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Dos and Don’ts of Conducting a Rule 506(b) Offering

When raising capital, a company must comply with securities laws. As previously discussed, all offerings of securities, must either be registered with the SEC or exempt from such registration. Rule 506(b) is the most commonly used securities exemption for private companies. Even after complying with the basics of this exemption, there are many nuanced requirements that, if missed, can jeopardize qualifying under the exemption. Failure to comply with Rule 506(b) can subject an issuer and its officers and directors to various penalties. The SEC and state regulators can institute investigations and administrative and civil actions, enter various orders, and impose significant monetary penalties, and can transmit evidence to the U.S. Attorney General, who can bring criminal proceedings. In addition, violating securities registration requirements entitles the purchasers to rescission rights under federal and state laws. This blog post compiles some of the best practices for conducting a 506(b) offering in a bullet-pointed list for easy reference.

Remember that you shouldn’t engage in any securities offerings without retaining a lawyer experienced in such areas, so the below pointers are not meant to be, or take the place of, legal advice.

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Rule 506(b) Offering Procedures

Who Should Conduct the Offering. Only the directors, officers, and employees of the company issuing securities or a registered broker-dealer should conduct the offering. Beware of people unaffiliated with a broker-dealer who claim they can raise money for your company if they are paid a fee. Doing so can legally jeopardize you and your company.

Offerees. Offers to invest may be directed only towards people or entities that meet both of the below requirements…

  1. you believe they are “accredited investors” because they fall into one or more of certain categories, including the following:
    • business organizations with assets over $5,000,000 and that were not formed for the purpose of investing in your company;
    • directors or executive officers of your company;
    • individuals with a net worth or joint net worth with a spouse over $1,000,000, not including primary residence as an asset;
    • individuals with income over $200,000, or joint income with spouse over $300,000, in the 2 most recent years and expecting the same income this year;
    • IRAs of such individuals;
    • trusts with assets over $5,000,000 not formed for the purpose of investing in your company and directed by a sophisticated person; or
    • entities in which all of the owners are one of the above.
  2. who fall into either of the following categories:
    • ideally, people with whom you have a pre-existing, substantive personal or business relationship. You must have sufficient information about them to evaluate their financial circumstances and sophistication; or
    • less ideally, people with whom you do not have a pre-existing relationship but to whom you are introduced through a personal network of experienced, sophisticated investors and whom you reasonably believe to be financially experienced and sophisticated by having them fill out an “Investor Questionnaire” before sending them the rest of the offering materials. The fewer people you contact, the better for avoiding prohibited “general solicitation.

What to Avoid

It is very important that you avoid the following:

  • accepting incomplete or inaccurate investment documents or accepting investments even though an investor marked he or she is not accredited
  • accepting funds from a potential investor prior to receiving and reviewing investment documents
  • cold calls, website communications, email blasts or newsletters, or public announcements at events that mention an offer of securities or that condition the public mind or arouse public interest in the Offering;
  • using any materials other than offering materials prepared by legal counsel to make an offer of securities;
  • distributing materials about your company, such as annual reports, that contain any content that could be construed as an offer of securities, except to the acceptable types of individuals described above;
  • compensating directors, officers, or employees for finding investors in connection with a subscription; and
  • compensating anyone else for finding investors or in connection with an investment, unless such person is a registered broker-dealer or placement agent with whom you have a signed agreement.

Documentation Procedures

Observe the following procedures in order to preserve the availability of the Rule 506(b) exemption for your offering and have appropriate documentation in the event of an audit by a regulator:

Contacting Offerees

  • If your offering materials are numbered (and it’s a good practice to number each one), fill in the number of each package of offering materials before providing to potential investors. The number should be unique to each person receiving the materials, regardless of whether they invest or not. (i.e. don’t re-use the numbers, even if you never hear from the person again.)
  • Include all items in the offering materials to each potential investor.
  • You can provide the offering materials in person or by mail, facsimile, or email.
  • When emailing the offering materials, consider adding security protections to electronic files such as encryption, password protections, and watermarks or statements in the cover email regarding confidentiality.
  • Keep a record of the number, offeree name, and date of transmittal.
  • If you use client relationship management (CRM) software, be sure to record the transmittal of offering materials to each potential investor in such program.

Securities Filings

  • Form D, a required disclosure filing, must be filed with the SEC 15 days after the first investment. Usually, your counsel will prepare the Form on your behalf, but in order for them to do that, you’ll need to tell them about the subscription as soon as it happens.
  • A copy of Form D must be filed in each applicable state 15 days after the first sale in that state. Usually, an issuer’s counsel will do this, but they’ll need to know right away when you get new investors.
  • Amendments to Form D must be filed in the case of certain changes. Let your counsel know promptly if any of the information in the filed Form D changes.
  • Amendments to Form D also must be filed annually as long as the offering continues.

Ongoing Maintenance

  • Keep a running total of the amount subscribed for.
  • Review the offering materials at least quarterly, and when any significant event occurs, and let your counsel know if any information in them requires correction or updates as soon as possible. If you are unsure which events or changes would require an update of the offering materials, err on the side of consulting with your attorney.

This post was written with extensive help from Jennifer Wilson.

This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

Alexander J. Davie

Alexander J. Davie

Alexander Davie is a corporate and securities attorney based in Nashville, Tennessee. Businesses of many varieties rely on his counsel and judgment throughout all stages of their growth. In particular, fund managers and investment management professionals seek the expertise Alex gained when he served as general counsel to a private investment fund. Alex also has significant experience and enjoys working with companies and entrepreneurial ventures, especially within the technology industry. As a believer in technology's ability to enrich people's lives and allowing people to connect with each other in new ways, he is passionate about helping tech startups achieve success. He is active in Nashville's startup community as a mentor at the Nashville Entrepreneur Center and participates in numerous other events geared towards making Nashville a nationally ranked location for starting a business.

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