A Reg D offering is a form of private offering – an offering of equities that are exempt from registration under the Securities Act of 1933. Any discussion of private offerings begins with the mantra-like recital of the axiom that there can be no sale of securities unless such securities are registered, or if there exists an exemption from registration. Registration is almost always a non-starter due to expense. Hence, the craft of the securities lawyer is to find the appropriate exemption from registration.
The go-to exemption for most early-stage startups is under Regulation D, promulgated by the SEC. Many entrepreneurs are familiar with a general rule of thumb, “only sell shares to millionaires” – this refers to the concept of the “accredited investor.” An accredited investor is, put simply, a high net-worth individual or a certain type of institution (such as banks, hedge funds, et cetera). For individuals, an accredited investor is someone whose net worth (excluding their primary residence) exceeds $1 million or whose annual income exceeds $200,000 over the last two years. Another category of accredited investor includes any director, executive officer or (if a partnership) general partner of the company, regardless of net worth. While various proposals have been raised to amend the definition of accredited investor to include other individuals with high sophistication but lower net worth, none have yet been adopted.
The upshot of selling only to accredited investors is that so long as no “general solicitations” are used, an unlimited amount of money may be raised. Moreover, state securities laws (known colloquially as “Blue Sky” laws) are preempted, meaning that the company does not have to worry about this additional tier of compliance. This is the Rule 506(b) exemption (Rule 506 is promulgated under Reg D). An offering under this exemption can include up to thirty-five non-accredited investors; however, these investors must be “sophisticated” (a facts-and-circumstances determination) and furthermore, there are extensive and expensive disclosures that must be made to non-accredited investors.
If a private offering does use “general solicitations” to attract investors, then no non-accredited investors may be included in sales and the company has to go further than a mere “check-the-box” document to determine accredited investor status of the purchasers. This could include review of tax returns, financial statements, bank records, and other documents that potential investors are reluctant to hand over. Still, this Rule 506(c) exemption also preempts state Blue Sky laws.
Can a company ever offer securities to non-accredited investors without having to absorb the huge expense of generating and producing IPO-level documents? Yes, under Rule 504, a company can raise up to $10 million in a year from an investor pool that includes non-accredited investors. The drawback is that this rule does not preempt state Blue Sky laws. The company therefore must undertake securities law compliance on a state-by-state level, depending on the residence of each investor. This alone typically makes Rule 504 a non-starter.
What happens if a company’s management simply decides to eat the risk of selling equity to a non-accredited investor without bothering with all the costly disclosures and filing requirements? I would compare this undertaking to driving a curvy mountain road at high speed with one’s eyes closed. Possibly, everything will work out okay. Most likely, it won’t, and the results will be catastrophic. What the company is doing in such a case is handing the investor a loaded weapon that may be turned against the company as soon as the investor becomes disgruntled. The investor can demand rescission with interest and attorneys’ fees, and can threaten to involve regulators.
Next, we will look at an essential but often overlooked component of a fully compliant Reg D offering, which is the filing of a Form D plus state notice requirements. If you have questions about how to structure your equity raise in compliance with federal and state securities laws, email or call today.