Rule 506(c): A Different Type of Crowdfunding?
I read a recent article on Joe Wallin’s Startup Law Blog regarding the differences between crowdfunding and Rule 506(c) offerings. Because of the recent changes to the SEC’s Rule 506 under Regulation D, I figured our readers would be equally interested in learning more about crowdfunding and Rule 506(c). I’ve highlighted some of the main points of Joe’s article below and included some of our thoughts about 506(c) offerings and crowdfunding.
Why all the chatter?
In the last year and a half, there has been a lot of talk about crowdfunding, general solicitation, and other innovative ways of raising capital. The chatter has increased recently because of the SEC’s recent repeal of the ban on general solicitation. The repeal of the ban has to do with general solicitations for Rule 506(c) securities offerings. Under the new 506(c), companies can advertise their offerings so long as all purchasers are “accredited investors”—an “accredited investor” is (generally) an individual who either has (i) a net worth that exceeds $1M excluding the value of their primary residence (but taking into account debts on the primary residence in excess of its fair market value), or (ii) $200,000 in income for the last two years, or $300,000 with spouse.
This change is monumental. For as long as you and I have been alive, companies selling securities under Rule 506 were banned from using general solicitation to offer their shares. Now issuers can use advertising to raise an unlimited amount of money from accredited investors.
What is crowdfunding?
Under Title III of the JOBS Act (the SEC has not yet enacted this rule passed by Congress in 2012), companies will be able to sell securities through online platforms to accredited and non-accredited investors. Investors invest small amounts of money and companies can only raise up to $1 million during any 12 month period. It’s like Kickstarter, but instead of receiving a T-shirt from the company, investors receive equity in the company they invest in.
You may be thinking that these types of offerings (Rule 506(c) and crowdfunding under Title III) sound a lot alike. And you’re right. Rule 506(c) offerings are a lot like crowdfunding, but they involve a restricted “crowd”—accredited investors only. Until the SEC issues final rules related to crowdfunding, there’s only one type of crowdfunding we can utilize: generally solicited Rule 506(c) offerings to accredited investors only.
Additional obligations for Crowdfunding
The JOBS Act provided that crowdfunding will not be legal until the SEC implements regulations that allow it. At this point, it is completely unclear whether this will happen anytime soon. Further, there are restrictions (under the JOBS Act) on how crowdfunding offerings are conducted. Specifically (and ironically, as Joe notes), companies using crowdfunding cannot generally solicit their offerings since they cannot “advertise the terms of the offering, except for notices which direct investors to the funding portal or broker.”
There are additional shortcomings of Title III of the JOBS Act—the portion that relates to crowdfunding. There are extra reporting requirements that require companies using crowdfunding to disclose certain information, most of which is considered confidential. Another shortcoming is the fact that there is limited value to companies of shareholders with relatively small holdings. Anytime a company takes on another shareholder, the company increases its obligation to provide annual information, maintain shareholder records, handle share transfers, and address a variety of other obligations that come with significant costs to the company.
The main differences between crowdfunding and Rule 506(c) offerings:
- First (and most importantly), crowdfunding under Title III of the JOBS Act is not yet legal and Rule 506(c) offerings are legal. Until the SEC issues regulations that govern crowdfunding, it is not legal.
- Second, there is no limit to the amount that your company can raise under a 506(c) offering. As mentioned above, crowdfunding offerings are limited to $1 million in any 12 month period.
- Third, Rule 506(c) offerings can only be offered to accredited investors. Once it is legal, crowdfunding will be available for both accredited and non-accredited investors.
- Fourth, you can advertise your Rule 506(c) offering, but you will not be able to advertise your offering if you’re using crowdfunding. Instead, you will only be able to direct potential purchasers to your broker or the platform for your campaign.
- Fifth, under Rule 506(c) there is no cap on the amount an individual investor can invest or the total number of investors that may invest collectively in an offering. For crowdfunding, there will be limits on the amount each investor can invest and a limit on the overall amount that the investors can collectively invest in an offering during a 12 month period.
- Last, companies that use crowdfunding to raise capital are required to use a registered broker or registered funding portal.
As is the case with any securities transaction, we urge you to proceed with caution and contact an attorney before beginning your 506(c) offering.
If you want to learn more about crowdfunding, Rule 506(c), or other innovative ways of raising capital for your business, feel free to contact us today.