By Greg Writer
On September 23, 2013, the amendments to Rule 506 of Regulation D under the Jumpstart Our Business Startups Act (known as the “JOBS Act”) became effective following the adoption of implementing rules by the Securities and Exchange Commission (“SEC”). These amendments lift the longstanding ban on general solicitations and advertisements to accredited investors. As a result, companies can now pitch their private investment opportunities to accredited investors through newspaper, television and website advertisements, and other previously prohibited means, if they comply with certain requirements. This will significantly increase the number of potential investors for small businesses and start-up companies.
Background of Rule 506. In general, when a company raises money by offering investments in its securities, including its equity or debt, it must register the offering under federal law and any applicable state securities laws unless exemptions from registration are available. Private companies normally seek to avoid registration under the securities laws because the costs of compliance are prohibitive. They will most commonly rely on Rule 506 of Regulation D under the Securities Act of 1933, which is also known as the “private placement exemption”, as the exemption from federal registration. Under Rule 506, companies will typically issue their securities only to individuals and entities that qualify as “accredited investors”. An accredited investor is deemed, by virtue of the investor’s financial position, sophistication and/or relationship with the company, to be capable of obtaining the information necessary to evaluate the benefits and risks of the potential investment. Among others, individuals who meet specific income and asset thresholds can qualify as accredited investors.
Rule 506 is an attractive exemption for private companies issuing securities (“issuers”) because it does not mandate disclosures of financial and other information when the offerings are limited to accredited investors. Thus, it greatly reduces the costs of compliance. Rule 506 also has the advantage of preempting substantive regulation of the offering by state governments. Connecticut, for example, only requires companies to file a copy of the SEC’s Form D exemption notice with the Department of Banking and pay a small fee (currently $150) in connection with any Rule 506 offering. Prior to the amendments to Rule 506 becoming effective, its main drawback was that issuers were prohibited from generally soliciting or advertising their offerings to accredited investors. Unless small businesses hired an intermediary (such as a registered broker-dealer) to locate investors, Rule 506 effectively limited their pools of accredited investors to their preexisting contacts and / or investors who were active in their area.
Amendments to Rule 506. Rule 506 has now been amended to, among other things, add a new provision – Rule 506(c) – which allows issuers to generally solicit and advertise to accredited investors, provided that the following conditions are met:
Satisfying the first requirement will be particularly challenging for issuers. The SEC’s implementing rules provide that issuers can use one of the following procedures to verify that their purchasers are accredited investors: (1) a general principles-based approach which takes into account, among other factors, the nature of the purchaser, the type of accredited investor, the information the issuer has about the purchaser, and the nature and terms of the terms of the offering; or (2) a non-exclusive list of four methods that are each deemed to meet the verification requirement. The non-exclusive list of methods that issuers may rely on, under appropriate circumstances, are: (1) income verification (which involves reviewing IRS reporting forms such as tax returns and obtaining a purchaser’s written representation regarding current income); (2) net worth verification (which involves reviewing certain asset and liability statements and obtaining the purchaser’s written representation regarding their liabilities); (3) third party verification (by, among others, a registered broker-dealer, licensed attorney or CPA); or (4) a grandfather clause (allowing issuers to accept a certification of accredited investor status from any natural person who invested in their prior Rule 506 offering(s) prior to September 23, 2013).
Preservation of the Old Rule 506. Some companies may decide that it is not worth the additional time and expense to verify the status of accredited investors in order to comply with the new Rule 506(c). It is important to note that these companies can still utilize the exemption under the old Rule 506 – which is now codified as Rule 506(b) – when raising money in a private offering. As such, they can still offer securities to accredited investors without any mandatory disclosure requirements as long as they refrain from general solicitations and advertisements.
Potential Benefit of the Amendments. Rule 506(c) will hopefully encourage more companies and investors to engage in private offerings. Some companies have been deterred from private investment offerings in the past because they did not want to hire registered intermediaries to locate accredited investors. In addition, the SEC estimates that over 8 million households qualify as accredited investors but only a few hundred thousand of them have invested in private offerings. General solicitations and advertisements could open up the investment market to a wider range of companies and accredited investors.
Potential Causes for Concern.
The SEC has already proposed additional rules that may limit the benefits of the Rule 506(c) and increase the costs of compliance. These proposed rules would, among other things, require issuers to submit their general solicitation materials to the SEC and would require issuers Form D exemption notices both before and after the offering. In addition, the SEC adopted “bad actor rules” concurrently with its JOBS Act implementing rules. The bad actor rules prohibit convicted felons and other bad actors from participating in any Rule 506 offering. Some issuers may be under the false impression that they can now advertise or solicit accredited investors without restriction. Accordingly, attorneys should take special care to counsel their clients on the new rules before they engage in activities that could blow their Rule 506 exemption.
Crowdfunding is defined as the funding of a venture or project through the raising of small amounts of money from each of a large number of people in exchange for a pre-defined reward. No stock options, loans, or venture capitalists needed, you just have to convince a whole lot of normal everyday people to invest in your startup company.
This is done by way of a website portal where everyone can see your project and donate or purchase goods or services. Individual contributions may not be much, sometimes just $10 or $20. However, we must consider the potential of the Internet.
To give you an idea how successful this method has been for a lot of entrepreneurs I recently read some statistics from the research firm Massolution and they estimated that about $5.1 billion dollars has been raised on crowdfunding portals in 2013 which is nearly twice as much as in 2012.
