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Every company, at some juncture, seeks opportunities for growth – whether it is developing a new product line, expanding into new markets, or opening a new division. These entrepreneurial endeavors typically necessitate capital infusion. Consequently, businesses explore various ways to attract investors. The decision of whether to pursue funding from the general public, a single high-net-worth individual, or a strategic business partner is crucial. Regardless of the preferred investor profile, exempt offerings remain the primary avenue for companies to secure initial capital. This article delves into the most prevalent exempt offering mechanisms employed by businesses to fuel their growth objectives.

A business may not offer or sell securities unless the offering has been registered with the Securities and Exchange Commission (the “SEC”) or falls within an exemption from registration. An exempt offering represents a method of raising capital where a company issues and sells securities without registering those securities with the SEC. In essence, investors provide capital to the company in exchange for equity or other securities issued by the company, bypassing the traditional SEC registration process.

There are many benefits and drawbacks of private offering compared to public issuances. 

• Advantages
  • Speed of the process. Private offerings are much faster than initial public offerings
  • Fewer regulatory requirements than for public companies
• Disadvantages
  • Limited access to capital; usually, fewer investors know and can participate in the offering than in public offering
  • Lack of liquidity; securities issued in private offering are restricted for sale
  • Dilution of ownership for existing shareholders. Once investors buy the company’s securities, the existing founders’ or shareholders’ share is decreased.

A few different exemptions from registration are available for businesses to raise capital without registration with the SEC. Some do not require any filings with the SEC, such as intrastate offerings. These exemptions are often called private offerings. A private offering is an offer to buy a company’s securities made to a group of investors rather than to the public. In private offerings, investors will receive “restricted securities” that may not be easily resold without following specific regulatory requirements.

Regulation D is the most commonly used procedure for raising capital. Fundraisers can choose the following exemptions set forth in Regulation D for this purpose:

• Rule 504 (“Limited Offerings”) allows businesses to offer up to $10 mil within 12 months and requires filing a notice with the SEC on Form D after the first sale of securities within the private offering. Companies that issue securities must comply with state securities laws and regulations in the states in which securities are offered or sold.
• Rule 506 (b) (“Private Placement”) allows businesses to raise an unlimited amount of capital from investors with whom the business has a relationship and who meet certain income, wealth, and professional criteria.
  • Securities in this offering can be sold to an unlimited number of accredited investors.
  • Securities may not be sold to more than 35 non-accredited investors. All investors must have sufficient knowledge and experience in financial matters to evaluate the risks of the investment.
  • The company must provide non-accredited investors with disclosure documents and financial statements outlined in Rule 506.
  • The company must file a notice with the SEC on Form D after the first sale of securities within the offering.
  • The offering does not have an offering limit for a 12-month period.
  • General solicitation or advertising of the securities is not permitted. The securities may be issued to a group of private investors with whom the business had a prior relationship before the offering began and who did not find out about the sale due to a public offer to buy securities.
  • The purchaser of the securities will receive “restricted securities” that may not be easily resold without following certain regulatory requirements.
• Section 4 (a)(2) (“Private Placement Exemption”) is often used for venture capital funding rounds or issuance to a small group of accredited investors. Under Section 4(a)(2) of the Securities Act of 1933, securities may be sold to a small group of sophisticated investors with sufficient knowledge and access to information about the offering. 
  
