Private Offering Exemptions

Quick guide to Offering Exemptions. Click here to view and download this easy to navigate PDF identifying some of the requirements, limitations, and perks of exemptions available to entities raising capital.

Please note that the information below is informative only in nature, is subject to change, and shall not be construed as offering legal advice in any way. You are solely responsible for your use of the information below. Please consult with an attorney for specific application of any exemption.

Screen Shot 2016-07-27 at 10.07.17 AM

Which exemption will work for you will depend on the particular needs of your business. Factors to consider include: how much money you’re looking to raise, what type of investors you wish to reach, how you plan to advertise your offering, and more. An in depth explanation of the basic breakdown covered in the attachment follows, and is separated by a few of the critical distinguishing factors.

Max Offering. In deciding which exemption is right for you, one of the first things you’ll need to consider is how much money you’re looking to raise. While Regulation D’s Rule 506(b) (“Rule 506(b)”) & (c) (“Rule 506(c)”) are considered “safe harbors” for the private offering exemption of Section 4(a)(2) of the Securities Act, and Regulation D’s Rule 506 permits raising an unlimited amount of money; the other exemptions set various limits on the amount of capital a company can raise. Regulation A+ differentiates between Tier 1 and Tier 2 (collectively referred to as the “Tiers”) offerings, each subject to a different set of max offering rules.  Tier 1 cap offerings at $20 million and the enhanced regulatory requirements of Tier 2 allow for offerings up to $50 million.

The remaining exemptions set far lower limits on max offering amounts. Rule 504 of Regulation D (“Rule 504”), sometimes referred to as the “seed capital” exemption and Title III of the JOBS Act’s Regulation CF (“Crowdfunding” or “Reg CF”) provide an exemption for the offer and sale of securities up to $1 million in a 12-month period and Rule 505 of Regulation D (“Rule 505”) sets the yearly limit at $5 million. It’s easy to see how the needs of a particular company could preclude or open up certain exemptions based on monetary needs and max offering limits.

Investor Type. A second forethought that a company may want to consider when determining which method is right for them is who they are looking to work with. The rules separate investors into two basic categories based on annual income, net worth, and sophistication: accredited investors; and unaccredited investors. The phrase “accredited investor” encompasses a variety of forms (for example: entities, trusts, enterprises and individuals). The statutory definition explaining what is required of each individual category can be accessed at the following link: Accredited Investor. Each exemption identifies what types of investors are eligible to participate in a given offering.

The Tiers of Regulation A+ and the Rule 504 allow practically anyone to invest, but the others set a variety of limits. Reg CF is rather permissive in allowing an unlimited number of accredited and unaccredited investors to participate, but it expressly precludes funds and venture capital firms. Rule 505 and 506(b) are increasingly restrictive in allowing an unlimited number of accredited investors, but a maxing out unaccredited investors at thirty-five (35) individuals and Rule 506(b) also requires all unaccredited investors meet specific sophistication standards (discussed below in Investor Education Requirement). Rule 506(c) is limited to offerings available to accredited investors only.

Some of the exemptions set additional limits. For example, Rule 505 and 506 disqualify felons and other “bad actors.” An issuer seeking reliance on either of these rules must determine whether the issuer (or any of its covered persons) is disqualified by prohibited behavior. Please seek advice from experienced counsel before endeavoring to use any of these exemptions.

Individual Investment Limit. Although the majority of the listed exemptions don’t set limits on individual investors, Tier 2 of Regulation A and Regulation CF set personal investment limits. Tier 2 investors, whether accredited or unaccredited, may only invest up to 10% of the greater of their net worth and annual income. Investors participating in Reg CF offerings are similarly limited by their net worth and or annual income, and may invest up to 10% of the lessor of the two if both are over $100k (with a maximum contribution of $100k/year), or up to 5% if not (with a minimum limit of $2,000).

Investor Verification. Each exemption differs in regards to issuer responsibility in verifying investor accreditation status. Neither Tier 1 of Regulation A+, nor Rule 504 require any further verification of investor status. This is likely because both accredited and unaccredited investors are viable participants and there is no limit on how much they can invest. Because the rest of the exemptions either limit the type of investors or the amount that they can invest—the remaining exemptions require some degree of investor verification. Tier 2, Rule 505, and Rule 506(b) simply ask that an investor “self-certify,” and Reg CF does the same but gives crowdfunding portals the authority to require more (probably because of portal liability, which discussed below). Rule 506(c) companies must be much more diligent in the process of verification, because this kind of offering is strictly reserved to accredited investors. As a result, they’re required to collect documents proving the investor’s claimed financials to confirm that they meet accreditation muster. This can be cumbersome, but is a must for any company seeking to use these exemptions.

