November 4, 2013
By Caroline Lee, SELC Legal Fellow
The materials available at this web site are for informational purposes only and not for the purpose of providing legal advice. You should contact your attorney to obtain advice with respect to any particular issue or problem.
Many are excited for the latest Jumpstart Our Business Startups (JOBS) Act amendments to the Securities Act of 1933. Rule 506(c) took effect on September 23, 2013, opening up an exemption for emerging growth companies to solicit and advertise an investment opportunity to accredited investors in certain circumstances. Historically, accessing capital from wealthy investors required involvement with the tight-knit angel and venture capital networks that came through connections or the sheer luck of a pre-existing relationship. Now, small businesses can advertise through social media, the newspaper or otherwise, to connect and to offer investment opportunities to these high net-worth individuals.
Less discussed is California’s Corporation Code § 25102(n), an already existing exemption that allows for the offer and sale of securities to “qualified purchasers” through a public announcement. California’s definition of a qualified purchaser has lower income and asset thresholds than comparable the federal definition of “accredited investor.” For example, an individual jointly or with a spouse needs to demonstrate either a net worth of $250,000 and a gross income of over $100,000 or a minimum net worth of over $500,000. Under federal rules, an accredited investor is defined as having an individual net worth, or joint net worth with a spouse, which exceeds $1 million dollars or an individual income of over $200,000 or a joint income exceeding $300,000. The federal definition of net worth excludes the value of the primary residence, while the California definition excludes the value of home, home furnishings and automobiles. While California restricts the type of advertising allowed, the exemption opens up investment opportunities to a wider sector of the population than merely the super-wealthy, albeit still limited to California residents (unless coordinated with other state exemptions).
Federal accredited investor vs. California qualified purchaser, income and asset qualifications
Federal Accredited Investor
California’s Qualified Purchaser
|Persons with an individual net worth, or joint net worth with a spouse, that exceeds $1 million dollars excluding the value of the primary residence;||A minimum net worth of $500,000 exclusive of home, home furnishings, and automobiles|
|An individual income of over $200,000 or a joint income with a spouse exceeding $300,000 for the two preceding years and a reasonable expectation of the same in the current year||A person either individually or combined with a spouse has a minimum net worth of over $250,000, and gross income over $100,000 in the previous taxable year, as well as a reasonable expectation of gross income for the current year of the same amount, exclusive of home, home furnishings, and automobiles|
|* Must also be assumed to have the capacity to protect her interests in connection with the transaction|
|* Can only invest up to 10 percent of net worth|
The new Rule 506(c) and California’s existing § 25102(n) are steps towards a more open and fair capital market. Rule 506(c) allows small businesses to directly contact wealthy investors without relying on the difficult to access venture capital and angel investor groups, or reliance on broker-dealers and other financial institutions. California takes it a step further to allow new investment possibilities for slightly less-wealthy investors. Additionally, because these investments should reduce the cost of compliance, startups could potentially aggregate smaller amounts of capital from a larger network of wealthy individuals. These exemptions to securities registration are outlined in further detail below.
Federal Regulation D, Rule 506(c)
Under the new Rule 506(c), an emerging growth business can elect to raise an unlimited amount of capital from accredited investors through public advertising.
Previously, a business would be required to have a preexisting relationship with the accredited investor in order to solicit an investment; a difficult task in light of the federal government estimate that only 7.4% of U.S. households were accredited in 2010. Alternatively, a business would have to show high returns on investment to try and penetrate the close-knit angel and venture capital firms. Now, with public advertising, businesses have a better chance of reaching these 8.7 million U.S. households, while simultaneously promoting their business through media and advertising.
One drawback for startups is that the new Rule 506(c) imposes additional requirements on the companies to perform due diligence to ensure investors are in fact accredited, which some view as an onerous task, as well as a source of litigation. Previously you could rely on the investor’s assurances of their income and asset qualifications, allowing accredited investors to self-certify. Now, the company must proactively verify accredited status of each investor, something the Angel Capital Association believes will “kill angel investing.” The SEC provides a nonexclusive list of acceptable methods of verification including IRS statements such as W-2 or 1099s, bank statements, securities holding statements, tax assessments, and credit reports. Additionally, the SEC allows third party verification by a registered broker-dealer, an SEC-registered investment adviser, a licensed attorney or certified public accountant in good standing. It is yet to be seen how the requirement to disclose sensitive financial information so that the issuer can verify income and asset status will impact investor interest.
The prior Rule 506 provisions remain—under Rule 506(b) companies can still seek investments from up to 35 unaccredited investors and an unlimited number of accredited investors so long as no public advertising or solicitation is utilized. If using Rule 506(b), no due diligence is necessary to determine income or asset verification and self-certification from the investor is permissible.
What is the application process?
To comply with either Rule 506(b) or Rule 506(c), Form D must be completed by the seller of securities and submitted through an online portal on the SEC website. However, SEC recently proposed Rule 510T, which is under public notice and comment, to amend the process and content of Form D. Rule 510T would require an “Advanced” Form D must be submitted no later than 15 calendar days prior to the first use of general solicitation or general advertising. It also contains additional questions regarding how the money will be utilized, and, if using 506(c), the types of advertising to be used and the planned method to verify accredited investor status. After submitting Form D on the SEC web portal, changes can be made within 15 days after the first sale of securities. If a seller elects to use the Rule 506(b) offering initially (without general advertising), she can later choose to switch to the Rule 506(c) by filing an amended Form D. However, this cannot be done in the reverse—a business cannot change from Rule 506(c) back to Rule 506(b).
