I enjoy strolling the aisles of my favorite hardware store to peruse the latest new tools that can help a hapless individual like me complete a home improvement project quicker and more effectively without making emergency calls to professionals to fix my mistakes. Just like there is a right tool for every project, but not every tool is suited for every task, entrepreneurs trying to build and grow their businesses have a selection of tools available to them when looking to raise capital. Let’s explore what tool might be best for your business.
First, a quick primer on securities regulation. Federal and state law requires companies raising capital through a securities offering to either register their offering with the regulator or qualify for an exemption. The definition of a security is incredibly broad and includes stock, LLC interests, convertible notes, SAFEs, many digital assets, warrants and a variety of other instruments that financial professionals dream up. The following are common tools for raising capital outside of an IPO or traditional debt financing with a bank.
Old reliable
Like the well-worn hammer, Rule 506(b) of Regulation D has been widely used to raise large amounts of capital for entrepreneurs. If your network consists of high-net-worth individuals or you know venture capital firms or family offices that are eager to fund your business this is the tool for you. Rule 506(b) is easy to comply with if you sell securities solely to accredited investors. Generally, an accredited investor is an individual with a net worth in excess of $1 million not including the value of their primary residence or annual income in excess of $200,000 individually or $300,000 with a spouse. Entities or trusts with assets of more than $5 million or that are owned solely by accredited investors also qualify. This exemption just requires a simple notice form be submitted to the SEC and the entrepreneur cannot publicly solicit investors for the offering. Importantly, states are preempted from regulating Rule 506(b) offerings. There is no limit on the amount sold or number of investors participating in the offering. This is the exemption for the well-connected entrepreneur who has high net worth individuals or institutional investors in their network.
Rarely used, but effective when needed
Let’s be honest, how many people regularly use the awl, file or random odd sized sockets lurking in your toolbox? Like those random tools, there are exemptions available for entrepreneurs who want to raise modest amounts of money from non-accredited investors in either just one state or a small number of states. If just raising money from investors in one state, a federal intrastate exemption is available that doesn’t have any limits on how the offering is conducted. If you are only selling to investors in two or three states, then you can rely upon Rule 504 of Regulation D provided your business limits the size of the offering to $5 million or less and submits a simple notice form with the SEC. In either case, the offering will still need to comply with state securities regulation in each state where investors reside or where your business is located. This exemption is designed for the entrepreneur with a locally based business that can limit their capital raise to a relatively small geographic area and is willing to accept the challenges of state securities regulation.
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The new tools
These are the shiny new tools that entice you as you walk down the aisle. Crowdfunding offerings are new, have received a lot of buzz and allow entrepreneurs to utilize modern technology to market their securities to the masses. The most common forms of crowdfunding offerings are:
- Regulation CF: Allows an entrepreneur to use internet-based advertising to raise up to $5 million from the public. Before the offering commences, certain disclosure materials need to be prepared and filed with the SEC, there are limitations on how much money an individual can invest, the offering can only occur on certain SEC-registered portals and after the offering is complete, the business will have simplified ongoing reporting obligations with the SEC. This exemption preempts state securities regulation. This exemption is designed for an early-stage entrepreneur, typically in a consumer-facing industry, that wants to publicize the offering to the masses, doesn’t need to raise significant capital and is comfortable with the regulatory burdens.
- Rule 506(c): If Regulation CF is for the masses, Rule 506(c) is for the country club set. Rule 506(c) permits an entrepreneur to solicit investors publicly, but securities can only be sold to accredited investors. Everything about Rule 506(b) above remains the same in a Rule 506(c) offering, except the entrepreneur can publicly solicit investors and there is a requirement to verify the accredited status of investors. This exemption is designed for the entrepreneur who may not have a lot of high-net-worth individuals in their network, but is confident, with some marketing, that high-net-worth individuals will fund their business.
- Regulation A: This is a simplified public securities offering that allows entrepreneurs to sell to the masses. There are two types of these offerings – Tier I and Tier II. Tier I allows entrepreneurs to sell up to $20 million of securities while Tier II allows entrepreneurs to sell up to $75 million of securities. Tier I offerings have reduced disclosure and financial reporting obligations, but are subject to state regulation, while Tier II offerings require heightened disclosure and financial reporting obligations, including audited financial statements, but preempt state regulation. Regulation A offerings, regardless of tier, require a disclosure document be filed publicly with the SEC and must be qualified by the SEC before any securities are sold. There are ongoing disclosure obligations after the securities offering. Regulation A is designed for entrepreneurs who need to raise significant capital publicly and are willing to take on the challenge of increased regulatory burdens for the ability to raise capital similar to a public company.
As they create their business blueprint, entrepreneurs should know the different tools available to them and which may be best for their situation. One last word of advice: unlike me with home improvement, before jumping into a capital raise, consult with an experienced securities lawyer and other professionals to ensure your capital raise is a success and doesn’t end up a disaster.
Alexander R. McClean is partner and Chair of the Securities and Capital Markets practice group at Harter Secrest & Emery LLP. He can be reached at 585-231-1248 or [email protected].
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