Shhhhh! That’s the first thing you learn when raising funds for a startup, or running a venture capital fund. You can’t let the common people know! No advertising is permitted, and even publicly discussing the fact that you are collecting funds could get you in trouble with the SEC. But this practice has been obsolete for 7 years, and nobody in the venture capital and startup world seems to know it.
The SEC rule commonly used by startups and VC funds, rule 506(b) of Regulation D, allows them to be exempted from the many reporting and disclosure regulations applied to stocks traded on the market, but at a severe cost: all investors must be accredited, meaning that they must have a degree of sophistication in investment and wealth greater than the common person.
Meant to protect regular people from investments that don’t report enough information to allow them to make a reasoned decision, the other effect of the accreditation requirement is that only rich people can play. You are not allowed to invest in these high-risk, high-reward funds issued by startups and venture capital funds, unless you are wealthy or you yourself are a founder of the business. A net worth of a Million excluding the value of your home, or annual income in excess of $200,000 for an unmarried person and $300,000 common income for a married couple, are required.
Rule 506(b) requires businesses that wish to be exempted from reporting requirements must raise money privately. Advertising for investors is not allowed. They can’t talk about their solicitation of funds to people who aren’t accredited. They can only make solicitations of investors who self-declare themselves as accredited. You’re supposed to have a phone book full of moneybags that you can approach quietly.
This means that startups and venture funds are under severe restrictions of their speech by SEC. You can’t talk about your solicitation for funds where the lowly non-accredited person can hear it. In practice, their lawyers tell them not to publicly discuss anything connected with a fund-raise, or even that their fund exists. Many software companies sell virtual data rooms to shut out the hoi polloi, secure data stores that accredited people can be invited to enter to view and sign documents, while the lowly non-accredited are locked out of that information.
Obviously, this made it difficult for businesses to raise money. So, in 2012, the Jumpstart Our Business Startups Act, or JOBS Act, was passed into law. In the words of SEC, the JOBS act “is intended, among other things, to reduce barriers to capital formation, particularly for smaller companies.” Enacted in 2013 as rule 506(c) of Regulation D, it allows solicitations of capital that are exempted from reporting requirements similarly to rule 506(b), but “general solicitation” that is visible to un-accredited people is allowed, including advertising of the solicitation. Thus, businesses are released from the odious restrictions on speech. The cost of this is that the requirement for accreditation of investors is increased. A fund operating under 506(c) can not just take the world of an investor that they are accredited. They must actively verify it, using tax forms, bank statements, etc.
Fortunately, there are third-party companies that will perform accredited investor verification for as little as $60, and will keep the documents presented by the investor private. Two such companies are:
Use of these companies is advantageous to the investor and the fund, because the fund need never be exposed to the investor’s private documents. They just get a pass or fail report on the investor’s accredited status.
Rule 506(c), to date, is mostly used by real estate funds. Even SEC does not understand why VCs and startups do not use it more. The Director of the SEC’s Division of Corporation Finance, Keith Higgins, said “one wonders why the new Rule 506(c) exemption has not caught on more widely with issuers who have long clamored for the general solicitation ban to be lifted.” There is the additional requirement of validation, with its increased paperwork load on prospective investors, but the effect of this is reduced by using third party validation companies that shield those documents from view, even by the fund that requested validation.
The few negative opinions I’ve gotten from VCs and startup founders, so far, have been focused on aspects of 506(c) that they consider to be problems:
It’s additional paperwork for the investor, and somewhat intrusive paperwork. Your investor will be providing a copy of their tax return and bank documents, or a letter from their fund manager. They don’t have to do that to invest in a 506(b) fund. In a way, I actually consider this a plus. I don’t want the kind of investor who isn’t willing to do a little extra work to get onboard my company.
There is also the issue of democratization of investment. Angels and VCs are about the most entitled people you will meet. But they aren’t the only people with money! Lots of people today meet the standards for accreditation, but their money isn’t currently being utilized effectively, because they aren’t in investment networks with the active angels and VCs. Those who aren’t so entitled, or connected, would be more likely to give my company the attention it deserves. And because 506(c) allows advertising of general solicitations, I can find them.
Another criticism was that it’s too easy to get in trouble with 506(c). For example, if the company that audits your investors for accredited status doesn’t do their job well, you could end up with an unaccredited investor, and (theoretically) be prosecuted for making a “public” offering without the required disclosures and regulation, rather than the private offering you intended. For this reason you should be careful in choosing the company that vettes investors, and the contract you get with them, and they should report to your lawyer. That way, the decision to accept or reject an investor is always based on advice of counsel – which offers additional protections.
Finally, there an innuendo that officers and staff within SEC don’t actually like 506(c), and objected to its passage as law. And that they thus will interpret the law as restrictively as possible, like a cop who looks for ways to ticket you because he doesn’t like your bumper sticker. But this is why we have lawyers and courts.
But for most people, the main objection to 506(c) is that it’s unknown, and relatively new. People like the old ways that they know work. But you get ahead by innovating!
I first encountered rule 506(c) after I had been a partner at OSS Capital for a year. I had felt constrained by the restrictions on speech that fund has under rule 506(b). When I started to found a separate company, the business incubator or “venture studio” Incubator.Fund, I resolved to use rule 506(c), and not simply for the free speech advantages. I have dedicated most of my life to charity, as one of the founders of the Open Source movement in software, and did not have a personal network, a phone book full of moneybags to raise funds from privately, as rule 506(b) assumes. The ability to advertise, using rule 506(c), allows me to reach far beyond my personal network.
Incubator.Fund is doing its initial bootstrap raise in the worst of times: in the middle of the COVID-19 disaster. The bootstrap investors will fund the legal and other work necessary to start the fund and its first incubated companies, and then to solicit for additional limited partners. But because of the awful state of the market (at this writing), I have to sweeten the pot: those bootstrap investors will be offered a portion of the general partner for taking the risk at the worst of times. Maybe that, and the ability to advertise, will be enough to get good investors onboard my company. But without rule 506(c), I doubt we’d have a chance to find them.
To learn more about rule 506(c):
About the Author
Bruce Perens is one of the founders of the Open Source movement in software. Before that, he helped to create the industry of 3D Character Animated Feature Film at Pixar and its academic predecessor. He is currently general partner at Incubator.Fund and partner at OSS Capital.