California Corporations Code 25102(n)
California has had a similar exemption allowing for the offer and sale of securities to qualified purchasers through a public announcement. Although the advertising requirements are more restricted than Rule 506(c), this exemption lowers the income requirements, opening up the investment opportunity for less wealthy individuals. Section 25102(n) has no restriction on the number of investors and when used in conjunction with the federal Rule 1001 exemption, up to $5 million can be raised. However, the securities issued through this exemption are restricted—each investor must represent that she is purchasing for her own account (or a trust account) and not for sale in connection with any distribution of the security (this is similar to the SEC Rule 144 resale restrictions that are imposed on all Regulation D offerings, including Rule 506).
Who is qualified?
Section § 25102(n) requires the seller to make a reasonably inquiry into whether the investor is qualified. A qualified purchaser is defined in several ways, the first category generally coincides with the federal exemption requirements:
- Excluded purchasers, defined in California Code of Regulations § 260.102.13, which includes officers, directors, promoters, accredited investors;
- Certain institutional investors including banks, insurance, companies, investment companies;
- A nonprofit, corporation, partnership, business trust having more than $5 million in assets;
- A corporation, partnership or other organization formed to invest in the offering, if all equity owners are qualified purchasers.
However, more significant for the movement towards increasing investment opportunity access, California also exempts natural persons with lesser monetary qualifications provided that they are also able to protect their own interests because of their business and financial acumen. Natural persons are considered qualified to invest so long as the offered security includes equal voting rights, either through one class of voting stock or preferred stock with equal voting rights, and the following conditions are met:
- A person either individually or combined with a spouse has a minimum net worth of over $250,000, and gross income over $100,000 in the previous taxable year, as well as a reasonable expectation of gross income for the current year of the same amount; or
- A minimum net worth of $500,000 exclusive of home, home furnishings, and automobiles; or
- A business with assets in excess of $5 million according to most recent audited financials; and
- Each person’s investment shall not exceed 10 percent of the net worth; and
- Each person by reason of her business or financial experience, or that of her uncompensated professional advisor, can be reasonably assumed to have the capacity to protect her interests in connection with the transaction.
The final requirement is the provision most open to interpretation. The theory is that because California allows the offer and sale of securities to less wealthy investors, it also requires some assurances that the individual is “reasonably assumed to have the capacity to protect her interests.” This could be as simple as a disclaimer on the investor certificate to indicate that the investor individually or by way of an independent financial advisor has the business and financial capacity to understand the risks involved with the investment. The exact requirements are not known, as there is little to no case law defining this requirement.
What advertising is allowed?
California’s § 25102(n) advertising requirements are more restrictive than that of Rule 506(c). Section 25102(n) allows for what is essentially tombstone advertising or a general announcement of the proposed offering. The advertisement can only be in writing, prohibiting in-person or telephone solicitation until the business has reasonably determined that the prospective investor is a qualified purchaser. The public announcement must include:
- The name of the issuer;
- The full title of the security;
- The anticipated suitability requirements;
- A statement that no money or other consideration is being solicited, an indication of interest made by a prospective purchaser involves no obligation or commitment, and if disclosure statement is required, no sale will be accepted until five days after the disclosure statement and subscription information is made;
- Any other information required by rule of the commissioner; and
- A legend that states where the prospective investor can seek more information.
If these provisions are satisfied, the business may also include (1) a general announcement of the proposed offering including a brief description, (2) the geographic location, (3) the price of the security to be issued or method of determining the probable price. Often, this general announcement is all one needs to draw potential qualified investors to the investment opportunity. After a prospective investor submits a questionnaire that demonstrates income and/or asset background such that the business can reasonably believe the investor is qualified, the full offering memorandum and other advertising materials can be provided.
What is the application process?
The filing procedure to utilize the exemption is fairly easy, keeping in mind both federal and state requirements. California requires a notice of transaction to be submitted to the State concurrent with the general announcement or initial offer, as well as filing fee of $600. Next, within ten business days after the close or abandonment of the offering, or not more than 210 days after the initial notice was filed, a second notice of transaction is required to be filed with the state.
The SEC has made it easy to coordinate the 25102(n) exemption at the federal level by providing a specific exemption for these transactions where no more than $5 million is raised, Rule 1001. Moreover, the offering can be coordinated with out-of-state investors so long as the state has a similar exemption and the proper filing procedures are followed.
The existing legal framework prevents a large sector of the startup business community from accessing capital markets and also prevents emerging growth companies from obtaining much-needed financing without reliance on large financial institutions or prized contacts within the closed venture investment circles. The new Rule 506(c) provides the opportunity for businesses to directly advertise to wealthy investors. One caveat should be kept in mind—increased advertising could spur litigation and claims concerning the veracity and sufficiency of the communication. Companies would be wise to seek counsel’s input on the advertising before public dissemination. Similarly, California’s exemption begins to open up direct investment opportunities to wider sector of the population by lowering the monetary requirements.