  Rule 506 (b) is regarded as a “safe harbor” under Section 4(a)(2). Rule 506 (b) provides objective standards that a business can rely upon in order to comply with the requirements of Section 4(a)(2) exemption. Conversely, if the company raising capital through 506 (b) private offering fails to meet the “safe harbor” requirements, it still will have the protection of general Section 4(a)(2) exemption.
  • Investors must have enough knowledge and experience to be regarded as “sophisticated investors”, or be able to bear the investment risk
  • The company issuing securities must provide investors with the information usually required for a prospectus for a registered securities offering.
  • The company issuing securities must not publicly advertise the sale of securities.
  • Investors are not allowed to resell the securities to the public.
  • No requirement to file a notice with the SEC about the issuance of the securities (no Form D required).
• Rule 506 (c) (“General Solicitation”). This offering allows companies to raise unlimited capital by soliciting investors through public marketing. The investors must meet certain wealth and professional criteria. 
  • This rule permits public solicitation
  • It does not have a limit for 12 months period
  • All investors must be accredited investors
  • The issuer must take reasonable steps to verify investors’ accredited investor status
  • The rule requires filing a notice with the SEC on Form D.

Other exemptions from registration, such as Regulation A or Crowdfunding, are also available for businesses that intend to attract capital. However, Regulation D is most widely used by start-ups and growing businesses. 

To compare the two most commonly used Regulation D exemptions – 506(b) and 506(c) exemptions we will dive into some intricacies of their procedures. Even though the benefits of general solicitation under a 506 (c) offering may seem compelling – the procedure allows for public marketing of capital raises – clients still may want to consider a few drawbacks of general solicitation in contrast to private placement under 506 (b).

• Administrative and financial burden. The biggest downside of general solicitation, which puts tremendous administrative and financial burdens on the issuing company, is the issuer’s ongoing obligation to verify the accredited status of investors during the initial and subsequent sales of securities.
  • The issuer is deemed to have established that an investor took reasonable measures to verify the accredited status of an investor if:
    • The investor provided a written representation that it is qualified or continues to qualify as an accredited investor.
    • The issuing company does not know any contrary information.
    • The prior verification was performed within five years.
  • The obligation to verify accredited status requires the issuer to request evidence of the investor’s income. It adds attorney, accrediting services, and bookkeeping fees to the cost of the raise.
• Cautiousness of investors and slow process. Investors are usually wary of an intrusion by the issuer when the issuer asks for sensitive information such as bank statements, credit reports, and tax returns to verify the investor’s wealth. Investors may decline to continue their participation in the offering for this reason.
• Greater risk of losing protection in the event of non-compliance. Unlike 506 (b) private placement, general solicitation, if not complied with, constitutes the issuance of unregistered securities, which is a violation. On the contrary, if the issuer fails to comply with the “safe harbor” of 506 (b) procedure, the issuer still has the protection of general Section 4(a)(2). 

Notably, general solicitation or general advertising of the sale of securities is prohibited in 506(b) procedure. Rule 502(c) provides some vague guidance on the meaning of “general solicitation” and “general advertising” by presenting examples of communications that may be considered as general solicitation or general advertising. These are: (1) “any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio; and (2) Any seminar or meetings whose attendees have been invited by any general solicitation or general advertising; …”

However, these communications may qualify as the “demo days” or “test-the-waters” private placement exemption created by Amendments to the Offering Framework. The Amendment came into force on November 2, 2020 (more information here: https://www.sec.gov/newsroom/press-releases/2020-273).

For example, the “demo days” exemption allows for the communications without considering them general solicitation if the communications are made during a seminar or meeting sponsored by a college, government, a non-profit organization, an angel investor group, or an accelerator. In general, seminars and “demo days” presented to a limited audience qualify as 506 (b) private placement and are not general solicitations.

The following factors can be crucial to determining whether the offering will have the protection of 506 (b) and will not be considered general solicitation:

• Pre-existing relationship between issuing company and investor
• Substantivity of this relationship
• Form of communications about the capital raise
• Number of potential investors receiving these communications.

It is important to keep in mind these factors in order to select the best path for infusion of investment funds.

In conclusion, securing capital is an unavoidable stage in the evolution of every enterprise. Exempt offerings create a pivotal mechanism for businesses seeking to fuel their growth. It is crucial to remember that capital raising requires careful consideration and expert guidance. Consulting with legal counsel is paramount to identify the most suitable offering structure that aligns with the company’s specific objectives.