distinctions hinge on investor eligibility, fundraising advertising, and the steps required to verify accredited investors. Rule 506b allows for a mix of accredited and up to 35 sophisticated, non-accredited investors without the need for public solicitation, while Rule 506c paves the way for general advertising but requires all investors to be verified as accredited. Throughout this article, we will dissect these critical differences to guide issuers in selecting the most suitable exemption for their funding needs.

Key Takeaways

  • Rule 506(b) of Regulation D allows companies, including smaller companies, to raise capital from an unlimited number of accredited investors and up to sophisticated, 35 non-accredited investors without public advertising but requires a pre-existing relationship and self-accreditation by investors.
  • Rule 506(c) permits general solicitation and advertising in capital raising but necessitates issuers to take reasonable steps to verify the accredited status of all investors, without the option to include non-accredited investors.
  • Both Rule 506(b) and Rule 506(c) allow for unlimited fundraising amounts and preempt state securities laws, but have distinct rules regarding investor eligibility, marketing practices, and verification processes, impacting an issuer’s decision on which rule to use based on their specific fundraising strategy.

What is Regulation D?

Regulation D, often referred to as Reg D, is a part of U.S. securities law that provides exemptions allowing companies, including smaller companies, to raise capital through the sale of securities without the need to register those securities with the Securities and Exchange Commission (SEC). This significantly simplifies the fundraising process while still maintaining robust investor protection measures.

The role of the SEC in regulating private placements

The U.S. Securities and Exchange Commission (SEC) serves as the guardian of the financial markets, ensuring their integrity and protecting investors. It oversees the offering and sale of securities, including those sold by private companies, in accordance with the Securities Act. Every offer and sale of securities must either be registered with the SEC or conducted under an exemption from registration, regardless of the company’s size or the number of investors involved.

This broad interpretation of security offerings includes actions like discussing fundraising with friends or making social media posts about investment opportunities. Therefore, the SEC’s role in regulating private placements is pivotal in maintaining market trust and facilitating capital formation.

Why companies choose Reg D for securities offerings

Regulation D is a beacon of hope for many companies, particularly startups and small businesses, seeking to raise capital. It offers a safe harbor that provides clear compliance guidelines and shields against potential regulatory storms. Companies often choose Regulation D as it:

  • Streamlines the fundraising process compared to public offerings
  • Allows for private placements of securities
  • Provides exemptions from certain registration requirements
  • Offers flexibility in terms of the types of securities that can be offered
  • Limits the SEC involvement to a notice filing of Form D

By utilizing Regulation D, companies can navigate the fundraising process more efficiently and effectively.

Overview of Rule 506(b)

Rule 506(b) of Regulation D is a popular choice for private securities offerings due to its flexibility and straightforward requirements. This rule allows companies to:

  • Raise capital from an unlimited number of accredited investors
  • Raise capital from up to 35 sophisticated non-accredited investors
  • Conduct the offering without public advertising or solicitation.

Requirements and limitations of Rule 506(b)

Although Rule 506(b) offers considerable flexibility, it comes with its own set of requirements and limitations. For instance, this rule does not permit public advertising or solicitation, ensuring that fundraising occurs through private channels without the use of media, public events, or broad-based communication. Furthermore, Rule 506(b) requires issuers to file Form D with the SEC within 15 days of the first sale of securities.

Despite these limitations, Rule 506(b) offerings are generally exempt from state laws, simplifying the compliance process for issuers. However, issuers are still required to file notice and pay a fee in every state (except Florida) within 15 days of the first sale to an investor within each state.

Accredited investor criteria

 

Investor

Under Rule 506(b), issuers can raise capital from an unlimited number of accredited investors and up to 35 non-accredited, sophisticated investors without public advertising. However, if only accredited investors are involved in a Rule 506(b) offering, the issuer is exempt from disclosure information that are otherwise necessary for non-accredited investors. This allows issuers to leverage their network of investors without the need for verification of each investor’s accreditation status, making it a favored choice for many private fund management.

Limitations on general solicitation and advertising

While it offers a number of advantages, Rule 506(b) does come with certain limitations, particularly in the realm of advertising and solicitation. Issuers using Rule 506(b) cannot publicly advertise or solicit investments, meaning fundraising must occur through private channels without the use of media, public events, or broad-based communication.

This restriction serves to maintain a private investment environment where issuers and investors are already somewhat familiar with each other, particularly in the context of primary residence investments.

Allowance for up to 35 non-accredited investors

Another distinguishing feature of Rule 506(b) is the allowance for non-accredited investors. This rule enables private funds to raise capital from a maximum of 35 non-accredited investors, provided these investors meet the sophistication criteria and are supplied with additional disclosure documents similar to those provided in Form 1A  required under Regulation A.

Sophistication generally means that by the investors background, education, work history, or financial representative has the knowledge and understanding of the investment, it’s structure, terms, and risks.

