What Founders Need to Know About 506(c) Offerings
On September 23rd, for the first time in 80 years, startups will be advertising their fundraising to the public. Facebook ads, tweets, Techcrunch articles, a demo day live-streamed to the 8m+ accredited investors across the US – it’s a whole new world. Previously, most of us never had a shot at investing in the rounds of the best companies. The insiders only had that kind of access. That's all about to change.
We think that’s a great thing. More Americans backing innovation helps our country. And, as a founder, giving your most passionate users an opportunity to invest alongside your professional investors is good for your startup. Win-win.
But there's a bunch of legal stuff for founders to know. So let's dig in.
Rule 506(c) Vs. Rule 506(b)
Rule 506(c) is a new exemption rolled out by the SEC which allows general solicitation. The exemption that startups relied on to raise financing over most of the past century - which bans such advertising - is now known as Rule 506(b). Startups can choose between 506(b) or 506(c) when they fundraise.
The major difference with 506(c) is the higher standard for ensuring that every investor in the offering is accredited. For both types of offerings, you should have a "reasonable belief" that an investor is accredited before accepting their investment. With 506(b), founders often take the investors own word, and take relatively few steps toward verifying it. That standard isn't good enough for 506(c); you must also take "reasonable steps" to verify that your investors are accredited.
As financings become more transparent, we expect 506(c) to gradually become the new standard. Before, the difference between a public and a private solicitation was murky, and regulators did not always pursue activities that blurred the line towards public solicitation, but there's no guarantee this will continue. Have you been on AngelList while actively fundraising, and then someone tweeted about it? Ever had a demo day pitch video uploaded to Vimeo? Those are technically the general solicitations that 506(c) was designed for. 506(c) is the safer way to go.
So, what are "reasonable steps?"
The SEC purposely did not define what "reasonable steps" to verify accredited investors actually means. In their own words, they don't want to force us "...to follow uniform verification methods that may be ill-suited or unnecessary to a particular offering or purchaser in light of the facts and circumstances..."
While this adds ambiguity and makes life more difficult until clear norms are settled on, this is actually a good thing, as we all can use common sense! It would be silly if Ron Conway was forced to provide tax returns when investing. He's Ron Conway!
You can verify that he's an accredited investor with ease: Google him!
Here's some guidance the SEC has provided on the types of information you could reasonably rely on to verify that an investor is an accredited investor:
- High investment amounts that aren't financed by third parties
- The average salary of someone's job title at a particular company
- Tax forms like W2, 1099, K1, or a filed 1040 over the last two years
- Bank statements, brokerage statements, certificates of deposit, tax assessments, or appraisals... combined with a credit report
- A letter from a broker/dealer, investment adviser, attorney, or CPA.
- Third-parties that have a reasonable basis to be relied on (i.e., Wefunder)
The SEC stated this is not an all-exclusive list. We feel there's also a good argument that you took "reasonable steps" if you found the investor was:
- the founder of a company acquired by Google
- an early employee at Facebook
- a celebrity investor (ie., Ron Conway).
- In other words, we interpret "reasonable steps" to be exactly that: reasonable.
How Wefunder makes it easier
We do most of the work for you. What startup founder has time to deal with this stuff? You have better things to do then asking potential investors for tax documents.
The SEC wants to see third-party verification marketplaces form. That's us.
When you fundraise via Wefunder, we verify that everyone who invests in your company is accredited. If it's needed, we'll handle asking for any tax forms, bank statements, or letters from accountants.
The SEC does require that you have a reasonable basis to rely on the judgment of any third-parties. If requested by your lawyer, we'll provide all of our methodology for determining accredited investor status on Wefunder. It's quite boring reading. Lawyers like that stuff.
What about the proposed rules for 506(c)?
You might have heard talk about a 15 day waiting period before fundraising or additional paperwork required for 506(c) offerings. These are in the proposed SEC rules (not the Final Rules live on September 23rd). Given the almost unanimous opposition and lack of a clear reason for their existence, we don't expect these rules to ever be voted on in their present form. Either way, the vote is months away, and we expect the proposed rules will not be in effect on September 23rd.
The SEC staff wrote these proposed rules from the perspective of how Wall Street raises money without understanding how startups are financed. During this comment period, they are hearing from the startup community. We expect them to correct the proposed rules, since they are "reasonable" people who try to do the right thing.
What happens if you screw up?
What happens if one of your investors turns out to be not accredited? As long as you had a reasonable belief at the time of taking the investment and you took reasonable steps to verify that the investor is accredited, you still can rely on the 506(c) exemption. Mistakes happen.
But, if you actually knew an investor you accepted was unaccredited at the time or did absolutely no diligence.... well, that's a Very Bad Idea. Don't do that. You'll lose your federal exemption, and will be spending a lot of money on lawyers.
If you enjoy reading government documents and want to check out the source, download the SEC Final Rules and jump to page 31 or so.