General Solicitation in Relation to Capital Raising

Startups may undertake any and all activities when they need to raise capital. Before the introduction of JOBS Act there were significant restrictions on what founders could do and say to the prospective investors and general public. One of the main restrictions was no solicitation in any form. Solicitation is defined very broadly under the securities regulations. Common business activities may be viewed as solicitation if the ultimate goal is to get investments. Advertisements, presentations, demo days, other meetups and certainly the offer of investment opportunity are considered solicitation. If founders of the company or any of its associated agents engaged in any form of solicitation the company would be held responsible for violation of the securities laws. Of course, companies are not prohibited to advertise their products and services in the regular course of business. When considering whether the activity constituted ‘general solicitation of investment’ the SEC looks at the timing of the activity and what was the goal of the activity.  For example, if a company didn’t do any marketing and suddenly raised its marketing activities around the time it started looking for investments, it may cause suspicion. Also, if a company advertises its product to a general public for sale is one thing, but when a company presents its business concept to a group of people who can be viewed as potential investors and with implication that a company is open for new partners, it’s quite another matter. 

 

With the development of the markets the legislator realized that the ban on solicitation significantly limited startups’ opportunities to obtain capital in private transactions (when shares of the company are not registered and sold on the stock exchanges). Consequently, it may unreasonably slow down the business. A new law had to be developed which would release the solicitation ban and at the same time would not compromise exciting protections of the public from unscrupulous market dealers. This is how JOBS Act was introduced and passed in the law.

 

JOBS Act does not give a green light on all kinds of activities in relation to capital raising as some mistakenly think. Actually, it has lots of its own restrictions. Before JOBS Act startups mostly relied on Rule 506 of Regulation D under SEC Act of 1933 when structuring private sales of securities. This Rule does not only relieve them of the registration requirement with the SEC, but also exempts from most state filings under blue sky laws. One of the conditions of Rule 506 was and still is that a company could not offer its securities through general solicitation or general advertising. How startups could possibly obtain the investments? The emphasis was on preexisting relationships. Rule 506 allows raising unlimited amount of capital from accredited investors. Since general solicitation was prohibited, founders could not approach a person unless they knew for sure that a person was an accredited investor. Brokers and other market participants who are in the business of connecting startups with investors were great help. They had lists of verified accredited investors and made sure they made only proper introductions.

 

JOBS Act amended Rule 506 to allow companies to use general solicitation to market their offerings, but imposed additional conditions. Realizing that there was no need to fix something that was not broken, Rule 506(b) was left untouched and in addition to it a new Rule 506(c) became effective in 2013. Now an issuer raising capital in a Rule 506 transaction has two options:

 

     The pre-JOBS Act Rule 506 exemption (Rule 506(b)). An issuer relying on Rule 506(b) is, as before, banned from using general solicitation to market its offering.

 

     New Rule 506(c), which allows the issuer to market its offering through general solicitation. However, Rule 506(c) has some additional requirements and restrictions that can add complexity and cost to the capital raising process and limit the issuer's flexibility.

 

Rule 506(b)   

Rule 506(c)

Unlimited amount of accredited investors and up to 35 “sophisticated” unaccredited

All investors must be accredited

Issuers must reasonably believe an invertors is accredited

Issuers must verify an investor is accredited (attorney’s fees, third-party accrediting services, record keeping costs, subject to audit)

 

If an issuer fails to satisfy the rule's requirements for a technical reason, may still claim exemption under Sec 4(a)(2)

Since general solicitation is prohibited under Section 4(a)(2) exemption, once an issue used it, it cannot use any other option

File an informational statement with the SEC within 15 days after the transaction

Proposed for future development: File an informational statement with the SEC least 15 days before any general solicitation

 

Submit general solicitation materials to the SEC

 

 

Include specific mandated legends on the materials (attorney’s fees, record keeping costs, subject to audit)

 

To decide if the additional costs and complexities in exchange for freedom to solicit are worth it, startup founders must understand precisely what they may gain or loose by relying on either Rules 506(b) or 506(c). That is, they should understand what activities are considered general solicitation and banned in a traditional 506(b) offering, but permitted in a Rule 506(c) offering. Depending on the issuer's particular situation, these additional permitted activities may be very valuable to the issuer, or not valuable at all. Startup founders are strongly advised to discuss both Rules with an experienced securities attorney, weight pros and cons of each, and only after that plan their capital raising activities. It is important because if an issuer violates any requirement of one or the other Rule at any time, an issuer may be prevented from using that rule in the future should he change his mind. The issue may loose the precious opportunity, especially considering that exceptions from the SEC registration in private transactions are already extremely limited.

