Startup Financing

Startup financing may not be the oldest profession in the world, but it is something that many Entrepreneurs have to do in order to get their companies off the ground.

Experienced Entrepreneurs will tell you that raising money for your Startup will be hard, especially if you do not have a large pool of potential Investors in your network.

A common misconception is that Investors will flock to invest in companies if they have a great business idea or disruptive technology.

In reality, identifying Investors is never that easy, and Founders often find themselves pounding the pavement hoping to come across Investors willing and able to back their Startups.

There is no need to panic, however, because today’s Founders have many Investor networking resources available at their fingertips. Social media platforms like LinkedIn, Facebook and Twitter make it easier than ever to connect with like-minded and influential people across a huge variety of industries, including potential Investors. Targeted platforms, such as AngelList, are even more focused on showcasing Startups and Early-Stage Companies to potential Investors.

With so many digital networking tools available to Founders, you may find yourself tempted to publicize your Financing online. We get it – the idea of reaching hundreds, if not thousands, of potential Investors at the click of a button may be enticing, but, before you hit the “post” button, you’ll need to make sure that you’re following the important securities laws governing General Solicitation.

So, how can Founders use digital networking tools effectively to attract Financing for their companies, while staying above board with respect to securities laws?

Federal Regulation D – What is it?

Let’s start with a high-level review of Regulation D, the federal Private Placement Exemption under the Securities Act of 1933, as amended (the “Securities Act”). In general, a company that wants to raise money through the offer and sale of Securities in the United States must first register its Securities offering with the Securities and Exchange Commission (“SEC”), unless there is a valid exemption from registration under the Securities Act. Regulation D serves as one such exemption and is the most common Federal Securities Law exemption used for Private Placements.

In short, Regulation D allows companies, including Startups, to raise money through the issuance of Securities without going through the extensive and costly process of registering their offerings (i.e., through an IPO). However, there are rules that companies must follow to qualify for a Regulation D exemption, including those related to how companies engage and approach potential Investors.

Rule 506(b) vs. 506(c): Which horse to choose for the regulation rodeo

Traditionally, a “private offering” has meant just that – the private offer and sale of Securities (i.e., not with General Solicitation or advertising) to a small group of Investors who meet certain qualifications regarding their net worth and/or sophistication. However, recent amendments to Regulation D now permit companies to raise money using General Solicitation without registering their offerings with the SEC.

Specifically, Rule 506 of Regulation D provides companies with two different ways of engaging and approaching potential Investors – a private offering or an offering with General Solicitation. Rule 506(b) is the traditional “private offering” exemption, which does not allow the issuer to use General Solicitation to attract Investors or to publicize the Financing. Alternatively, Rule 506(c) is the newer “General Solicitation” exemption, which does allow an Issuer to use General Solicitation of Investors, with a few important caveats. For example, an Issuer who wants to use General Solicitation for its offering must verify an Investor’s Accredited Investor status before such Investor may receive specific information (i.e., terms) related to the Financing.

The table below highlights the important differences between Rule 506(b) and Rule 506(c):

	Rule 506(b) Private Offering	Rule 506(c) General Solicitation Offering
Communications with Investors:	No General Solicitation Advertising of security offering is not allowed Companies may approach Investors if there is a substantive, pre-existing relationship	General solicitation allowed Advertising allowed, including via social media, e-mail and offline methods
Eligible Investors:	Accredited Investors and up to 35 non-Accredited Investors who meet specific sophistication requirements	Only Accredited Investors are allowed to invest
Accredited Investor Verification:	Self-certification – typically, with an Accredited Investor Questionnaire	Company must follow SEC guidelines to verify Accredited Investor status Must verify an investor’s Accredited Investor status prior to providing them with specific information regarding the financing Vetting goes beyond just Accredited Investor Questionnaires. Learn more about verifying Accredited Investor status here
Offering Size:	No limit on offering size	No limit on offering size
Disclosure requirements:	Company decides on what information to provide, but must not violate anti-fraud prohibitions All information must be made available to both Accredited Investors and non-Accredited Investors Company must be available to answer questions	Company decides what information to provide, but must not violate anti-fraud prohibitions Company must be available to answer questions
Filing Requirements:	Must file a Form D with SEC Companion Blue Sky Law filings may be required	Must file a Form D with SEC Companion Blue Sky Law filings may be required
Intermediaries:	Not required, but if used must be a registered Broker-Dealer or exempt	Not required, but if used must be a registered broker-dealer or exempt

