Every founder knows that capital raises are rarely easy for any business. Thanks to recent amendments to Regulation D of the Securities Act of 1933, Rule 504 may offer a more streamlined approach.
Capital raises take many forms, including a simple “friends and family” cash-for-equity raise, a new partner or investor buying into your business, or a more complex transaction involving seed or Series A equity or convertible debt financing. No matter the size or complexity of your capital raise, compliance with state and federal securities laws can be confusing, time consuming and expensive.
The federal government (through the Securities Act of 1933) and each state (through their own “blue-sky laws”) regulate the offering and sale of securities. Because the Securities Act and blue-sky laws define “securities” broadly, almost all capital raises involve securities and require compliance with these laws. Every offer or sale of securities (an “offering”) must be registered with the U.S. Securities and Exchange Commission (SEC) and each state in which the securities are offered or sold … unless it meets an exemption.
Options for Exemptions
The most common exemptions from federal registration for private offerings are in the SEC’s Regulation D (“Reg D”). Reg D describes specific safe harbors and exemptions in Rules 504, 505, 506(b) and 506(c). Each rule contains its own set of requirements, qualifications and limitations that must be met to rely on the rule’s exemption and avoid registration, such as no general solicitation or advertising, sales restrictions and other requirements specific to each rule.
Rules 504 and 505 exempt certain offerings based on the limited size or character of the offering. Before the SEC’s recent amendments, the maximum amount that could be raised was $1 million under Rule 504 and $5 million under Rule 505.
Due to the dollar limitations and other requirements under Rules 504 and 505, most companies have traditionally relied on Rule 506(b) for exemption from the Securities Act’s registration requirements. Rule 506(b) is advantageous because it has no dollar limitation and it “preempts” state blue-sky laws. That means if you rely on Rule 506(b), you don’t have to find a separate blue-sky exemption for each state involved (though you may still need to file some basic state forms).
Rule 506(b) specifically allows a company to raise an unlimited amount from unlimited accredited investors and up to 35 nonaccredited investors. In the capital-raising context, an “accredited investor” is typically a wealthy individual who meets certain net worth requirements while a “nonaccredited investor” is an individual who does not meet those requirements. However, if any nonaccredited investors participate in a Rule 506(b) offering, the issuing company must provide them with very detailed disclosures in advance of sale. Preparation of these disclosures can be time consuming and expensive and may include updated financial statements (potentially including audited financial statements), extensive nonfinancial disclosures regarding the business, and other regulatory disclosures. These costly disclosure requirements make participation of nonaccredited investors impractical, if not impossible.
The Case for Rule 504
On Oct. 26, 2016, the SEC amended Rule 504 to increase the maximum amount of securities that may be sold from $1 million to $5 million in any 12-month period and Rule 505 was removed.
With the increase of the dollar limitation to $5 million, the rarely used Rule 504 may now be a useful alternative to Rule 506(b) for capital-raising efforts by startups and small to mid-size companies because it allows an unlimited number of investors, accredited or not (subject to blue-sky law limitations noted below).
Unlike Rule 506(b), Rule 504 does not require the company to provide any particular line item or other information to nonaccredited investors in order to claim the exemption (though it is still advisable to provide all material nonpublic information to potential investors).
The primary disadvantage of Rule 504 is that—unlike Rule 506(b)—compliance with Rule 504 does not preempt all blue-sky laws. As a result, if you rely on Rule 504 for federal exemption, you will need a blue-sky exemption in every state where your securities are offered or sold.
If your offering is limited to a handful of states, Rule 504 may be better compared to Rule 506(b) since many states have “limited offering” exemptions. For example, both Missouri and Kansas blue-sky laws contain limited offering exemptions for certain sales to up to 25 investors, accredited or nonaccredited (subject to certain qualifications).
For startups and companies contemplating a capital raise under $5 million and a limited number of investors (including nonaccredited investors) in a few states, Rule 504 may provide an easier and more streamlined path to federal and state securities law compliance. If, however, your capital raise involves more than $5 million or potential investors in many states, Rule 506(b) will likely remain your
best option.
No matter the size or complexity of your capital raise, the deal should be vetted for compliance with federal and state securities laws.
This article is for informational purposes only. It does not constitute legal advice or solicitation. Readers with legal questions should consult an attorney. The choice of a lawyer is an important decision and should not be based solely upon advertisements