Advertising and General Solicitation. Another area which separates the exemptions is how companies are permitted to reach investors and advertise their offerings. Some of the exemptions deviate from Securities Act’s long standing prohibition on general solicitation and advertising, while others hold on to at least a slight remnant of the rule.

Both Tiers of Regulation A+ and Rule 506(c) abandon the prohibition altogether and allow unlimited solicitation and general advertising. In contrast, all of the other exemptions restrict the ways in which a company can reach potential financial backers.

Rule 504, 506(b) and Reg CF set somewhat of a middle-ground as far as solicitation and advertising go.  As a general rule, companies electing to use Rule 504 may not advertise or solicit, unless one of the enumerated exceptions apply, these include: (a) selling in accordance with a state law requiring the public filing and delivery to investors of a substantive disclosure document; (b) selling in accordance with a state law requiring registration and disclosure document delivery, selling in a state without those requirements and delivering disclosure documents mandated by a state in which it registered to all purchasers; or (c) selling exclusively according to state law exemptions permitting general solicitation and advertising, so long as sales are made only to “accredited investors.” Therefore, even though generally the prohibition on advertising and solicitation will stick for companies using Rule 504, certain circumstances may permit otherwise. Rule 506(b) permits the solicitation of people that companies have a pre-existing relationship with; and Reg CF allows for “limited notices” on the internet.

Rule 505 is the most extreme in this regard, and under no circumstance may a company conducting an offering under this exemption advertise or solicit available investors.

Pre-filing and Testing the Waters. One characteristic unique to both Tiers of Reg A+ is that companies may “test the waters,” before putting time and money into pre-filing. Though this process may seem incredibly beneficial for companies raising capital, it isn’t available to Regulation D rules—but this is probably because there are no pre-filing requirements. Therefore, the unavailability is somewhat immaterial as far as Rule 504, 505, and 506 go because companies can proceed with offerings without the burden of pre-filing in the first place. In contrast, Regulation CF issuers may not test the waters and must undergo extensive and often times expensive pre-filing requirements before opening an offering.

So what is testing the waters? Before filing an offering statement with the SEC, testing the waters means that companies may solicit interest in their contemplated securities and determine whether there is enough of a market to prior to incurring the full range of legal, accounting, and other costs associated with preparing and filing an offering statement.  Companies testing the waters must include certain language, or legends, in solicitation materials—notifying investors that no money for securities is currently being solicited, and that any indication of interest is non-binding. Nonetheless, this could be a great way of predicting the success of a potential Reg A+ offering, and avoiding fruitless expense.

While companies using Rule 504, 505, and 506 are not required to pre-file with the SEC before conducting an offering, they must file what is called a “Form D” within fifteen (15) days of the first sale to notify authorities of the amount and nature of the offering.

Unlike the other exemptions, Reg CF requires robust SEC pre-filing, and does not permit testing the waters; but it is easy to see how some companies may inadvertently do so by tracking analytics of the limited internet notices available for type of offering.

Closing Speed. Companies raising capital may also want to consider the urgency of their particular circumstance.

Selling securities pursuant to Regulation A+ depends on prior approval and “notice of qualification” from the SEC after staff review of company offering materials. The process of approval can take weeks, and SEC involvement in Reg A+ offerings is very different than the arms-length involvement and speeding closings for all of the Regulation D offerings (Remember: Rules 504, 505, and 506 simply require the filing of a Form D after the first sale has been made).

One pitfall of Rule 506(b) is that it has a thirty (30) day waiting period. Unlike the other Regulation D exemptions, offering issuers have to be able prove a relationship of a minimum of thirty (30) days with an investor before they are allowed to know about the deal. The purpose of the “cooling off” period is for the broker-dealer or company to make sure that the investor is suitable for the investment and is sophisticated enough to make the investment.

Offering Documents. Each offering has different requirements for exactly what information must be provided to investors. While Rule 504 has no specific offering document requirements, many of the other rules are far stricter in this arena.

Regulation A+ offerings require companies submit offering circulars to all investors that are first approved by the SEC. Rules 505 and 506(b) let companies decide what information to give to accredited investors, but companies must give non-accredited investors disclosure documents equivalent to those used in registered offerings. Additionally, if a company provides additional information to accredited investors, it must also give it to non-accredited investors. Offerings under Rule 506(c) are much different. Companies do not have to comply with document disclosure requirements because all investors must be accredited, and theoretically should have the judgment and bargaining power to request any information needed. In either sect of 506 offerings, companies must be available to answer questions from potential investors.

