Understanding Common Registration Exemptions for Start-ups

By Frederick Ou Esq. and Vincent Cheng

When start-up companies issue stock to venture-capital investors, the stock-purchase agreement will typically include representations and warranties from the investors that they understand that the shares purchased are “restricted securities¹,” and are not registered with the SEC because a particular exemption from the registration provisions of the Securities Act of 1933 applies to such securities². In addition, the investors will also normally represent and warrant that they are “accredited investors” as defined in Regulation D under the Securities Act of 1933 (see below). These representations and warranties are equally important to the start-up company and the investors: the company must ensure that the offering and sale of its stock strictly complies with federal and state securities laws, as violations of these laws can have serious consequences, while investors who represent and warrant that they are accredited investors, but who do not meet the necessary criteria, will be liable for making such misrepresentations. Therefore, it is vital that both start-up companies and investors have a full understanding of the relevant requirements under U.S. securities law.

Common Registration Exemptions: Section 4(a)(2) of the Securities Act of 1933 is the primary statute used to provide an exemption from registration for venture-financing deals. Rather than making an offering under Section 4(a)(2) itself, however, most start-up companies instead take advantage of certain rules provided by the SEC under what is known as Regulation D, the most common of which are Rule 504 and Rule 506. Below, we have summarized the basic features and key distinctions between the Rule 504 and 506 exemptions under Regulation D, in order to assist start-up companies and their venture-capital investors:

A. Rule 504 Exemption

  1. $5 Million Dollar Limit.  In a Rule 504 offering, a company can only offer and sell up to $5 million in securities in any twelve-month period. This is one of the main disadvantages of Rule 504 versus Rule 506.
  2. No General Solicitation or Advertising. Companies utilizing Rule 504 are prohibited from general solicitation or advertising. This includes, for example, publishing ads in newspapers or magazines or on public websites, broadcasting ads over television or radio, or holding seminars open to the general public. In other words, under Rule 504, a company can only offer securities to investors with whom it has a pre-existing, substantive relationship.
  3. No Investor or Information Requirements. Unlike with Rule 506 as discussed below, there is no requirement under Rule 504 that investors be accredited or sophisticated, and there is no limit on the number of investors. This is the primary benefit of using Rule 504 over others. In addition, no specific information is required to be given to investors, although it is still advisable for the offering company to provide material, non-public information to potential investors, and the offering company must ensure it still complies with relevant anti-fraud laws and regulations.
  4. Must Comply with State “Blue Sky” Laws. Another disadvantage of Rule 504 versus Rule 506 is that, in addition to ensuring compliance with federal securities law, issuers must fulfill the requirements of the securities laws of each state in which it is selling to an investor (either by registering or finding an applicable exemption). This state compliance can become very burdensome when potential investors reside in several different states.
  5. Must File Form D Electronically with the SEC after First Sale. The issuing company must file Form D with the SEC within fifteen days after its first sale of securities. This is a free and relatively simple filing that only discloses limited, basic information of the issuer and the offering.
  6. Purchasers Receive Restricted Securities. This means that investors generally cannot sell their stock in the issuing company within one year after sale. Stock certificates will bear a legend stating that such shares are restricted, and may not be resold unless registered with the SEC or a certain registration exemption applies. The relevant exemptions and conditions for resale are detailed in Rule 144 promulgated under the Securities Act of 1933.

B. Rule 506 Exemptions

There are two different exemptions available under Rule 506:

Rule 506(b) Exemption

  1. No Dollar Limit. Unlike under Rule 504, there is no dollar limit on the amount of capital a company can raise under Rule 506.
  2. No General Solicitation or Advertising. Rule 506(b) has the same rules against general solicitation and advertising as under Rule 504 above.
  3. May Sell to Unlimited Accredited Investors, and up to Thirty-Five Non-Accredited, Sophisticated Investors. Unlike with Rule 504, under a Rule 506(b) offering, the issuing company may only sell securities to up to thirty-five non-accredited investors. Furthermore, these purchasers who are non-accredited investors must be “sophisticated” investors, meaning that they have enough knowledge and experience in financial and business matters that they can properly evaluate their potential investment and understand the risks involved. The burden of proving that a non-accredited investor is “sophisticated” is on the issuing company and this is a very subjective standard, so companies selling to non-accredited investors under Rule 506(b) must be careful to get enough information on such non-accredited investors and keep accurate records thereof. In addition, issuing companies are required to give any potential purchasers who are not accredited investors certain additional financial information, thus increasing the time, expense, and risk involved in such an offering. Since such information is not required to be given to accredited investors (although it may be given optionally for other purposes, of course), it is usually advisable that companies utilizing Rule 506(b) only sell to purchasers who are accredited investors.
    • Rule 506(b) also allows accredited investors to self-certify this status, which is significantly less burdensome for the issuing company than under Rule 506(c), which requires the issuing company to independently verify each purchaser is an accredited investor.
  4. Do Not Need to Comply with State “Blue Sky” Laws. One of the main advantages of Rule 506 compared to Rule 504, is that Rule 506 offerings are exempt from state filing and registration requirements.
  5. Must File Form D Electronically with the SEC after First Sale. Same as with Rule 504.
  6. Purchaser Receives Restricted Securities. Same as with Rule 504.