Once you pick a horse, you have to ride it

Once an Issuer has gone down the path of General Solicitation, it’s hard, if not impossible, to go back. The following are some issues to be aware of:

You cannot have your cake and eat it too. While Rule 506(c) allows companies to use General Solicitation for their Financing, companies cannot simultaneously hold a Rule 506(c) offering with General Solicitation at the same time that they are holding a Rule 506(b) private offering. Think about it – if Issuers were able to switch back and forth between these exemptions, then it would make it very easy to skirt the rules.
At least, not at the same time…While Issuers can hold a Rule 506(c) offering after completion of a Rule 506(b) offering, Issuers generally must wait at least six months before holding a Rule 506(b) offering after a Rule 506(c) offering has completed.

The Rule 506 exemption that a company chooses will impact what the company can and cannot do with respect to the Financing, and may impact its ability to raise additional money in the future. Before you go down the path of General Solicitation, it is important that you understand the differences between Rule 506(b) and Rule 506(c), as choosing the wrong one or violating the requirements of either may have serious consequences for your company.

Don’t get sly with the SEC

Although General Solicitation is available under Rule 506(c), for practical reasons, many Issuers still choose to raise money under Rule 506(b). However, some Issuers raising money under Rule 506(b) may push the envelope regarding General Solicitation, including through social media posts and e-mail blasts about their Financings. News flash: Your social media post is considered General Solicitation…and so is that mass e-mail blast.

We’ll tell you a little story. We once had a client who claimed that he wasn’t violating the rules regarding General Solicitation, because he had only e-mailed the terms of his offering to 125 of his “closest” friends. While it’s possible that this gentleman really did, in fact, have 125 friends, it was not likely that all of these relationships fit within the parameters of Rule 506(b), and he certainly did not vet each recipient’s Accredited Investor status prior to hitting “send.” The problem here was that this particular client was already raising money under Rule 506(b), so when he sent mass e-mails to his “closest” friends, he actually was engaging in General Solicitation. This called into question the company’s Rule 506(b) exemption for prior sales of Securities in the Financing and created a quagmire regarding the exemption that the company could rely on for future sales of Securities.

While certain companies know that they are pushing the envelope or crossing the line, many Founders do not realize when they are actually engaging in General Solicitation. For example, certain pitch fests, demo days and even press releases may be considered General Solicitation under certain circumstances. Whether a particular Investor communication qualifies as a General Solicitation requires a fact and circumstance specific analysis. We strongly encourage you to work with qualified legal counsel to ensure that you keep all of your investor communications above board and in compliance with the exemption that you intend to rely on for your financing.

Questions to ask yourself before hitting the “send” button:

If you’re thinking about raising money under Rule 506(c), there are a few practical questions you should ask yourself before you get started:

Are you ready and willing to vet your Investors’ Accredited Investor status? Asking Investors for their financial related information may be uncomfortable. Make sure you’re prepared to ask the right questions and to reject Investors who do not qualify.
Will you really reach an ideal Investor pool? While you generally can reach more people online than through traditional networking avenues, you should think about whether the potential Investors you are reaching will be ideal for your company. Remember that once someone invests in your company, you’ll have to deal with them for the long term.
Will you attract the right kind of attention for your company? Not all companies will benefit from General Solicitation, especially if your business concept is difficult to understand. While General Solicitation may work well for companies with flashy products and social-media savvy team members, it may not be a great choice for companies offering complex biotech solutions.

Raising money definitely is not easy, but don’t make the process even more difficult by failing to navigate the necessary securities law requirements. If you get it wrong even with the first seed offering, you may face regulatory issues that will derail your financing now and in the future.

Startup Financing – Rule 506 (b), Rule 506(c), and Federal Regulation D