Regulation CF is the strictest of the exemptions in terms of offering documents. The Reg CF doors are open to a wider pool of investors, but issuers need to file a Form C with the SEC and must distribute it to investors at least twenty-one (21) days before the offering. Form C’s include the: (1) Name, legal status, address, website; (2) Directors, officers, background, offices held; (3) Identity of 20% beneficial holders of voting securities; (4) Description of the business; (5) Financial condition; (6) Target offering amount, maximum amount, deadline; (7) Description of the securities including prices and how determined; (8) Use of proceeds; (9) Ownership, capitalization, indebtedness; (10) Offering mechanics; and (11) Related party transactions. Companies and intermediaries must be very precise in confirming the information provided on the Form C to avoid liability discussed in a later section (Liability).

Financial Disclosures. A very important concern for many companies is what level of financial information must be disclosed alongside their offering. Audits and Certification from a certified public accountant (“CPA”) can be timely and costly, and sometimes they are required, but sometimes they’re not. Tier 1 and Tier 2 issuers must provide balance sheets and other financial statements for the two most recently completed fiscal years, or for such shorter time that the company has been in existence.  Tier 2 issuers must have the financial statements audited in accordance with either the auditing standards of the U.S. Generally Accepted Auditing Standards (“GAAS”) or the standards of the Public Company Accounting Oversight Board (“PCAOB”). Alternatively, Rules 504 and 506(c) do not require the submission of any particular financial disclosures.

Rules 505, 506(b) & Reg CF have similar requirements for financial disclosures that differ depending on various factors. Companies conducting offerings under the Rule 505 or 506(b) exemptions must provide financial statements certified by an independent public accountant; however, if a company other than a limited partnership cannot obtain audited financial statements without unreasonable effort or expense, only the company’s less than four (4) month old balance sheet must be audited. Limited partnerships unable to obtain required financial statements without unreasonable effort or expense may furnish audited financial statements prepared under the far more lenient federal income tax laws. Reg CF financial disclosures depend on the amount being raised, and whether the company is a first time issuer. As far as the amount of the offering goes: (1) if under $100k, preparation of financial documents can be conducted internally; (2) if between $100k-$500k the company must submit CPA reviewed financials; and (3) if between $500k-$1 million they must be audited by a third party accounting firm. The SEC loosens the requirements for first time crowdfunding issuers that are offering more than $500k, permitting reviewed, rather than audited, financial statements; this can still cost a crowdfunding company a pretty penny.

Ongoing Disclosures & Termination of Ongoing Reporting. Each of the offerings naturally differ in regard to what ongoing information must be provided to the SEC. Tier 1 offerings require updates of certain issuer information electronically, no later than thirty (30) calendar days after termination or completion of an offering. Tier 2 on the other hand requires electronic filing of annual reports, semiannual reports, interim current event updates, and forms at the termination or completion of an offering.

Compared to Regulation A+’s rigid ongoing obligations, Reg D Rules are practically or literally non-existent. Rules 504 and 506(c) require no ongoing reporting or disclosure whatsoever, probably because the rules lack an initial disclosure requirement, but the remaining Reg D Rules maintain the routine of their initial course of disclosure procedures. Rules 505 and 506(b) offerings that include unaccredited investors must comply with minimum ongoing disclosures mimicking those of a registered offering and if information is given to accredited investors it must be given to unaccredited investors. A company must only provide disclosures at the termination of an offering if unaccredited investors are involved; if not, it’s up to the issuer.

Transfer Restriction. Some of the securities sold under the exemptions are limited as restricted securities, while others are not. “Restricted securities” are securities issued in private offerings that must be held by purchasers for a certain period of time before they can be resold. Regulation A+ securities are not restricted for purposes of aftermarket resales, but securities purchased through Regulation D Rules and Regulation CF are restricted. Purchasers of restricted Reg D and Reg CF securities may not freely trade the securities for one (1) year after the offering. Therefore, the transfer restriction on securities is something companies and purchasers should consider in choosing between offering types.

Intermediary. Unlike all of the other exemptions, companies using Reg CF must use an intermediary. This means that companies cannot crowdfund through this exemption on their own, and must engage an intermediary.

Other exemptions permit the use of intermediaries but make it rather impractical. Federal law and the laws of the individual states prohibit a person from engaging in the business of facilitating securities transactions without a license. This means the person engaged in such a business (a securities broker or dealer) must be licensed and a member of the Financial Industry Regulatory Authority (“FINRA”), or a licensed representative of a FINRA member. There is a limited exception from broker registration for Rule 506 intermediaries but to qualify for this exception, the intermediary may not receive any compensation in connection with a purchase or sale of the securities. As a result, many qualifying intermediaries are unwilling to work with companies utilizing this exemption.