This provision provides issuers with the flexibility to engage a wider range of investors, increasing the potential pool of capital.

Advantages of using Rule 506(b)

Rule 506(b) offers a number of advantages for issuers. For one, this rule is exempt from state blue-sky laws, reducing the compliance burden on issuers. Additionally, investors in 506(b) offerings can self-verify their accredited status, simplifying the process for general partners.

Moreover, if only accredited investors are involved, general partners can avoid submitting extensive disclosure documents to the SEC that are required for non-accredited investors. These advantages make Rule 506(b) a preferred choice for many issuers.

Overview of Rule 506(c)

On the other side of the coin, we have Rule 506(c), a newer addition to Regulation D. Introduced in 2013 as part of the JOBS Act, this rule offers a more modern take on private securities offerings, with a distinct set of regulations that cater to the needs of a digital age.

Requirements and limitations of Rule 506(c)

Rule 506(c) is characterized by stricter accredited investor requirements compared to Rule 506(b). Unlike its counterpart, Rule 506(c) allows for the public advertisement of securities offerings, but all investors must be verified as accredited. This means that, while issuers can reach a wider audience, they also bear a heavier burden to verify the accreditation status of their investors.

Unlimited fundraising amount

Similar to Rule 506(b), Rule 506(c) also allows issuers to raise an unlimited amount of capital without a predetermined cap on the investment sum.

This means that the potential for fundraising under Rule 506(c) can be as significant as under Rule 506(b).

Accredited investor criteria

In contrast to Rule 506(b), Rule 506(c) has the following characteristics:

  • It is exclusively available to accredited investors, with no provision for non-accredited participants.
  • Issuers are required to take reasonable steps to confirm the accredited investor status of participants. Most frequently verification is attained through a professional opinion provided by the investor’s CPA, attorney, or broker-dealer (financial advisor). There are other methods of verifying accredited investor status including reviewing tax returns or bank statements, but the professional opinion is most common.

Ability to use general solicitation and advertising

One of the key features of Rule 506(c) is the ability to use general solicitation and advertising. This means that issuers can use a variety of marketing channels, from social media to traditional media, to reach potential investors, expanding the pool of potential investors. However, all investors must be accredited, underscoring the importance of the verification process.

Verification of accredited investor status

Under Rule 506(c), issuers are required to take ‘reasonable steps’ to verify that all investors are accredited. These steps can include reviewing financial documents, such as tax returns or bank statements, or obtaining written confirmation from professionals like attorneys, broker-dealers (financial advisors), or CPAs. This verification process, although rigorous, helps maintain the integrity of private placements and limits participation to investors who are likely to understand and bear the investment risks. In our (Crowdfunding Lawyers) experience, 80% or more of the verifications happen through the professional opinions.

Advantages of using Rule 506(c)

Despite its stricter requirements, Rule 506(c) offers several advantages. Its allowance for general solicitation and advertising can potentially lead to more rapid capital accumulation and a quicker attainment of full subscription. Additionally, investors in Rule 506(c) offerings are typically sophisticated and financially experienced, which may lead to a more knowledgeable and robust base of investors for the issuer.

Key Differences Between 506(b) and 506(c): Distinct Paths to Raise Capital

Now that we have explored both Rule 506(b) and Rule 506(c), it’s time to delve into their key differences. These two rules offer unique paths to raise capital, with distinct regulations regarding investor eligibility, marketing practices, and verification procedures. Understanding these differences can help issuers select the rule that best aligns with their fundraising goals and capabilities.

Investor Pool: Accredited vs. Sophisticated Participants

Rule 506(b) accommodates a mix of accredited and sophisticatednon-accredited investors, while Rule 506(c) is exclusively for accredited investors. This difference can significantly impact an issuer’s investor pool and consequently, their fundraising strategy.

For instance, issuers with a wide network of non-accredited investors might find Rule 506(b) more advantageous.

Marketing and Solicitation Flexibility

The ability to advertise and solicit investments is another key difference between Rule 506(b) and Rule 506(c). While Rule 506(b) prohibits general solicitation, Rule 506(c) permits it, allowing issuers to advertise their offerings broadly and solicit investments from the public.

This flexibility in marketing and solicitation can prove advantageous for issuers seeking to reach a wide pool of potential investors.

Verifying Accreditation: Trust but Verify vs. Prove It

The verification process for investor’s accreditation status also differs between Rule 506(b) and Rule 506(c). Under Rule 506(b), investors can self-certify their accreditation status. However, Rule 506(c) requires issuers to take reasonable steps to verify the accreditation of all investors, which may include reviewing tax forms or bank statements, or obtaining professional certifications.

This difference in verification requirements can affect the ease and speed of the process to raise money through fundraising.

