Raising Capital: Final Installment

By Brett Melson Wednesday, April 13, 2011

As we noted in our previous posts on raising capital, under federal law, any offer of securities must either be registered under the Securities Act of 1933 (the “1933 Act”) or qualify for an exemption from registration.  A registered offering under the 1933 Act is extremely time consuming and expensive, and generally occurs only once a company is thoroughly established and has gone through various levels of venture-stage and mezzanine financing.

In this post, we discuss Rule 506 of Regulation D, the last and most versatile of the three main private offering “safe harbors” from 1933 Act registration.  Rule 506 allows a company to raise an unlimited amount through the sale of either debt or equity, but imposes requirements on the type of persons that may invest and the manner in which the solicitation of investments may be made.

Investor Requirements

Accredited Investors.  A company may raise funds from an unlimited number of accredited investors.  An accredited investor is generally defined to include:

(1)     a person whose individual net worth, or joint net worth with that person’s spouse at the time of his or her investment exceeds $1,000,000;

(2)     a person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year;

(3)     an entity (such as a partnership, limited liability company, corporation or trust) with more than $5 million in total assets; and

(4)     an entity in which all of the owners are accredited investors.

For purposes of calculating net worth, a potential investor must exclude the value of his or her primary residence.

Non-Accredited Investors.  A company may also raise funds under Rule 506 from up to 35 non-accredited investors.  These non-accredited investors, however, must have sufficient knowledge and experience in financial and business matters, on their own or in conjunction with a representative, such that the company reasonably believes the investors are capable of evaluating the merits and risks of the prospective investment.

Limitation on Manner of Offering

As was the case with other types of private offerings, such as Rule 504 and 505, capital raised in a Rule 506 offering cannot be raised through any “general solicitation” or “general advertising.”  This means that a company cannot seek investors through public media, such as newspaper or magazine advertisements, television or radio advertisements or other public communications.  The best way to avoid general solicitation is to solicit investors with whom the company or its personnel have pre-existing relationships, such as personal or prior business relationships, or to employ a registered broker-dealer to link the company with pre-qualified individuals.

Filing Requirements

Each investment made pursuant to a Rule 506 offering must be reported to the Securities and Exchange Commission on Form D within 15 days of the investment.  A copy of the Form D is also generally required to be sent to the securities regulator of the state in which the investor resides or is domiciled.  The Form D is a very brief filing.

As we have noted in previous posts on capital raising, you should consult with an attorney prior to seeking investors.  The rules governing capital raising are complex and involve both state and federal regulations.

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