Small business fundraising: 506(b) vs 506(c) offerings

What is Regulation D?

As a small business entrepreneur, raising capital is a key component to starting, buying and running a business. Thus, the SEC, under the Securities Act of 1933, created a few exemptions that help small businesses gain funding without having to meet the requirements or pay the costs of a registered offering (e.g., an IPO). 

Along with Regulation A+ and Regulation Crowdfunding, Regulation D is one of the key exemptions for raising capital without registering the securities with the SEC.

Securities sold through Regulation D are commonly referred to as private placements. 

What Type of Investment Can I Raise with Reg D?

Entrepreneurs can raise debt or equity through a private placement. While most debt that your average consumer knows about is not considered a security or regulated by the SEC, debt raised to fund a business can qualify as a security.

Typically there is a four-factor test to determine whether a note is a security:

• Motivation of buyer and seller: Is the motivation of the seller to raise capital? Is the buyer’s motivation to earn profits?

• The plan of distribution: Are the notes offered broadly / to the general public for investment purposes?

• The reasonable expectations of the investing public: Is there a reasonable expectation of the investing public that securities laws apply?

• The presence of alternative regulatory regime: Is there an alternative regulatory scheme that reduces the risk of the instrument, thereby rendering the application of the Securities Act as unnecessary?

Requirements for Raising Capital with Reg D

Even though the issuer is exempted from registering with the SEC under these rules, there are still a number of requirements when raising funds under Reg D. For example, the issuer must file a  Form D with the SEC no later than 15 days after the first sale of its securities. It should be noted that Form D doesn’t mean the issuer is approved or registered with the SEC. 

The specific requirements will vary based on which exemption an entrepreneur decides to use: rule 506(b) or rule 506(c).

Rule 506(b) Offering:

If an entrepreneur (or, “issuer” as referred to by the SEC) elects to raise capital using rule 506(b) within regulation D, there are a few important characteristics an issuer must know about. 

First, an issuer can raise an unlimited amount of money, given an investor’s willingness to invest in the business.

Second, an issuer can have an unlimited number of accredited investors buy securities in the business. 

Third, the issuer can raise from up to 35 non-accredited investors. However, the issuer MUST have a “substantive pre-existing relationship” with these investors. 

While 506(b) is unique in that entrepreneurs can raise from friends and family who are not accredited, that feature comes with certain requirements.

• The entrepreneur needs to make additional disclosures and is required to prepare a private placement memorandum (PPM).

• Non-accredited investors must meet the standard of having sufficient knowledge and experience to weigh the risks and merits of the investment

• Non-accredited investors may use a purchase representative (e.g., financial advisor or attorney)

Lastly, due to this exemption allowing for non-accredited investors, there is an explicit bar on entrepreneurs marketing to investors (e.g., cold emails, social media posts). 

Why? Well, in the eyes of the SEC non-accredited investors are less savvy and have a lower tolerance for loss. What is a substantive pre-existing relationship?

According to various no-action letters, two facets are important: (1) how you created the relationship, and (2) the passage of time. The goal is to avoid entrepreneurs “building relationships” as part of a capital raise. Instead, entrepreneurs must know the investors well enough to understand their financial position and know its reasonableness.

Rule 506(c) Offering:

Under 506(c), an entrepreneur or “issuer” can raise an unlimited amount of money, given an investor’s willingness to invest in the business, and can have an unlimited number of accredited investors buy securities in the business. However, an issuer can only sell its securities offering to accredited investors and the issuer must take reasonable steps to prove that the investor is an accredited investor. 

A key takeaway from rule 506(c) is that by limiting the capital raise to accredited investors, the entrepreneur has more freedom and lower requirements on the raise. 

• The issuer is free to solicit, market or advertise its securities offering

• The disclosure requirements are lower and less intense than a 506(b) offering

• A private placement memorandum does not need to be created

Key Differences Between 506(b) and 506(c):

The main difference is whether the offering can be sold to non-accredited investors and the requirements and restrictions that follow that.

506(b) capital raises can be sold to non-accredited investors where the entrepreneur has a substantive pre-existing relationship, whereas 506(c) raises can only be sold to accredited investors.

Although 506(b) broadens the universe of investors, it comes with additional filing requirements and a prohibition on marketing or advertising your capital raise.

What’s the Best Offering Type for You?

The most common offering type for issuers is 506(b). For established companies and well-networked fund managers, 506(b) allows them to quickly raise large amounts of capital through their pre-existing relationships. Their disclosure requirements are as low as 506(c) as they will never need to include non-accredited investors.

For small business raises, 506(c) is becoming more common. Given that small businesses are most cost conscious, 506(c) allows them to avoid disclosure requirements and the legal costs that come from additional legal documents and a formal private placement memorandum (PPM).

At the end of the day, the best offering varies based on the capital being raised and the entrepreneur’s existing network. It is always best to consult a legal and/or financial advisor when considering raising capital.

Information posted on this page is not intended to be, and should not be construed as tax, legal, investment or accounting advice. You should consult your own tax, legal, investment and accounting advisors before engaging in any transaction.