Seeking Business Investors without the Burdens of Securities Registration
By Elizabeth C. Buckley
When a group of individuals or entities decides to combine resources to start operating a new business, lawyers in our firm often get involved to assist with the formation of the new business entity; generally a partnership, LLC, or corporation. However, sometimes an entrepreneurial client has developed an idea for a business, but needs to seek out investors in order to bring the business plan to fruition. These two scenarios may sound similar, but they are not.
Because the Securities Act of 1933 (the “Act”) defines “security” very broadly, the latter category of business entity formation—where one seeks investors for a new profit-seeking enterprise—technically constitutes an offer to sell securities. And, under the federal Act—as well as state law—it is unlawful for anyone to offer or sell any security unless the security is registered or exempt from registration.
The registration of a security is an administratively burdensome process which would normally be prohibitively expensive for those seeking to establish a small business. However, there is good news: the Act provides several “exemptions” which allow a person to offer and sell securities without registration in certain circumstances. The least costly exemptions—both in terms of the money and time one would be required to invest—are under Rule 506 of Regulation D.
Under Rule 506(b), a company can sell securities (i.e. equity in the company) to an unlimited number of “accredited investors” and raise an unlimited amount of money. The only restrictions are that offerings must be “private placements;” the company cannot engage in public solicitation or general advertising to seek investors. Rule 506(b) also allows a company to accept investments from up to 35 non-accredited investors, although the non-accredited investors must be “sophisticated,” in that they “have sufficient knowledge and experience in finance and business matters to be capable of evaluating the risks and merits of the investment.” Furthermore, non-accredited investors must be given specified disclosures about the company, which could be costly to prepare.
Companies seeking to solicit investors via general advertising may rely on Rule 506(c). Rule 506(c) is similar to Rule 506(b) in that an unlimited amount of money may be raised from an unlimited number of accredited investors but, under Rule 506(c), (i) public solicitation is allowed, but (ii) the company may ONLY target accredited investors. To qualify for this exemption, the issuing company should be able to provide evidence that its advertising efforts were directed toward accredited investors and it must take reasonable steps to verify that anyone who ultimately invests in the company is actually accredited.
Although there are various other federal and state exemptions that permit a company to offer or sell securities without the expense and hassle of registering, Rule 506 is the most simple and least costly. There are no expensive documents or disclosures to prepare (especially if only accredited investors are subscribed). The only required documentation is a Form D, which must be filed with the SEC within fifteen days after the first sale. The Form D must also be filed in the states where sales occur. A company may also wish to draft a simple subscription agreement or other contract to evidence compliance with Rule 506 and otherwise memorialize the relationship between the issuing company and the investors, but neither Rule 506 nor the Act require a subscription agreement. Another distinct benefit of the Rule 506 exemptions is that they also serve as exemptions under state securities laws, so the issuing company does not need to seek an additional exemption at the state level.
If you have any additional questions about business entity formation for small businesses, contact Elizabeth Buckley at 919-821-7700 or email email@example.com .
 The term “accredited investor” is defined at 17 C.F.R. §230.501(a), and includes certain types of entities as well as individuals with a net worth of $1MM, excluding the value of the person’s primary residence, or an income over $200K for the last two years (or joint income with a spouse over $300K) and reasonable expectation of the same income through the current year.