Rule 506(c) Exemption

  1. No Dollar Limit. Same as with Rule 506(b).
  2. General Solicitation or Advertising Allowed.  The main advantage of Rule 506(c) is that general solicitation and advertising is allowed, provided that all purchasers are accredited investors.
  3. Accredited Investors Only.  Unlike with Rule 504 or 506(b), securities in a Rule 506(c) offering can only be sold to accredited investors. Furthermore, Rule 506(c) requires that the issuing company take reasonable steps to verify that each purchaser qualifies as an accredited investor (such as reviewing the purchaser’s W-2s, tax returns, bank statements, etc.)—self-certification by the purchaser is not enough, unlike with Rule 506(b). This added required disclosure often makes Rule 506(c) offerings less attractive to potential investors.
  4. Do Not Need to Comply with State “Blue Sky” Laws. Same as with Rule 506(b).
  5. Must File Form D Electronically with the SEC after First Sale. Same as with Rule 504.
  6. Purchaser Receives Restricted Securities. Same as with Rule 504.

“Accredited Investor” Defined: The term “accredited investor” is defined in Rule 501 of Regulation D.

An individual qualifies as an accredited investor if he or she (a) earned more than $200,000 (or $300,000 together with his or her spouse) in income in each of the past two years, and reasonably expects to earn the same in the current year; (b) has a net worth of more than $1 million (alone or together with his or her spouse), excluding the value of his or her primary residence; or (c) is a director, executive officer, or general partner of the issuing company (or of a general partner of the issuing company).

An entity (such as a corporation, partnership, nonprofit company, or trust) generally qualifies as an accredited investor if (a) all of the entity’s equity owners are accredited investors; (b) it is a corporation, partnership, section 501(c)(3) non-profit organization, or business trust, with more than $5 million in total assets and that was not formed for the specific purpose of acquiring the offered securities; (c) it is a trust with more than $5 million in total assets, which was not formed for the specific purpose of acquiring the offered securities and whose purchase is directed by a “sophisticated” person; or (d) it is a type of entity described in Rule 501(a)(1) or (2), such as a bank, savings-and-loan association, registered broker or dealer, insurance company, investment company, Small Business Investment Company, government-employee-benefit or ERISA plan with more than $5 million in total assets, or private business-development company.

Summary

It is most common for start-ups seeking to raise funds in a private offering to use the exemption under Rule 506(b), but only sell to accredited investors in order to avoid the additional information requirements when selling to non-accredited investors explained above. Rule 504 has risen in popularity as an alternative, however, after the SEC increased the offering limit under Rule 504 from $1 million to $5 million in October 2016, but issuing companies utilizing Rule 504 must be wary of complying with state securities laws, which is not an issue under Rule 506(b). The Rule 506(c) exemption has proven to be less popular because of its requirement that issuing companies actively verify that purchasers are accredited investors, which in turn drives away potential investors who are concerned about their financial privacy.

The bottom line is that a company issuing securities must always keep in mind what exemption it is utilizing when raising funds from outside investors such as angel investors, venture capitalists, and even friends and family. Violation of securities laws early in the life of a company, even if only a small amount of money is involved, may become very difficult and expensive to later fix, and can taint a company’s attractiveness to future investors. Therefore, it is vital that start-up companies be careful and diligent with their legal compliance, and not take shortcuts due to an urgent need for additional cash.

Footnotes:

  1. “Restricted Shares” are those securities acquired in the unregistered sales under certain exemptions for SEC purpose. See Securities Act of 1933 Rule 144(a)(3). 
  2. Generally, a company cannot offer or sell its securities unless the transaction is either registered under Securities Act of 1933 or exempt from registration with the SEC. See Securities Act of 1933 § 5. 

© 2018 MT Law LLC. All Rights Reserved. Do not post without permission from the author.

For any questions or more information on these or any related matters, please contact an attorney in the firm’s corporate practice group. A list of such attorneys can be found by clicking Our Team on this page. Frederick Ou Esq.(fou@mtlawllc.com) and Vincent Cheng (hmcheng@mtlawllc.com) participated in drafting this posting.

Disclaimer

This article is for informational purposes only. It does not constitute advertising, legal advice or legal opinion. It is not promised or guaranteed to be correct or complete and may or may not reflect the most current legal developments. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, an attorney–client relationship. MT Law LLC and the authors expressly disclaim all liability in respect to actions taken or not taken based on the contents of this article. Readers with legal questions should consult an attorney. The choice of a lawyer is an important decision and should not be based solely upon informational articles.

ABOUT THE FIRM

MT Law is a full-service law firm representing clients in a wide range of practice areas including Business and Corporate Law, Immigration Law, Real Estate Law, Tax Law, Estate Planning and Intellectual Property. Headquartered in historic Lexington, Massachusetts, MT Law has additional offices spread across the United States in Boston, New York City, San Francisco, and Los Angeles, as well as offices in Beijing and Shanghai. For more information, please visit www.mtlawllc.com.

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