A fact of pursuing equity funding for your company is that every offering or sale of securities – whether stock, LLC interest, bonds, or other forms – is considered a public offering and must be registered with the federal Securities and Exchange Commission (SEC), unless the offering meets an exemption from registration. Many emerging growth companies do not realize the starting premise that in order to be in compliance with federal and various state securities regulations, the offering or sale needs to qualify for an exemption (such as various private offering exemptions).
One frequently relied-upon exemption is Rule 506, which is a part of the SEC’s Regulation D. However, a major limiting factor for Rule 506 offerings relates to whether sales are made to accredited versus unaccredited investors. Details of accredited versus unaccredited are a separate discussion, but think of unaccredited investors as ordinary individuals. Under the two subcategories of Rule 506 offerings [Rule 506(b) and Rule 506(c)], offerings and sales to unaccredited investors will either be impractical [in the case of 506(b)] or expressly forbidden [in the case of 506(c)]. As a result, if even a single offeree is not an accredited investor, Rule 506 is not a viable option.
So what is the company to do if it is planning a funding round but one or more of the investors are unaccredited? In this case, Rule 504 may “fit the bill.” Key advantages of Rule 504 are that the company is allowed: (a) to offer and sell securities to an unlimited number of investors, both accredited and unaccredited, and (b) to raise up to five million dollars (increased from one million dollars in 2016). As a result, early stage companies may find this exemption useful, especially when raising a seed round or smaller A round.
Like all private offering exemptions, Rule 504 comes with substantial limitations. First and foremost, general solicitation is absolutely prohibited – no posting to the company’s website or social media accounts, no ad in the Wall Street Journal, etc. Another concern is that while state securities regulations on Rule 506 offerings are highly limited (this was a key provision of the 2016 National Securities Markets Improvement Act), those regulators are not similarly restricted in relation to Rule 504 offerings. This means it is especially important for any company considering a Rule 504 offering to consider the states where the potential investors live and the regulatory regime in those states. There are other limits as well, which need to be understood before proceeding with the details of a Rule 504 offering.
One word of caution is that although sales to unaccredited investors are permitted under Rule 504, it may be unadvisable to make such sales, depending on the individual. The company should always be diligent to ensure that investors understand that investment in an early stage company is inherently risky and that the investors could experience a loss of their investment. In addition, while there are no specific disclosure requirements in a Rule 504 offering, it is vital that the company work with legal advisors to be sure that it is providing sufficient written disclosure regarding the company’s situation, business plan, management team, planned use of funds, and other key items. To sell equity in your company without this disclosure leaves an open highway for dissatisfied investors to later pursue a variety of remedies including rescission (i.e., you may have to give the money back!) and various forms of damages.
As a final note of caution, the above information is a high-level summary of securities law basics, and does not constitute legal advice, which can only be done based on the specific facts and circumstances of your specific situation; a company planning a raise should always work with legal advisors to be sure that they fully understand and comply with whatever federal and state regulations are applicable.