TO recent report of the SEC’s Office of the Small Business Capital Formation Ombudsman presents a study on how venture capital sponsors use the Rule 506(c) exemption under Regulation D of the Securities Act of 1933 in the fundraising.
Rule 506(c) allows 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 earn more 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 most frequently used.
When the SEC enacted Rule 506(c) in 2013the SEC emphasized that the “reasonable steps” one must take to comply with the Rule 506(c) requirement is a “principled verification method.” “[W]Whether the measures 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 buyer and transaction. For example, a capital raise that is primarily comprised of institutional investors for which there is extensive publicly available data (such as pension funds, funds of funds sponsored by a registered investment advisor, or nonprofit endowments for which data is available publicly). Form 990PF) will likely have very little need to make any inquiries beyond publicly available information. However, a capital raise comprised primarily of high net worth investors with whom the sponsor has limited or no private relationship will need to perform more due diligence and research on its 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 take this additional step. Beyond the cost to the sponsor, the report notes that sponsors believe there is a negative perception about the use of Rule 506(c) and that it indicates weakness in the market for venture capital fund interests.
However, in many cases, the flexibility that Rule 506(c) provides sponsors in the permitted use of general call and the relatively low cost of Rule 506(c) for many sponsors whose investment base is institutional investors or the result of long-standing investments Relationships should offset the effects of any negative perceptions. By relying on Rule 506(c), sponsors can avoid violations by violating the general solicitation prohibition by appearing at conferences, speaking to industry publications, or otherwise discussing their business. They may also have more freedom to discuss with potential portfolio companies about raising capital from the sponsor itself.
The report offers insight into why Rule 506(c) offerings are less common in venture capital, private equity or hedge funds. However, the rationale revealed in the report may not always reflect other benefits of using the Rule 506(c) exemption.
We present three channels that help explain why 506(c) has not been widely used:
• Track record paradox: The ability to advertise publicly in 506(c) reduces reliance on personal networks, but arm’s length fundraising requires a track record. This creates a paradox: few people have a solid track record but have not developed strong personal networks along the way.
• Access to the crowd: We show that a limit of 100 investors for private 3(c)(1) funds creates a regulatory barrier to 506(c) managers’ access to small retail investors.
• Investor verification costs: While not burdensome in principle, we show that perceived costs and accompanying signaling problems play a role in helping explain low 506(c) adoption.