The passing of the JOBS Act created much fanfare, especially given the relaxation of the securities laws with respect to the use of “general solicitations.” Notwithstanding the excitement from the blogosphere, the revised rules also come with some hidden costs that make using a “general solicitation” in fundraising less attractive.
First, what is a “general solicitation?” General solicitations refer to the public advertisement of a fundraising effort through mass communication. Raising money through any of the following means likely involves a general solicitation:
• a mass newsletter or email,
• a company (or personal or third party) website open to the public,
• a public speaking engagement, including industry conferences, trade shows or similar
• a posting on social media with public access (such as Facebook, LinkedIn, etc.), or
• displaying videos on television or the Internet.
Generally, any method you would use to communicate to a large audience of people, including unaccredited investors, that your company is raising funds and the terms of such fundraising will likely be deemed a general solicitation.
Since September 23, 2013, entrepreneurs seeking to raise money have been allowed to engage in general solicitations, subject to certain new restrictions. Most important, new Rule 506(c) allows companies to use general solicitations subject to the following conditions:
• you may only sell equity securities to accredited investors,
• you must now go through a more robust process to verify that your purchasers actually
are accredited investors (more on this below), and
• you must file a Form D with the SEC and check a box to confirm whether you raised
money under 506(b) (the old rule) or 506(c) (a general solicitation).
While this all sounds pretty streamlined, there are some hidden costs to conducting a “general solicitation.”
More Onerous Verification Requirements
One of the primary hidden costs of conducting a general solicitation arises from the new requirements about the level of verification your company must undertake to ensure that the purchasers of your securities are, in fact, “accredited investors.” Previously, accredited investor status was typically verified by self-certification (e.g., having the purchaser execute an accredited investor questionnaire, checking the boxes that stated he or she was accredited and signing the document). Now, under new Rule 506(c), a company conducting a general solicitation must take “reasonable steps” to verify that all investors in the offering are accredited. Based on SEC guidance to date, the issuer will need to undertake a much more cumbersome and fairly invasive process to confirm the accredited status of its purchasers. In fact, SEC guidance on Rule 506(c) states that “self-certification” is not sufficient to prove accredited investor status. Rather, the issuer (or a third-party verification service) should review evidence of such investor’s net worth, which evidence could include tax returns, Form W-2s, bank statements and/or credit reports. Imagine the embarrassment of having to ask each of your investors to supply personal bank statements or W-2s! Investors could easily be turned off by this level of scrutiny and, in some cases, might forego making the investment altogether if they are required to hand over personal financial information as a condition for investing. The regulations do allow for third-party verification of accredited investor status, including by an attorney, accountant or other third party, and some third party service providers are already popping up to provide these services. But the transaction costs and additional time necessary to conduct such investigations may be significant.
Failure to Meet Filing Requirements Can Be Fatal
Unlike the prior Rule 506 offerings, offerings under Rule 506(c) are exclusive—meaning that if the exemption is not available to you because of a procedural defect, including the failure to file the Form D on time, there is no fallback position under any other federal securities law exemption. Before these changes take effect, offerings made under the old Rule 506 could rely on Section 4(2) of the Securities Act if there was a technical defect in the application of the Rule 506 exemption (old Rule 506 provided a safe harbor under the Section 4(2) exemption). However, because Section 4(2) cannot exempt a general solicitation, no such safety net exists for these new types of Rule 506(c) offerings. If a company fails to comply with all the requirements of Rule 506(c), no federal exemption would be available to cover the offering and the company would have effectively engaged in an unregistered public offering of securities—exposing it to the full panoply of liability for this type of securities law violation, including liability for the company’s control persons.
Potential for Additional Requirements
The SEC has made proposals to further amend Rule 506 to, among other things, require the Form D filing for an offering involving a general solicitation to be made 15 days before the actual offering. This would be difficult to comply with. Additionally, the SEC has proposed that all general solicitation materials be submitted to the SEC—which would impose another regulatory burden on your company.
What Does This Mean for Today’s Entrepreneurs?
Think very carefully before publicly promoting your fundraising efforts and seek advice from legal counsel as to the pros and cons of doing a “general solicitation.” You may ultimately decide that the benefits outweigh the costs, but it’s always better to be aware of those costs (and plan for them) before embarking on the process.
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