by Joe Rockett

     My colleague, Brad Davenport, did an excellent blog on the selection of the right entity for your business venture. In this blog, I want to take the natural progression to address the question of how to raise capital for your business enterprise without running afoul of the United States securities laws.

      In all securities offerings, the overarching principle that will develop the strongest relationship between you and your investors that will serve you well in good times and down times, is make full disclosure.  Full disclosure means make no misstatement of a material fact and do not omit to state a material fact.  That principle will build strong relationships and trust and will enable you to best defend yourself if allegations of misstatements or omissions are visited upon you.

     Let’s consider two rules that will allow your capital raise to be exempt from registration with the Securities and Exchange Commission (“SEC”) – they are Rule 506(b) and 506(c).  In my next blog we will explore a third alternative, the recently adopted Crowdfunding Regulation.

     The Jumpstart Our Business Startups (“JOBS”) Act was signed into law by President Obama in 2012.  The SEC developed and adopted regulations to implement the JOBS Act’s mission to ease the regulatory burdens on small businesses seeking capital for startups, as well as additional funding following the startup.  In this blog, I will discuss the high points of amendments to Rule 506.

     For years, Rule 506 has allowed entrepreneurs to raise unlimited amounts of capital without registration, provided the requirements of the Rule were strictly followed.

     With the adoption of the JOBS Act, the SEC undertook to craft a more effective exemption within the framework of Rule 506.  Originally, the Rule was the means for raising capital in unlimited amounts, provided a few limiting factors were observed in how the offering was conducted to retain the character of a non-public offering which was the requirement of the enabling statute, Section 4(2) of the Securities Act of 1933.  The principal limitations are (i) the offer must be made to no more than 35 non-accredited investors, but the rule allows an unlimited number of accredited investors; and (ii) the offer must be made without public solicitation or advertising..  Accredited Investors include numerous categories of institutions and individuals, but the most often used category is that of individuals with either a $1,000,000 net worth, or with annual income of $200,000, or with joint income with one’s spouse of $300,000 per year, for each of the two most recent years.

     When the staff of the SEC went to work to make Rule 506 more useful for small entrepreneurs to raise capital, the main thrust was to craft an exemption that would remove the prohibition against public solicitation and advertising.

     Thus, Rule 506 was expanded to two subsections in an effort to make the Rule  more effective for the entrepreneur seeking to raise capital.  The Rule was amended to add an additional exemption, Rule 506 (c), that now allows a business in need of capital to raise investor funds through a broad public solicitation, and advertising, but with a more strenuous test for whether the participants in the offering are accredited, which I will explain below.

     So, now we have two parts to Rule 506 – 506(b), which is the traditional exemption – no public solicitation or advertising; and 506(c) that allows broad public solicitation and advertising, but with a more strenuous verification requirement for documenting who is an accredited investor.

     To comply with new Rule 506(c), the issuer must take “reasonable steps to verify that the purchasers of securities sold in the offering are … accredited investors.”  You may ask, what are “reasonable steps” to verify that a purchaser is accredited, i.e., has a $1,000,000 net worth or annual income of at least $200,000?  How does an entrepreneur verify such facts?

     The SEC offers certain non-exclusive inquiries (506(c)(2)(ii)) to support the verification.  They are:

(A) With respect to the income requirement, review IRS income reporting forms, such as Forms W-2, 1099, K-1, and 1040.  This is not intended to be an exclusive list.  In addition, the purchaser must represent that he or she reasonably expects to have that amount of  income in the current year as well.

(B)(1) With respect to net worth, the Rule suggests reviewing statements of assets, such as bank statements, brokers’ statements, and appraisals by independent third parties.

(B)(2) With respect to the liabilities side of net worth determinations, look at credit reports by nation-wide consumer reporting agencies.

(C) If that level of examination of your prospective investor is too exhausting and intrusive, then the issuer may rely on confirmation of net worth or income from a registered broker, registered investment advisor, an attorney, or a certified public accountant.

     It is worth emphasizing that the stated means of verification are not exclusive or mandatory.  They are merely examples of acceptable methods of verifying accredited investor status.  

     Finally, the 506(c) exemption is not available to an issuer with certain “bad actors”.  Rule 506(c) is not available to issuers with respect to whom any executive officer, director, 20% shareholder, general partner, managing member or certain other persons, within the past 10 years, have been convicted of a crime, whether a felony or misdemeanor, in connection with (i) the sale of a security; (ii) making a false filing with the SEC; or (iii) conducting business as an underwriter, broker, dealer or investment advisor or paid solicitor of purchases of securities.

     This blog is intended only to address, in a general way, two exemptions from registration available to businesses in need of capital.  The discussion of exemptions does not exhaust all exemptions or all technical requirements of the rules examined here; to do so is beyond the scope of this brief overview.

     State “blue sky” laws also come into play in connection with capital raises and will require either registration or availability of an exemption from registration in each state in which securities are offered.

     Finally, no capital raising effort should be undertaken without the assistance of legal counsel.

     In my next blog, I will cover another exemption from registration – crowdfunding and the SEC’s recently adopted Crowdfunding Regulation.

     If you have questions, you may reach Mr. Rockett at 405 272 9241.

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