• Guide to Publicly Offered Private Placements Under New Rule 506©
  • September 30, 2013
  • Law Firm: Duane Morris LLP - Philadelphia Office
  • Background:

    A company that needs capital to expand its business or fund its operations often chooses to sell stock or other securities to investors in order to meet its funding requirements. All offerings of stock or other securities are regulated by federal and state securities laws, which generally require public offerings to be registered with federal and state securities agencies. Because registration can be costly and time-consuming, many companies raise capital by selling stock or other securities pursuant to exemptions from these registration requirements (i.e., in a private placement). Companies seeking to raise capital commonly rely on the exemption found in Rule 506 of Regulation D under the federal Securities Act of 1933, and the corresponding exemptions under state securities laws. Rule 506 was amended, effective September 23, 2013, to make it easier for companies to find investors. These amendments allow companies to make general solicitations with respect to private sales of securities. (Until then, general solicitations were prohibited for this type of securities offering.)

    While other exemptions remain available to companies selling their stock or other securities, the following summary is intended as a guide for conducting a sale of stock or other securities under Rule 506(c), the provision recently added to Regulation D in order to permit general solicitations. It is important to note that we have used the term "company" throughout these materials because the guide applies to all entities, such as corporations, limited liability companies and partnerships.

    While the new rules, which went into effect on Monday, are designed to accelerate capital formation for emerging businesses, commentators from several investment banks that serve the sector have indicated that their firms have a "wait and see" stance to implementation of general solicitation for their private offerings of securities. Duane Morris will be scheduling a webinar next month to discuss and debate these approaches.

    Step 1 - Making Sure Your Company Does Not Have Any "Bad Actors":

    As a preliminary matter, when the Securities and Exchange Commission (the "SEC") amended Regulation D to permit general solicitations, it also added provisions to restrict those with a history of regulatory issues from availing themselves of this newly added flexibility. Accordingly, your company will need to make sure it is not in violation of the "bad actor" provisions found in Rule 506(d). These provisions are designed to preclude certain felons and other "bad actors" from using the Rule 506 exemptions, including the exemptions in Rule 506(c) that permits general solicitations. This means that if your company or any of its directors, general partners, managing members, executive officers, promoters or other representatives participating in the offering, as well as anyone, in general, who owns 20% of your company, has been convicted of any felony or misdemeanor involving securities, certain regulatory matters with the SEC or certain other securities transactions, or has been barred from participating in certain securities transactions by a court or other regulatory authority, your company will not be permitted to sell stock or other securities under the exemptions in Rule 506, including the exemptions in Rule 506(c) that permit general solicitations.

    Step 2 - Determining the Amount of Funds You Can Raise:

    Rule 506(c) does not limit the amount of funds your company can raise from investors.

    Step 3 - Finding Potential Investors:

    Prior to the recent Rule 506(c) amendments, your company would have been prohibited from conducting a general solicitation of potential investors in connection with the sale of stock or other securities. This meant a company could not, for example, use the Internet to advertise or even announce that the company was selling stock or seeking investors. The new Rule 506(c) changes (subject to certain other criteria, as set forth below), now allow your company to conduct a general solicitation. Thus, under Rule 506(c), your company can advertise an offering of its stock or other securities through a variety of forms of general solicitation, including:

    • Website and other forms of online advertising;
    • Television;
    • Radio;
    • Electronic mail;
    • Social media, such as Facebook and Twitter;
    • Press releases; and
    • Direct mail marketing.

    While general solicitations generally will not include the detailed information about your company that will need to be provided to investors before they purchase the stock or other securities your company is offering (see Step 5 below), a general solicitation should include the method by which a potential investor can contact your company.

    Assuming your company is successful in finding potential investors, your company should have a process in place to communicate with, and obtain information from, these potential investors. Your company will need to obtain specified information about each potential investor to determine whether such potential investor is permitted to purchase the stock or other securities your company is offering. Therefore, it will be helpful to include in your company's initial responses to potential investors:

    1. A questionnaire that the investors could complete and return to the company and

    2. A description of the process that potential investors could undertake to enable the company or a third party to certify that such investor is permitted to purchase your company's stock or other securities. (See Step 4 below for discussion of the applicable investor qualifications).


    It is important to note that, although undertaking a general solicitation should make it easier for your company to locate potential investors, you still may want to engage intermediaries to act on your company's behalf to help locate potential investors. Examples of intermediaries include registered broker-dealers and potentially aggregators of "accredited investors," as described in Step 4 below. One advantage of using an intermediary is that the intermediary may be able to assist with the administrative process of distributing and collecting investor questionnaires and determining whether a potential investor will be permitted to purchase the stock or other securities your company is offering.

    Step 4 - Determining Which Investors May Purchase Stock or Securities:

    Rule 506(c) allows for only certain types of investors to purchase a company's stock or other securities. Specifically, if a company is offering stock or other securities pursuant to a general solicitation, the company can only sell stock or other securities to "accredited investors." This means that while your company may solicit all types of potential investors, your company actually may sell stock or other securities only to accredited investors. Individual investors are "accredited investors" if they have either:

    1. A net worth of at least $1 million, excluding the value of such investor's primary residence or
    2. Income of at least $200,000 in each year of the last two years (or $300,000 together with such investor's spouse, if married), and have the expectation to earn the same amount in the current year.

