Should I use 506(b) or 506(c) to raise seed capital for my startup company?

Startup companies that need to raise seed capital ($100,000-$2,000,000 approximately) should consider either a Title II Regulation D 506(b) or 506(c) private offering, which each have far less regulatory and filing requirements than other fundraising regulations like Regulation CF and Regulation A+.

The choice between doing a 506(b) or 506(c) private offering is up to the company, and should be determined before soliciting investors about the securities offering. Below is a brief summary of the two types of offerings, as well as the benefits and setbacks of each.

506(b)

Regulation D of the 1933 Securities Exchange Act lays out the regulations for a 506(b) private offering. A company doing a 506(b) offering is exempt from registering the securities with the SEC. The only filing that must be made with the SEC is a Form D (and subsequent amendments), and possibly similar filings under blue-sky laws depending on where your investors reside. The company can sell its securities to an unlimited number of accredited investors (annual income of at least $200,000 or net worth exceeding $1 million) and up to 35 non-accredited, sophisticated, investors (though companies probably should stick to accredited investors as “sophisticated” is up for interpretation). The company needs to have a “reasonable belief” that its investors are accredited, which is typically accomplished by having the investor fill  out a questionnaire displaying how they believe that they are accredited.

The downside of 506(b) is that the company is unable to “generally solicit” its securities offering, meaning that it cannot advertise that is attempting to raise money, orally, in print, online, or in any other form, to the general public. For any investors that end up investing into the company, the company (really meaning its founders, employees or agents) must be able to prove that it had a “pre-existing, substantive business relationship” with the investor.

506(c)

The SEC added 506(c) to Regulation D in 2013 which says that companies can only sell securities to accredited investors, unlike 506(b). However, the more important difference between 506(b) and 506(c) is that under 506(c) a company can generally solicit its sale of securities, either in print, radio, email, or other means. The caveat with general solicitation is that any accredited investor that does invest needs to have an independent accountant or attorney verify that the investor is accredited by reviewing the investor’s tax returns, financial statements, and any other documents that go to show the investors financial status.

Choosing which regulation is right for you

506(c) opens up the investor pool for a startup company to anyone that it can reach via its marketing campaign, while 506(b) is limited to who the founders have in their contact list.

When considering which regulation to use for your offering, consider this:

A company should have a private placement memorandum for investors to review and sign, as well as a shareholder agreement, and other relevant documents that a shareholder would need to review (like company bylaws).

Adding more paperwork slows down the fundraising process, possibly gives the investor more time to back out, or the investor may not feel comfortable disclosing their financial information to a third-party.

A business decision should be made concerning the actual process of onboarding an investor, and what an investors preference might be. If a company has a few “family and friend” investors that are going to invest, but it wants to generally solicit to find the remaining investors, the company should first find out what the family and friend investors are comfortable disclosing, as this can dictate how the company can proceed in attracting more investors.

A company can always switch from a 506(b) to a 506(c) offering, but it can’t do the reverse if it has already advertised that it is raising money. Therefore, this decision should be made early on. Founders with a good network might be safer sticking with a 506(b) offering, while founders that don’t have a private network of accredited acquaintances may choose to do a 506(c) offering, but the business considerations of the process should be considered just as much as the legal process.

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.

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