In part 1 of this blog post we talked about the new changes to Rule 506 and the general sentiment of investors in regards to them. I would like to go into a little more detail as to why it is so easy to fall into the 506(c) trap. First, a little plug: my company is organizing a Meetup on Monday, 9/30, with two veteran securities lawyers who can help all of us navigate these murky waters. Please join us!
CASE STUDY: SEC REGS KEEPING STARTUPS PENNILESS
Say you have a startup. You’ve got a great team, built the MVP, and are getting good traction. In an effort to raise a seed round, you build a 3-minute video with a demo of the product, information about the team, and the terms of your offering. You post the video to your Angellist profile and tweet your followers that you are looking for investors. 31 days later, you land a meeting with famed angel investor Paul Singh, who ends up loving the company. Before writing a check, his lawyer does some quick due diligence, and that’s when everything falls apart. Why? Because it turns out you’ve inadvertently used general solicitation, and he does not want to deal with the ramifications. Including:
1. Accredited Investor Proof: According to the imminent SEC 506 amendments, your posts on Twitter and Angellist may constitute a 506(c) general solicitation offering. This method allows you to court only funders whom you have taken “reasonable steps” to ensure are accredited investors. Such certification would require Paul to provide his W2, tax returns, or a bank statement. Angel investors are very unlikely to hand over this information to a founder, no matter how interested they are in the company.
2. Advance notice of general solicitation: The new rules the SEC has written require you to file a “Form D” 15 days prior to any public statement about your fundraising. That means before you tweet or post a video, the written or spoken words must be provided along with any visual materials you post. Turns out, your tweet also should have been accompanied by one of those really long disclosures you see at the end of a legal document. That’s right, you will have to pre-file your tweets with the government – and no, the required disclosure won’t fit within Twitter’s 140 character limit.
3. 506(b) and 506(c) don’t mix: Remember that “friends and family” money you already raised? You are going to have to give it back. That money, raised without general solicitation from non-accredited investors, means you implicitly chose the 506(b) option. But when you went on Twitter and talked to Paul, you moved into 506(c) territory and the SEC forces you to choose one and only one. At this point, you have to stick with 506(c) or wait 6 months to try again with 506(b), a chunk of time you probably can’t afford to lose. So you stick with the 506(c) path but now you must return any money you had received from people who don’t meet the standards for an accredited investor – even your parents.
4. Landing in SEC penalty box is easy: Remember the video and tweet you sent out without first submitting a Form D 15 days beforehand? The SEC gives you a one-time-only pass if you make the filings within 30 days of your posts. Trouble is, you didn’t even realize this was an issue until you met Paul and his lawyer 31 days after posting. You’re a day too late, and it may cost you everything.
5. Strict penalties: Your failure to follow the 506(c) solicitation guidelines means that the SEC can force you to return any money you’ve raised and ban you from raising money at all for one year. This ban stays with you for the next 5 years as well, meaning your next startup is doomed before you begin.
General Solicitation: Worth All the Trouble?
So, if you’ve been following, you’re now familiar with the minefield that is Rule 506(c) – basically you can advertise your fundraising, but only if you comply with a slew of draconian rules that will serve to stop most in their tracks. You’ll have to file a Form D 15 days prior to talking about your company every single time, even in the smallest way (a tweet, a shared video, etc.). Every time you make a change to anything considered offering materials (and the SEC’s definition of this is exceptionally wide, which Pandodaily has written a great post on), you will have to re-submit that form. And, everything you send out to the general public must include a legal disclosure far too long for even the shrewdest tweeter.
With rules that are so restrictive and consequences so severe, the question is clear: Why would any startup use the general solicitation offered in the proposed changes to Rule 506(c)? Startups would be better off raising money through angels and VCs with the new Rule 506(b). That would be a good approach, except that the SEC has made it too easy to fall into the general solicitation route by accident; the definition is just too vague. Many things that founders currently do could be considered general solicitation. A demo day, a video of your pitch being posted to the internet, an angelist profile, a tweet that you are raising money: All of these things could be construed as general solicitation and the SEC has not made it clear where they will draw the line. Unless these rules are clarified, investors might steer startups into using 506(c) to be on the safe side, leading right back to the tangle of issues they were initially hoping to avoid.
WHAT’S TO BE DONE?
The SEC has mandated that general solicitation under the new rule 506(c) goes live on Monday, September 30. However, SEC Chairwoman Mary Jo White has told Congress that the additional rules I’ve been discussing will go into effect at an as yet undetermined date. This means that there is still time to submit comments to the SEC telling them that the proposed rules are overly burdensome on startups and do not align with the spirit of the JOBS Act legislation, which was to make this all easier not impossible. Angelist and Pandodaily have organized letter-writing campaigns with some suggested bullet points and an easy link to send your comments to the SEC. I have sent my own letter and urge you to do the same.
Again, these rules are complicated, and if they’re adopted, your startup life becomes riskier than it already was. I would love to see you at our MeetUp where you can get more information about all of this. Thanks for reading.