Please understand, they’re not selling stock or borrowing money on these crowdfunding websites. They are merely pre-selling their product or their service, their movie, their music or just flat out getting donations from lots of people. It really is super cool to see ” the crowd” back entrepreneurs on these crowdfunding websites supporting entrepreneurs and their dreams. The last time I looked the largest crowdfunding campaign was the Pebble Watch raised over $10 million pre-sales of their watch.
So needless to say, this become a very viable method for the entrepreneur to finance their company. But in reality these crowdfunding websites/portals are nothing more than a e-commerce platform that allows the average entrepreneur to set up a store to pre-sell their product or service. From there the entrepreneur must market and drive traffic, using social media, email marketing, etc. etc. to the store asking people to buy their product or service or support their venture through some kind of reward.
So depending on how much money you need to raise, your pre-money valuation and your upside potential this may be a very viable alternative to looking for investors. If you feel this may be for you please visit www.Angelnetwork.com/crowdfunding and if you would like a copy of Greg Writer’s book titled “Saving America One Crowd @ A Time” visit www.SavingAmericaOneCrowdAtaTime.com
So you drive a bunch of traffic to your crowdfunding campaign, tell all your friends about it, and maybe get featured on a few blogs. You go to bed, eager to see the results of all your hard work in the morning, and…nothing happens. There are no pledges. Despite tracking your analytics, none of the visitors are converting into backers.
At this point, if you’ve driven relevant traffic, you might ask yourself “Do people not care about this type of project, or am I doing something wrong with the presentation?”
Here is a crowdfunding campaign checklist to make sure you have every chance for success:
“Never Invest Your Money Until YOU’VE Done Your Due Diligence”
Definition: The research and analysis of a company done in preparation for any business transaction.
So in each newsletter we will share with you the best and most effective ways to quickly do your due diligence, and share with you some cool questions to ask so you can decide if you want to move forward on a more elaborate due diligence process.
As a side note I would like you to consider that venture capital firms sometimes been hundreds of thousands of dollars doing their due diligence. So it really depends on how big of the investment you are considering, the upside potential and the amount of time you want to invest in the due diligence process when considering investing in some entrepreneurs deal.
Here are couple my favorite questions that really give us an idea of the commitment level of the entrepreneur. The first one is to ask them how much money they ever raised from their friends and family. I can’t tell you how many business plans I have thrown in the trash can because of the answer to this question.
The worst answer is: “I would never asked my friends and family to invest”. Needless to say the answer to this question is very tale tale to the confidence and mindset of the entrepreneur.
My second favorite question is: What’s wrong with your deal? I have asked this question hundreds of times and it literally amazes me how many entrepreneurs have never considered their deal could fail, let alone try to address the realities of what could go wrong and probably will go wrong.
This is another one of those questions that when answered wrong or from a lack of knowledge is just a sure sign that I’m not investing in this deal.
If you want more information on how to do more extensive due diligence please go to www.Angelnetwork.com/duedilligence.
We are going to start with some basic guidelines, which will vary from person to person but are worth considering for you.
• Know Who is Responsible
There’s only one person responsible for the investments you make-If you want to be successful, you have to take 100% responsibility. Most of us have been conditioned to blame something outside of ourselves for the parts of our investments we don’t like, stop it! It’s all up to you.
• How Much Can You Afford to Lose?
Far too many gamblers go into a game with only a vague idea of how much they can afford to lose. Don’t! The smart ones learn to know exactly how much they can spend and stick to it. The same is true for an investor. Remember that ‘Just one more investment’ is the loser’s mantra! Another point that’s crucial to remember is that you must NEVER, under any circumstance, invest with money you cannot afford to lose.
• Know What Success Really Means
If you can figure this out it will make the investment journey a lot easier. If you are going to just measure wealth and success by dollars, its going to be a rough road but if you are thinking more along the lines of how many of the people you want to have love you actually do love you, maybe you are on a better track but that is for you to figure out. It should end up being the ultimate test of how you’ve lived your life.
This is so important, we will be talking a lot about this one. How and when can you get your money out?
• Be Willing to Be Different
Don’t base your decisions upon what everyone is saying or doing. Contrarian is sometimes the best position.
• Don’t Over Cook a Decision
Get access ASAP to any information you need to make a decision, give yourself a reasonable time and stick to a deadline. Hopefully in time you will learn to make up your mind and act on it.
• Calculate the Value of the Opportunity to You in Advance
Your leverage is always greatest before you begin a job — that’s when you have something to offer that the other party wants.
• Valuation of the Deal Itself
Entrepreneurs constantly want to value their deal now based on getting your money and everyone else’s and figure future earnings into the mix? What? Really? We are going after this one big time because it happens all the time. Ever watch shark tank, tell them Mr. Wonderful.
• Watch Small Expenses in a Deal
Investing in a company that isn’t mindful of small expenses will probably not be mindful f the large ones either.
• Assess the Risks-Due Diligence will be the focus
There are always risks, we are going to find them and discuss them.
• Limit Your Debt
It doesn’t pay in this volatile market place to borrow a significant amount — not to invest, not for a mortgage. Many investors think their borrowing is manageable but become overwhelmed by debt.
• Know When to Quit
Or at least when to take a little off the table of success and diversify further. Let’s have some fun and make some money!