    Other types of accredited investors include:

    • A corporation, business trust, trust or partnership, not formed for the specific purpose of purchasing your company's stock or other securities, with total assets in excess of $5,000,000;
    • An investment company registered under, or a business development company as defined in, the U.S. Investment Company Act of 1940;
    • A Small Business Investment Company licensed by the U.S. Small Business Administration under Section 301(c) or (d) of the U.S. Small Business Investment Act of 1958;
    • A private business development company as defined in the U.S. Investment Advisers Act of 1940;
    • An entity in which all of the equity owners are accredited investors;
    • An ERISA employee benefit plan if the plan has total assets in excess of $5,000,000 or if the investment decision is made by a plan fiduciary that is a bank, savings and loan, insurance company or registered investment advisor; and
    • Self-directed employee benefit plans that are controlled by an accredited investor.

    Selling stock or other securities to non-accredited investors can result in significant adverse consequences for your company, including a right of rescission for investors (i.e., the right to receive their money back), a future "bad actor" designation (as described in Step 1) for you and/or your company, and other fines and penalties.

    In order to satisfy the individual accredited investor requirement, your company should take "reasonable steps" to verify that the purchasers of its stock or other securities are accredited investors. The SEC has stated that reasonable steps include:

    • Reviewing each investor's tax returns and/or bank statements and evaluating the liabilities of such investor or, alternatively,
    • Obtaining a certification from a third party, such as an accountant of each investor, that such investor satisfies one or more of the accredited investor thresholds.

    If your company desires to use a third-party verification service, your company could, for example, provide a form letter to potential investors that would list the various categories of "accredited investors" and provide a space for such third party to certify only that the applicable investor satisfies one or more of such categories. As an additional example, although not included in the specific methods provided by the SEC, your company may also want to consider verifying a potential investor's income by obtaining a letter from the investor's employer.

    It is important to note that whatever verification process your company chooses to use with respect to verifying accredited investor status, your company will need to have policies in place to protect confidential information of potential investors and ensure that your company is complying with all applicable privacy rules and regulations.

    Step 5 - Preparing the Transaction Documents:

    You will need to document in legally binding agreements your company's sale of its stock or other securities, and the purchase of the stock or other securities by accredited investors. These documents will set forth all of the terms of such purchase and sale and will need to provide for, among other things:

    • The type of security your company is offering (e.g., common stock, preferred stock, partnership interests, limited liability company interests, promissory notes, etc.);
    • The price of the security;
    • The terms and other economic rights that apply to the security. These rights may include rights to dividends or other distributions or interest payments for a debt security, priority payments in the event the company is dissolved, anti-dilution protections, rights to convert the security into other company securities, events of default for a debt security and registration rights for the security. Registration rights relate to an investor's ability to resell the purchased stock or other securities and are discussed in greater detail below;
    • The voting rights that apply to the security, such as rights to elect directors or managers of your company and rights to approve fundamental transactions of your company (e.g., a merger or a sale of assets); and
    • Representations from the investors, which include representations about the investors' accredited investor status.

    The documents that embody the above terms typically include subscription agreements and the charter documents relating to the company. Your company may also need to obtain a legal opinion from legal counsel regarding the offering's compliance with certain laws and other contractual obligations of your company.

    In addition, because the securities laws require that investors have full, fair and complete disclosure of all material facts about your company, you will also need to provide the investors with certain information about your company. This information could be provided in separate materials prepared by the company (such as annual reports and financial statements), or it could be set forth in a private placement memorandum. In either case, the materials should describe your company, its business operations, the members of its management team and any other material facts related to your company and should include financial statements. The materials should also set forth a description of risk factors related to a potential investment in your company. Examples of risk factors include a description of your company's limited operating history; risks related to the industry in which your company operates; risks specific to your company's products, technologies or services; and the risk that the investors may lose their entire investment in your company.

    The materials should also provide information about the restrictions applicable to the resale of such stock or other securities. Because the stock or other securities sold by your company under the exemptions in Rule 506(c) are "restricted securities," resales of such stock or securities by investors are not permitted for at least six months without registering such stock or securities or selling such stock or securities pursuant to an available exemption from registration. It is vital to inform investors about this limitation on the liquidity of their investment.

    Step 6 - Completing the Sales of the Stock or Other Securities:

    The closing will occur when your company accepts the investors' subscription for your company's stock or other securities, the investors deliver the purchase price for the stock or other securities and your company issues and sells the stock or other securities to the investors. You may decide to hold one closing at which all investors will purchase their stock or other securities or you may hold multiple closings throughout a pre-determined period of time. Depending on the type of security that has been offered and sold, at the closing your company may also issue to the investors stock certificates or other certificates representing the purchased securities.

    Step 7 - Governmental Filings:

    Although Rule 506(c) is designed to allow for the sale of stock or other securities without a costly and time-consuming registration process, your company will need to make certain informational filings with the SEC. In addition, although the stock or other securities sold under Rule 506(c) will be "covered securities" under the National Securities Markets Improvement Act of 1996 (meaning state securities registration requirements are preempted by the federal laws), your company may need to make similar informational filings with state regulatory authorities in the states in which the investors reside. Because each state has different filing requirements, including pre-filing requirements in some states, it is essential to determine where each investor resides and the applicable filing requirements before any stock or other securities of your company are sold to investors.

    In addition, the SEC is currently considering new filing requirements, which may include making a filing of your intent to use general solicitations before the first general solicitation occurs, making a closing filing after the termination of the offering, submitting general solicitation materials to the SEC prior to using such materials and including certain legends and other specific disclosures on all general solicitation materials.