Navigating Investor Eligibility and Verification Procedures

Understanding and navigating investor eligibility and verification procedures is crucial for issuers to assure compliance with the chosen rule and successful capital raising. Whether an issuer opts for Rule 506(b) or Rule 506(c), they must be well-versed in identifying eligible investors and conducting the requisite verification procedures.

Establishing a Pre-existing Relationship

Under Rule 506(b), issuers are required to have a substantive and pre-existing relationship with potential investors before offering them investment opportunities. This pre-existing relationship must be formed before the commencement of the securities offering or through a broker-dealer or investment adviser before their involvement in the offering. This requirement helps maintain the private nature of Rule 506(b) offerings and ensures that issuers and investors have a certain level of familiarity with each other.

Conducting Reasonable Steps to Verify

Rule 506(c) stands in contrast with other rules under the SEC’s Regulations by requiring issuers to take ‘reasonable steps’ to ensure that all investors are accredited. This verification process is necessary to comply with the regulation. These steps can include reviewing financial documents, such as tax returns or bank statements, or obtaining written confirmation from professionals like attorneys, broker-dealers, or accountants.

While this verification process can be more rigorous compared to Rule 506(b), it ensures that only financially sophisticated individuals or entities participate in Rule 506 c offerings.

Compliance and Legal Considerations: Balancing Transparency with Practicality

Balancing transparency with practicality is crucial when it comes to the disclosure requirements under Rule 506(b) and Rule 506(c). While Rule 506(b) requires more extensive disclosures for non-accredited investors, Rule 506(c) focuses on verifying the accreditation status of all investors. Understanding these disclosure requirements can help issuers ensure regulatory compliance while effectively communicating with potential investors.

Additional Disclosure Documents for Non-Accredited Investors

Non-accredited investors participating in a Rule 506(b) offering must be provided with disclosure documents similar to those of a registered offering. These documents provide non-accredited investors with pertinent information about the issuer and the offering, helping them make informed investment decisions. Moreover, if any information is voluntarily provided to accredited investors, it must also be made available to non-accredited investors.

The Burden of Proof for Issuers

On the other hand, Rule 506(c) places the burden of proof on issuers to verify the accreditation status of all investors. This requires issuers to take reasonable steps, such as reviewing tax returns or bank statements or obtaining written confirmation from professionals like attorneys or accountants.

Though rigorous, this verification process ensures that only financially capable individuals or entities participate in Rule 506(c) offerings.

Filing Essentials: Form D and Regulatory Risks

Another crucial aspect of private securities offerings under Regulation D is the filing of Form D with the SEC. Both Rule 506(b) and Rule 506(c) require issuers to submit this form within 15 days of the first sale of securities. However, failure to comply with this requirement can lead to serious regulatory consequences.

Timely Submission Post-First Sale

Timely submission of Form D is crucial for issuers. This form must be filed with the SEC within 15 days following the first sale of securities in both Rule 506(b) and Rule 506(c) offerings. Additionally, in all states except Florida, there is an additional filing of the Form D and payment of filing expenses. This deadline is important to note, as missing it could lead to regulatory consequences.

The filing fees charged by states is generally between $100 to $600 whether there is one or 100 investors residing in the state. The primary outliers are Florida which requires no filings and New York which currently charges a $1800 filing fee.

Consequences of Non-Compliance

The consequences of non-compliance with SEC filing requirements can be severe. Failure to meet these requirements could lead to:

  • A ban from using the Rule 506 exemption
  • Civil fines
  • Disqualifications from other Regulation D exemptions
  • Orders to cease and desist
  • Injunctions
  • Possible restitution
  • In certain cases, criminal penalties.

Therefore, issuers should ensure they are well-versed in the filing requirements and are diligent in their compliance efforts.

Importance of Legal Counsel in Navigating Reg D Offerings

Navigating Regulation D (Reg D) offerings can be a complex and challenging process, requiring a deep understanding of securities laws and regulations. Legal counsel plays a crucial role in ensuring that companies conducting Reg D offerings are compliant with the law and avoid potential pitfalls along the way.

Other benefits of seeking legal counsel are:

  1. Risk Mitigation: By having experienced legal counsel on board, companies can identify and mitigate potential risks associated with Reg D offerings, protecting themselves from legal issues in the future.
  2. Due Diligence: Legal professionals conduct thorough due diligence to verify the legitimacy of the offering, the company’s financials, and other critical aspects, providing an added layer of credibility to potential investors.
  3. Documentation: Lawyers assist in drafting and reviewing the documentation required for Reg D offerings, such as private placement memorandums and subscription agreements, ensuring accuracy and completeness.
  4. Investor Protection: Legal counsel helps uphold investor protection by ensuring that all disclosures are transparent and that investors are fully informed about the risks involved in the investment.

