Startups need funding, and most startups want to raise money with as little legal red tape as possible. But when a startup takes investment money, it is issuing securities, and federal securities laws generally require a company – or “issuer” – to register the offering and sale of any securities with the Securities Exchange Commission (“SEC”). The bad news is that most early-stage companies don’t have the legal resources to comply with the SEC’s registration and reporting requirements. The good news is that Congress and the SEC recognize this and so have created certain exemptions from the registration requirement.
The most commonly used exemptions derive from Sections 4(a)(2) and 3(b)(1) of the Securities Act of 1933. Section 4(a)(2) exempts issuer transactions “not involving any public offering,” while Section 3(b)(1) authorizes the SEC to create additional exemptions. The SEC adopted Regulation D (“Reg D”) in 1982 to clarify and expand the exemptions available under these two sections. The SEC further expanded Reg D in 2013 following passage of the Jumpstart Our Business Startups Act of 2012 (“JOBS Act”).
Until this year, Reg D included three rules – Rules 504, 505, and 506 – that provided specific exemptions from registration. Rules 504 and 505 exempted certain offerings up to $1 million and $5 million, respectively. Rule 506 spelled out two “safe harbors” – 506(b) and 506(c). If an offering met the conditions of either of Rule 506’s “safe harbors,” it would be deemed a transaction “not involving any public offering” and would be exempt under Section 4(a)(2).
Last October, the SEC amended Reg D “to assist smaller companies with capital formation.” The amendments changed Reg D in two main ways. First, Rule 504 was amended to increase its dollar limit from $1 million to $5 million. Second, Rule 505 was repealed because amended Rule 504 rendered it redundant. The Rule 504 amendment was effective January 20, 2017. Rule 505 was repealed as of May 22, 2017.
So where does that leave us? The below chart summarizes the former and current Reg D exemptions. (Note: This chart contrasts some of the exemptions’ main features and does not detail all applicable legal requirements.)
|Rule 504 [before 2017 amendment]||Rule 504 [as amended in 2017]||Rule 505 [repealed in 2017]||Rule 506(b)||Rule 506(c)|
|Dollar Limit (12-month aggregate)||$1 million.||$5 million.||$5 million.||None.||None.|
|Permitted Investors||Anyone.||Anyone.||Unlimited accredited investors and up to 35 non-accredited investors.||Unlimited accredited investors and up to 35 non-accredited but financially sophisticated investors.||All investors must be accredited.|
|Verification of Investor Accreditation||Not applicable.||Not applicable.||Issuer must reasonably believe that investor is accredited.||Issuer must reasonably believe that investor is accredited.||Issuer must take reasonable steps to verify that investor is accredited.|
|General Advertising & Solicitation||Permitted only in certain circumstances, depending on state law.||Permitted only in certain circumstances, depending on state law.||Prohibited.||Prohibited.||Permitted.|
|Disclosure Requirements||No specific disclosure requirements.||No specific disclosure requirements.||Enhanced disclosures required under Rule 502(b)(2) if any investor is non-accredited.||Enhanced disclosures required under Rule 502(b)(2) if any investor is non-accredited.||No specific disclosure requirements.|
|“Bad Actor” Disqualification||No “bad actor” disqualification.||Exemption unavailable to “bad actors” under Rule 506(d)(1).||Exemption unavailable to “bad actors” under Rule 505(b)(2)(iii).||Exemption unavailable to “bad actors” under Rule 506(d)(1).||Exemption unavailable to “bad actors” under Rule 506(d)(1).|
|Compliance with State “Blue Sky Laws”||Issuer must comply with state laws.||Issuer must comply with state laws.||Issuer must comply with state laws.||State law requirements preempted.||State law requirements preempted.|