editione1.0.1Updated September 19, 2022
You’re reading an excerpt of Angel Investing: Start to Finish, a book by Joe Wallin and Pete Baltaxe. It is the most comprehensive practical and legal guide available, written to help investors and entrepreneurs avoid making expensive mistakes. Purchase the book to support the authors and the ad-free Holloway reading experience. You get instant digital access, commentary and future updates, and a high-quality PDF download.
The Securities Act (also known as the Truth in Securities Act) states that “every offer and sale of securities be registered with the Securities and Exchange Commission (the ‘Commission’), unless an exemption from registration is available.”
An exemption (or exempt offering) is an offer and sale of securities that does not have to be registered with the SEC because the SEC has adopted an exemption from registration that you can qualify to use.
The two most common ways for private companies to sell securities are through the following exemptions:
an “All Accredited Investor Rule 506(b) offering”
a Rule 506(c) offering
We’ll get into the details below, but the primary difference between Rule 506(b) and Rule 506(c) is that if a company generally solicits its offering it is taking the 506(c) exemption and must take “reasonable steps to verify” that its investors meet the criteria of accredited investors, while under 506(b), companies can solicit only to people who affirm beforehand that they are accredited investors, and there is no verification requirement for the company.
General solicitation (or general advertising or public advertising) means using radio, TV, the unrestricted internet, and other means of soliciting investors. General solicitation and general advertising are defined in Rule 502(c) of Regulation D.
The All Accredited Investor Rule 506(b) offerings (or Rule 506(b)) is the most common way for private companies to raise money. Under Rule 506(b), companies cannot “generally solicit” or “generally advertise” their securities offerings. In a Rule 506(b) offering:
A company can raise an unlimited amount of money from accredited investors.
The company can’t generally solicit or advertise the offering.
The company is required to file a Form D with the SEC and state securities divisions within 15 days of its first sale of the securities in the offering.
Each investor has to check a box averring that they are an accredited investor, and the company does not have to take any further action to verify that the investor is accredited as long as the company’s belief that the investor is accredited is reasonable. This means you will not have to provide any personal financial information to the company to prove you are accredited.
State securities regulators cannot “merit review” or condition the offering on any basis.
founderBy following the 506(b) rules—only soliciting accredited investors and only allowing accredited investors to invest—a company dramatically reduces their securities offering requirements. Rule 506(b) offerings are popular because the rules are easy to follow. There are no specific information requirements, meaning companies don’t have to spend weeks preparing expensive disclosure documents. A company can raise money on a term sheet and an executive summary and pitch deck. And the company doesn’t have to prepare the definitive legal documents until it has commitments on its term sheet. This means that the legal fees for preparing the definitive documents come due at or after the money committed has come in (which is a nice timing coincidence). Finally, the company does not have to file anything with securities regulators until after it has closed the deal.
confusionUnder Rule 506(b), it is also possible to sell to up to 35 non-accredited investors, but if a company does this it has to provide registered offering level disclosure to all of the investors. This is why companies usually limit their offerings to accredited investors only.
A Rule 506(c) offering is an exemption under Regulation D in which companies can generally solicit, but they have to take additional steps to verify the accredited status of their investors. Rule 506(c) offerings are less common than Rule 506(b) offerings primarily because of the verification requirement.
In a Rule 506(c) offering:
A company can raise an unlimited amount of money from only accredited investors.
The company can generally solicit and advertise the offering, which means:
posting on unrestricted websites
advertisements published in newspapers and magazines
communications broadcast over television and radio
seminars and meetings where attendees have been invited by general solicitation or general advertising
The company has to take reasonable steps to verify the accredited investor status of each investor.
confusion Until recently, general solicitation in (the public advertising of) private company securities offerings was illegal. If you generally solicited a private company securities offering, you risked jail time. This changed with the JOBS Act in 2012. Now it is not illegal to generally solicit your private company securities offerings, but if a company generally solicits or generally advertises its offering, then it is conducting a 506(c) offering and it must take reasonable steps to verify the accredited investor status of its investors before it can accept their investments.
Reasonable steps to verify means that a company might ask to see your Form W-2 or Form K-1 or Form 1099 to verify that you meet the income test. Alternatively, the company might ask to see your personal financial statements and ask to run a credit report on you to confirm your liabilities and verify that you meet the net worth test. This is a process many investors are not familiar with and is an additional burden to closing an investment. For this reason, many companies choose not to generally solicit or generally advertise their offerings.
Conveniently, service providers do exist that provide verification services (meaning verifying that the investors are accredited). Therefore, it is not necessary that the investors provide their personal financial information directly to a company; they can provide it to a third party instead, who would then provide a certification to the company, which the company could rely upon.
Though 506(b) is by far the most common exemption for private companies to raise money, followed by 506(c), there are others you may run into. are other ways for private companies to raise money other than Rule 506 of Regulation D. If you would like to review a comprehensive list of all of the exemption available, you can find one starting on page 11 of this 2020 SEC release. They include:
Title III equity crowdfunding (Regulation CF). Under this exemption, companies can raise up to $1.07M during any 12-month period. But they have to use either a registered broker-dealer or registered crowdfunding platform, such as Wefunder. Title III is becoming more popular, but right now the amount of money raised in Title III equity crowdfunding offerings is a small fraction of what is raised in Rule 506 offerings. However, as of the writing of this text the SEC has proposed new rules that would allow companies to raise up to $5M in a Title III equity crowd raise, and the individual investor limitation amounts would not apply to accredited investors. This favorable regulatory change might make the use of Title III much more common in the future.
Regulation A+. Regulation A+ is an exemption that allows companies to raise as much as $50M during any 12-month period. But the exemption is expensive to use, and thus not used very frequently by the overall startup community. It might become more popular in years to come, however.
State crowdfunding laws. Some states have laws allowing companies to raise money in crowdfunding-type offerings. For example, Washington State has a crowdfunding exemption allowing companies to raise up to $1M during any 12-month period, provided certain conditions are met.
Various state exemptions. Each state typically has its own rules as well. But for the most part, companies tend to raise funds from investors from a number of different states, and tend not to rely on state-specific exemptions.
It is very common to hear an entrepreneur say that their first round of investment was “friends and family.” This is understandable: when the company is little more than an idea, it is likely only to be able to get money from people who are betting on the entrepreneurs based on a pre-existing relationship.
Many states have exemptions allowing companies to raise money from non-accredited investors with whom they have a pre-existing, substantive relationship under Rule 504 of Regulation D. It is beyond the scope of this book to provide a state-by-state analysis, but, for example, California has such a law, as does Washington State, where companies can raise up to $1M during any 12-month period from both accredited and up to 20 non-accredited investors.
cautionAs an investor, you do need to be careful about this. There is no “friends and family” exemption from registration under the federal securities laws. There are federal securities law exemptions pursuant to which companies can raise money from unaccredited investors (Rule 504, Title III, Reg A+, Rule 506(b)), but none of these exemptions have as exempt a category of purchasers identified as “friends and family.” For the most part, the federal securities law exemptions require either that the purchaser of the securities be “accredited” or the company provide registered offering level disclosure so that the purchasers of the securities had access to the same information they would have had if the company had registered the securities.
You might wonder, do companies engage in general solicitation if they pitch to an angel group? The SEC has provided specific guidance around angel groups and how they can facilitate companies meeting angels without triggering the general solicitation rules:*