When embarking on a Reg D offering, having a knowledgeable team of lawyers by your side can make all the difference. Crowdfunding Lawyers specialize in securities laws and regulations, making us the ideal partners for companies seeking to navigate the complexities of Reg D offerings.

By choosing Crowdfunding Lawyers for your legal counsel needs, you can benefit from:

  • Expertise in securities laws and regulations
  • Tailored legal advice specific to crowdfunding and Reg D offerings
  • Guidance on compliance matters to ensure a smooth offering process
  • Dedicated support in drafting essential documentation and disclosures
  • Peace of mind knowing that your offering is conducted in accordance with the law

For reliable legal counsel and expert guidance in navigating Reg D offerings, consider partnering with Crowdfunding Lawyers to safeguard your offering’s success and maintain compliance every step of the way.

Capital Raising Strategy: Which Rule Fits Your Goals?

The choice between Rule 506(b) and Rule 506(c) should align with the issuer’s specific marketing plans. This includes assessing their existing investor pool, their ability to meet fundraising goals with or without public advertising, and their ability to verify investors’ accreditation status.

Assessing Your Investor Network

The composition of an issuer’s investor network can significantly influence the choice between Rule 506(b) and Rule 506(c). For instance, issuers with a wide network of non-accredited investors might find Rule 506(b) more advantageous, given its allowance for non-accredited investors.

Conversely, if an issuer’s network predominantly consists of accredited investors, Rule 506(c) could be the more practical route, given its provision for general solicitation and advertising.

Considering the Impact of Advertising

The potential impact of advertising is another key factor to consider when choosing between Rule 506(b) and Rule 506(c). If an issuer aims to reach a wider audience and rapidly accumulate capital, Rule 506(c) could be a more suitable option, given its allowance for general solicitation and advertising. However, this strategy also necessitates a more rigorous verification process for investor accreditation, which may require additional resources.

Alternatives to Rule 506 Offerings: Exploring Regulation CF

Beyond Rule 506(b) and Rule 506(c), there are other pathways for capital raising. One such alternative is Regulation Crowdfunding (Reg CF), which offers unique regulatory requirements and investor limitations, providing a different approach to fundraising.

Regulation Crowdfunding Basics

Reg CF requires the following:

  • All transactions must be conducted online through a platform registered with the SEC, such as a broker-dealer or funding portal.
  • Non-accredited investors are subject to individual investment limits within a 12-month period when participating in a Regulation CF offering.
  • Securities purchased through a crowdfunding offering generally cannot be resold for at least one year, imposing a mandatory holding period.

Comparing Regulation CF with Rule 506(b) and Rule 506(c)

When comparing Regulation CF with Rule 506(b) and Rule 506(c), several differences emerge. Unlike Rule 506 offerings, which have restrictions on investor types, Regulation CF allows companies to raise funds from both accredited and non-accredited investors. However, it is subject to a maximum capital raise limit of $5 million in a 12-month period, making it a more suitable option for smaller-scale funding needs.

Thus, while Regulation CF offers a more inclusive approach to fundraising, it may not be suitable for all issuers.

Frequently Asked Questions

FAQ

What is the key difference between Rule 506(b) and Rule 506(c)?

The key difference between Rule 506(b) and Rule 506(c) is in investor eligibility and marketing practices. Rule 506(b) allows a mix of accredited and non-accredited investors and prohibits general solicitation, whereas Rule 506(c) is exclusively for accredited investors and permits general solicitation.

Can non-accredited investors participate in a Rule 506(c) offering?

No, non-accredited investors cannot participate in a Rule 506(c) offering as it is exclusively for accredited investors.

What is the main advantage of using Rule 506(b) for fundraising?

The main advantage of using Rule 506(b) for fundraising is that it allows for a mix of accredited and non-accredited investors, providing a larger pool of potential investors for the offering. This can help in raising capital more effectively.

What is the main advantage of using Rule 506(c) for fundraising?

The main advantage of using Rule 506(c) for fundraising is the ability to reach a wider audience of potential investors through general solicitation and advertising. This can significantly increase the chances of attracting investment.

What is Regulation Crowdfunding (Reg CF)?

Regulation Crowdfunding (Reg CF) is an alternative capital raising pathway with unique regulatory requirements and investor limitations, offering a different approach to fundraising.

Seeking Legal Help To Ensure Compliance

In conclusion, understanding the differences between Rule 506(b) and Rule 506(c) is crucial for issuers looking to effectively raise capital. Both rules offer distinct pathways to fundraising, each with its own unique set of requirements and limitations. By carefully considering their fundraising goals, investor network, and marketing strategy, issuers can select the rule that best fits their needs.

Navigating the world of private securities offerings can be complex, especially when dealing with financial and business matters and attempting to sell securities. As such, it is always advisable to seek professional advice to ensure compliance and successful raising capital.

Contact Crowdfunding Lawyers today!

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