A recent report from the SEC's Office of the Advocate for Small Business Capital Formation presents a study on how the Rule 506(c) exemption under Regulation D of the Securities Act of 1933 is used in fundraising by venture capital sponsors.
Rule 506(c) permits an issuer of securities to engage in general solicitation as long as the issuer takes “reasonable steps” to verify the “accredited investor” status of its investors and all investors are "accredited investors." “Accredited investors” under Regulation D are generally individuals who either earn greater than $200,000 per year or have a net worth of more than $1,000,000 (excluding the individual's primary home) and entities that have a net worth of more than $5,000,000. There are more categories to define an “accredited investor,” but these are the categories that are more commonly used.
When the SEC promulgated Rule 506(c) in 2013, the SEC emphasized that the “reasonable steps” one must take to meet the Rule 506(c) requirement is a “principles-based method of verification.” “[W]hether the steps taken are ‘reasonable’ will be an objective determination by the issuer (or those acting on its behalf), in the context of the particular facts and circumstances of each purchaser and transaction.” For example, a capital raise that is mostly comprised of institutional investors for whom there is ample publicly-available data (such as pension funds, funds-of-funds sponsored by a registered investment adviser, or nonprofit endowments for which there are publicly-available Form 990PFs) will likely have a very low need to conduct any inquiry beyond the publicly available information. However, a capital raise that is composed mostly of high net worth investors with whom the sponsor has a limited or no private relationship will need to undertake more diligence and inquiry on their investors, likely through the use of a third party service such as verifyinvestor.com.
Many sponsors, as noted in the report, do not want to undertake this additional step. Beyond the cost to the sponsor, the report notes that sponsors believe there is a negative perception on the use of Rule 506(c) and that it signals weakness to the market for venture capital fund interests.
However, in many instances, the flexibility that Rule 506(c) provides sponsors in the permitted use of general solicitation and the relatively low cost of Rule 506(c) for many sponsors whose investment base are institutional investors or the result of long-standing relationships should outweigh the effects of any negative perception. By relying on Rule 506(c), sponsors can avoid foot-faults on violating the general solicitation ban when appearing at conferences, speaking with industry publications, or otherwise discussing their business. They may also be more free to engage with prospective portfolio companies about the sponsor's own capital raising.
The report offers insights into why Rule 506(c) offerings are less common in venture capital, private equity, or hedge funds. However, the rationales that the report reveals may not always reflect other benefits to utilizing the Rule 506(c) exemption.