HOW TO KEEP THE SEC FROM RUINING YOUR SEED ROUND, part 1

As an entrepreneur or startup founder you may be passingly familiar with fundraising terms like “Reg D” or “Rule 506.” If you’re like me, you’ve probably had too much on your plate to really understand them. I’m afraid now is the time. In a matter of days, the SEC plans to implement several big changes and continuing to operate with anything less than full understanding could tank you. This post should help, as will the Meetup I’ll tell you about at the end.

A LITTLE BACKGROUND

The vast majority of seed round investment in tech startups happens under Rule 506 of Regulation D of the Securities Act Section 4(2). Nearly a trillion dollars was raised this way in 2012 alone. If you’re hoping to raise money from an Angel or a VC, this is probably the exemption your lawyer will use, so you should understand the changes that are about to take effect.

Congress legislated these changes in last year’s JOBS Act to make fundraising easier for startups. It required, for the first time since the SEC was created to regulate such things, that the SEC truly open up the avenue of “general solicitation,” allowing startups to publicly advertise their fundraising to anyone and everyone as long as they only take money from accredited investors (basically wealthy people). This form of fundraising is being offered under a new exemption called 506(c). The SEC took the traditional form of the 506 exemption that Angels and VCs typically used and are now calling in 506(b). This could have been a really great move. Unfortunately, the SEC decided to create an additional set of rules well beyond what Congress had required that make 506(c) nearly impossible to use. These rules are so bad that founders who use them could easily find themselves shunned by investors. Ed Chalfin, an angel investor and entrepreneur whose company was successfully acquired by Texas Instruments, put it bluntly: “I will not invest in opportunities where this new requirement applies.”

In addition to the bad sentiment investors have in regards to 506(c), the new rules come with some really tough penalties if you make a mistake. To give you a sense of their seriousness, the penalties start with a 6-month prohibition on fundraising and can range to a 1-year ban that will follow the individual entrepreneurs for 5 years even at new startups. Also, in case you think this is just for those intending to use equity crowdfunding, the crown jewel of the JOBS Act, that is not the case. These rules for general solicitation apply whether you stick to the Angel and VC community or decide to take your fundraising to the crowd.

Most investors have not made a big deal about the changes because the SEC still allows them to invest in startups the old fashioned way under Rule 506(b). Famed investor Fred Wilson summarized those sentiments in a great blog post a few weeks ago. Unfortunately, I think these opinions are wrong. The way that the SEC set up these rules, many founders will inadvertently be forced to use the 506(c) exemption, which could be a major problem for the entire industry.

This stuff can get a bit confusing, which is why this post will continue tomorrow, when I’ll write more specifically about why these changes are so problematic and what can be done to fix the situation. It’s also why I’m helping to organize a Meetup where you can hear from two expert attorneys with decades of experience on SEC regulations, crowdfunding, and startup law. Please join our group and attend on Monday, 9/30!

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