Private FinancingsThere’s nothing more relaxing than a long drive right? The stereo’s bumping, you’ve got your bouncing baby startup strapped tightly in the car seat in the back, and you’re looking for ice cream, because your startup is about to startup some major crying without ice cream. If you speed, you’ll get to it quickly. If you jump the curb and cut through someone’s lawn you might get to it even faster. But all of that is illegal and dangerous. Do it even once and there’s a chance you could suffer a calamitous outcome, and above all, you’d be putting your precious baby startup in jeopardy. The same applies to private company financings. You’ve GOT to know and adhere to the “rules of the road” or all of the work you’ve done up to this point could be for not.

The rules for most private company financings are found under the Securities Exchange Commission’s (SEC) “Rule 506,” which dictates how individuals and startups must conduct themselves when seeking investment funds by selling securities (a share of stock, a convertible note, etc.). Running afoul of these rules can not only prevent you from raising the funds that you need, it could subject your personal assets to exposure (no corporate liability shield will be there to protect you), and in the worst case scenario, subject you to civil and criminal penalties. So, these rules can’t be taken lightly.

The Rules of the Road for Private Company Financings under Rule 506

Before you start your securities offering, you have to identify an applicable securities law exemption from registration. What does this mean? Each time your company issues a security, the company must register the securities offering with the SEC and state securities divisions with jurisdiction unless there is an applicable exemption from registration under the securities laws. Meaning, you have to identify a specific provision under both state and federal law that says that either for the type of transaction you are involved with or the type of securities you are selling, you do not have go through a registration process with the SEC or with the particular state. Registration is a very expensive process. Thus, exemptions are key.

In general, for most private companies, the exemption most frequently relied upon in the fund raising context is Rule 506 under federal Regulation D. Under Rule 506, companies can raise an unlimited amount of money, as long as they abide by the following “rules of the road”:

1) General Solicitation, Know What You Are Doing – Rule 506 used to flat out prohibit the offer or sale of securities by any form of general solicitation or general advertising.  Now Rule 506 is split into two rules – Rule 506(b) (the “old rule 506”) and Rule 506(c).  Under old Rule 506, now known as 506(b), you still can’t generally solicit. The rule states that “neither the issuer nor any person acting on its behalf shall offer or sell the securities by any form of general solicitation or general advertising.” Advertising seems like a great way to find prospective investors, but that’s a no-no under Rule 506(b).  No matter how tempting it is to post to Twitter or LinkedIn that you are raising money, don’t do it.

Under new Rule 506(c), you can generally solicit, but if you do, you have to take additional steps to verify that all of your investors are in fact accredited investors. The rules say that this means you have to ask them for their Forms W-2, or their personal financial statements. Your prospective investors may get upset when you ask them for this information. Or they may back out of your deal. Thus, before you generally solicit, consider carefully what you are getting yourself into. Red this blog post: 10 Things To Consider Before Generally Soliciting.

2) Accredited investors only – One of the keys in raising money in Rule 506 offerings is to accept funds only from accredited investors. If you accept funds from only accredited investors, there is no specific information that you need to provide (no audited financials, for example). Note: that doesn’t mean you don’t have to provide information; it just means that there is no specific format for the types of information you have to provide. You’re still subject to the anti-fraud requirements of federal and state law. Here’s another important note: The rule that says that in a Rule 506(b) offering you can raise money from up to 35 non-accredited investors —don’t be misled. Keep on reading the rule. If you do, you will see that, if you accept money from any non-accredited investors (even one), you will have to provide the potential investors a voluminous amount of information. The same as in a registered offering. Read—very, very expensive. You probably don’t want to do this. So, accept money from accredited investors only.

Accredited investors generally are:

High net worth individuals – The SEC defines this individual as “a natural person” (a human being as opposed to a “legal person” such as a corporation) who has individual net worth (meaning, net of debt), or joint net worth with the person’s spouse, in excess of $1 million at the time of the purchase, not including the value of their primary residence (vacation homes can count).

High income person – This is a natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year.

Entities In Which All Owners Are Accredited – This can be a business in which all of the equity owners are accredited investors.

Director or Executive Officers of the Company – These individuals can be a director, executive officer, or general partner of the company selling the securities.

Certain Other Entities – Entities with assets in excess of $5 million not specifically created in order to acquire the securities offered can qualify.

3) File Forms D – In a Rule 506 offering, you are supposed to file a Form D with the SEC and with most states in which investors are resident within 15 days of first raising money.

4) Be careful with finders – Be careful with folks who want to charge you a fee to help you raise money. First, any such fees will have to be disclosed to investors as part of the offering. Second, the SEC and state securities regulators take a dim view of finders, especially finders who are not registered as broker/dealers (for an example, see The SEC will want you to disclose on your Form D who you used as a finder in your financing. And certain states give investors the right to rescind investments in which unregistered finders were involved (e.g., see California’s law on finders).

5) Beware of “integration” with other offerings – In Rule 506 offerings, you have to be careful, because all sales that are part of the same offering must meet all of the terms and conditions of Regulation D. So, if you sold stock to friends and family who were not accredited three months ago—and now you want to sell stock to investors in an all accredited investor offering—your prior stock sales to your friends and family may be “integrated” into, and disrupt, your planned all accredited offering and not allow you to rely on Rule 506.

6) No Bad Actors – If you are a regular reader of this blog, then you may have heard the term bad actors mentioned. For a full detailed description of bad actors see the article Willful Blindness: The Rule 506 Securities Law Exemption and the New “Bad Actor” Rules. The SEC has now adopted the final rules that prohibit companies from using Rule 506 if bad actors are involved with the company. The new rules are now in effect. You can read them here:

If you are raising money under Rule 506, you now have to investigate your directors, executive officers, 20% or greater shareholders, and other officers involved in your offering. If they are “bad actors,” you have to make disclosure of this to your investors, and or you may not be able to use Rule 506 at all. Always consult counsel on your offerings.

Be Careful

So let’s recap: don’t advertise for funds unless you have carefully thought it through, file your Forms D with the SEC and state securities regulators, choose only accredited investors, be wary of finders, look out for integration, and keep your eye out for bad actors. It seems like a lot, but nobody said that there weren’t going to be potholes in the road to your dreams. We just know that swerving around them is a heck of a lot less damaging than plowing into them. Now drive safely…somebody needs some ice cream.

About Joe Wallin

Joe Wallin focuses on emerging, high growth, and startup companies. Joe frequently represents companies in angel and venture financings, mergers and acquisitions, and other significant business transactions. Joe also represents investors in U.S. businesses, and provides general counsel services for companies from startup to post-public.
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