Which is better for you – Reg. A+ or Rule 506?

Why it matters. Let’s begin by pointing out why Reg. A+ and Rule 506 matter to you. If you obtain funding for your business from a bank, the bank will often ask for a personal guarantee (which entrepreneurs avoid like the plague). But, if you obtain funding by selling equity (or by obtaining loans from private investors), there is no “personal guarantee” – so long as you comply with the federal and state securities laws. Compliance isn’t difficult: either (1) register your sale of shares (or Notes) with the SEC and state authorities as a “public offering,” or (2) qualify your offering under one of the several “exemptions from registration.” Rule 506 is one such exemption (some would say that Reg. A+ is also another exemption, because the approval process is streamlined, compared to the typical IPO registration process). If you do not register your offering or fall within an exemption, investors have the right to demand their money back (with interest!) and attorney fees for up to one year after they invest. They have a right to recover their money from the Company (of course) but also from the entrepreneur owners. There is the hidden personal guarantee in all of this!

Overview. There are several exemptions under federal securities law – the most popular being Regulation D (or “Reg. D”); within Reg. D, there are three different exemptions (Rules 504, 505 and 506) – the most popular being Rule 506. In addition, there are several exemptions under state law. Historically, entrepreneurs had to fit their offering into the framework of a federal exemption and a state exemption in each state in which an investor resided. However, the burden of state securities law compliance has been greatly reduced by changes in federal and state securities laws, so long as the entrepreneur complies with – you guessed it – Rule 506.

Rule 506 compliance can be relatively simple: (a) sell only to “accredited investors” (actually, you can also sell to up to 35 investors who are not accredited but if you do so you must provide them with burdensome additional disclosures about the business); (b) raise enough money to give yourself at least a six month cash runway (if you have to raise another round of funding within six months, the two offerings – the one you did now and the one you will do within the next six months – will be combined for purposes of testing whether the exemption has been met); (c) don’t use any “general solicitation or general advertising” to solicit investors (in other words, sell only to those to whom you or your advisors have some substantial pre-existing business relationship); (d) tell your investors they cannot resell the shares they purchase from you for up to one year after they invest; and (e) file a Form D with the SEC and with each state in which your investors reside (the SEC and most states accept electronic filing of these forms, so the process is very streamlined).

Comparing Rule 506 with Reg. A+:

• there is no SEC or state administrative review of your paperwork with the Rule 506 offering – draft it up, file the Form D (which doesn’t include the paperwork) and close your deal;
• there is no limit as to how much you can raise in a Rule 506 offering (Reg. A+ limits are $20 million for Tier 1 offering and $50 million for Tier 2 offering);
• under Rule 506, you are primarily limited to “accredited investors” (whereas in Reg. A+ there is no such limitation and you can sell your shares to orphans and widows); and
• As a practical matter, Rule 506 is restricted to “quiet offerings” – as noted, under Reg. D you generally cannot solicit your investors through general advertising. Technically speaking, recent SEC changes to Reg. D Rule 506 do allow entrepreneurs to solicit investors through general advertising – but here is the catch: with a “quiet offering” the entrepreneur can rely on the investor’s own “self-certification” of his or her status as accredited; with “loud offerings” (i.e., fundraising through general solicitation or general advertising), the entrepreneur must exercise some sort of due diligence to confirm that the investor is actually accredited (for example, according to the SEC, take a look at the investor’s tax return, his or her investment portfolio, or have a CPA or lawyer who is familiar with the investor write a letter confirming their net worth and income); this kind of disclosure and invasion of privacy is a non-starter for many investors.”

All in, it seems to us that the Rule 506 “quiet offering” will still be the path of least resistance for entrepreneurs; yet, there may be some particular deals where Reg. A+ is appropriate (for example, real estate investment trusts, or other deals which are not attractive to the investors who are already in the entrepreneurs’ network and so must be presented to a wider audience, etc.).

Bonus – Two Additional Traps to Avoid:

• If you pay someone to help you raise funds, and their pay is in any way contingent on the amount of funds raised, be sure they are registered broker/dealers;
• Besides the registration/exemption rule, federal and state securities laws also have strict anti-fraud rules – we can help you comply with these.