The result is that most company offerings with the option end up moving forward without engaging an intermediary, and all Regulation CF offerings use intermediaries, typically online portals, which must be registered with the SEC.

State Preemption. While some of the federal exemptions preempt the registration rules of the states, others do not. Tier 1 offerings require companies register or qualify their offering in any state in which they seek to offer or sell securities. This process is otherwise known as “coordinated review,” and companies should contact the states they intend to offer or sell securities for further guidance on compliance with state law requirements. Tier 2 offerings are not required to register or qualify their offerings with state securities regulators, but they are still subject to state law enforcement, antifraud authority, filing fees and other state filing requirements.

State securities law preemption varies by rule under Regulation D. Offerings under Rule 504 and 505 do not preempt state securities laws and companies conducting such offerings must comply with the registration laws of each individual state. Rule 506 takes a different approach, which is identical to Tier 2 preemption. Under section 18 of the Securities Act: private Rule 506 offerings are exempt from state registration and review. Nonetheless, states maintain the authority to investigate and bring enforcement actions for fraud, impose state notice filing requirements and collect state fees, which can be very expensive. No matter the exemption a company chooses to uses, it is always wise to check the relevant state laws.

Liability. One very important forethought that companies and investors should consider is what extent of liability will apply. The rules are very similar, with a few key differences – all intending to protect investors from fraud or misrepresentation by the companies they’ll be trusting their money with.

The main source of antifraud liability authority is found in Rule 10b-5 of the Securities Act of 1934 (the “Act”). This rule extends to all issuers of securities and is often referred to as the Act’s “antifraud provision.” The antifraud provision includes a private right of action, giving purchasers of securities a legal course of action against issuers found to be defrauding investors. Damaged investors can sue the person making misstatement, but must prove that the person either knowingly or recklessly misinformed in their offering. This can be near impossible for investors working with companies utilizing one of the exemptions because the exemptions typically require little or no representation. Sometimes what isn’t said is just as damaging as what is—so other rules attempt to close the gap, but tend to leave holes for many of the exemptions.

Unlike Rule 10b-5, section 12(a)(2) relaxes the burden of proof for harmed investors, but this section does not apply to all of the exemptions. One key benefit is that the additional rule specifically addresses material omissions that mislead, and unlike 10b-5, is not strictly applicable to untrue statements.  Here the investor need only show that the statement in question was false or omitted—leaving the defendant to prove that it did not know, and with the exercise of reasonable care could not have known it was false or should have been disclosed. Section 12(a)(2) only applies to Reg A+ and Reg CF, so Regulation D investors are precluded from the rule’s protection.

Another key difference distinguishing one exemption from the rest is who can be held liable for misleading or omitted statements. While antifraud liability typically only permits purchasers of tainted securities to sue the seller (i.e. the company), Reg CF offerings extend liability to the intermediaries. This furthering of liability gives buyers of misrepresented securities an additional party to sue in the case of fraud or material omissions and misrepresentations—naturally placing the heavy burden of looking into the legitimacy of companies on portals facilitating crowdfunding transactions. Failing to do so could open intermediaries up to serious legal consequences.

Investor Education Requirement. The only rules with specific investor education requirements are Rule 506(b) and Reg CF. Under 506(b) unaccredited investors must meet specific sophistication requirements, and under Reg CF, portals must provide investors with specific educational materials.

Unlike many of the other exemptions, Rule 506(b) has a sophistication requirement in particular circumstances. Companies selling to unaccredited investors under Rule 506(b), either alone or with a purchaser representative, must ensure that the investor has sufficient knowledge and experience in financial and business matters to be capable of evaluating the merits and risks of the prospective investment. This definition leaves room for interpretation but it is important to define what that means to you and be able to back up your own personal definition.  For example, it could be a CFO, CPA, accountant, business owner, banker etc. If the SEC were to ask why you thought this person was “sophisticated” you should be able to point to an internal set of standards to prove that caution was taken when making the determination.

Similarly, Reg CF requires that intermediaries distribute informational materials to investors, and unlike 506(b) this applies to both accredited and unaccredited participants. Intermediaries must provide disclosures and investor educational materials that are written in plain language at the time potential investors open accounts with the funding portal. Specifically, they must provide information explaining the risk and exposure of investment, and must receive an affirmative acknowledgment of investor understanding before allowing an individual to participate on the intermediary’s platform.

While the information may seem common sense, and likely isn’t enough to scare off potential investors—the time and cost of providing sufficient information and possibility that it could potentially deter investment is an additional consideration a company must regard in determining which course of action to pursue.

Again, please note that the information above is informative only in nature, is subject to change, and shall not be construed as offering legal advice in any way. Please consult with an attorney for specific application of any exemption.