 

Creators should recognize the additional marketing options available under Rule 506(c) offerings in exchange for more stringent regulatory requirements. Below I review what forms of solicitation are prohibited, pursuant to the SEC guidance, if an issue intends to rely on Rule 506(b) when structuring an investment transaction later. As previously noted an issuer should consider whether he needs to undertake these activities in order to obtain capital. If not, additional complications of Rule 506(c) may not be worth it.

 

Private Discussions with Specific Individuals or Entities

 

Depends how a company or its founders know the investor. If founders contact an investor through informal networks, social media, phone email, personal meetings, it is a general solicitation prohibited under Rule 506(b). If founders approach an investor with whom they had preexisting substantive relationship, it is not a general solicitation.

 

Substantive Preexisting Relationship is "one in which the issuer (or a person acting on its behalf) has sufficient information to evaluate, and does, in fact, evaluate, a prospective offeree's financial circumstances and sophistication, in determining his or her status as an accredited or sophisticated investor. " SEC’s guidance issued in 2015

 

To satisfy this standard, generally, a relationship must be formed with a prospective investor before the beginning of the offering that the investor is being approached about. If a prospective investor is approached by a third party, such as a broker-dealer, the requirement is the same – such third party must have preexisting relationship with an investor. Accordingly, no cold-calling, cold-mailing, e-mailing, social media messaging or random approaches are allowed under Rule 506(b), but allowed under Rule 506(c).

 

Informal Networks and Other Contacts

 

Having a substantive preexisting relationship with each person approached for an offering is not the only way for an issuer to show that it made contact without using general solicitation. If a company has relationship with a sophisticated investor, this investor can refer the company to other sophisticated investors that are members of a formal or informal investor network. If a company is not selective in kind of potential investors it approaches or it happened to contact people who lack financial experience and sophistication, it is more likely that it is engaged in general solicitation.

 

Public Website, Social Media and Print or Broadcast Mentions of the Offering

 

A business might want to attract investors by mentioning its capital raising on a website, online or broadcast media, social media, various professional platforms. If a medium is accessible to anyone, such as a public website, it is certainly a general solicitation. It is different from posting offering information on a website behind the wall to be delivered only to potential investors who have already been identified without the use of general solicitation. For example, nowadays there are multiple platforms, which connect investors and companies looking for money. Operators of those platforms must verify the investors before they grant them access to the company’s offering. In other words, these platforms are brokers, which have preexisting relationships with investors, which allows them to make an offering on behalf of the companies.

 

Online Funding Platforms

 

Nowadays there are multiple platforms, which operate under different principles. Many are run with consideration that a company will be conducting offering under Rule 506(c), which allows general solicitation and, therefore, all information about the offerings is open to the site visitors. Others verify the status of the potential investors through multiple questionnaires and document gathering and, only after ensuring that an investor is accredited, provide the investor with password-protected access. Accordingly, founders should be careful when submitting their offering information to various platforms.

 

Product Advertising and Business Announcements

 

Usually companies operate ongoing business at the same time they are looking to raise capital. Marketing its products or services to customers and making public announcements about business events are not banned. It will be considered a general solicitation under the rule if it contains an offer to buy a security, somehow implies the possibility, or structured in a way to raise interest to the company’s shares rather than the product itself. Whether particular product advertising constitutes a general solicitation or not depends heavily on the facts and circumstances around each business activity. A company should be careful not to include predictions, projections, forecasts or opinions with respect to the business valuation or other forward-looking information.

 

Demo Days, Pitch Events and Other Meet-ups

 

Startups often attend events where they and peer companies present their business models, products and services. Is it a general solicitation? Again, it depends on how the particular event is conducted. If attendees were invited by the means of general advertising or announcements on unrestricted websites, such presentations will be considered a general solicitation. Sometimes the events are organized for a particular group of investors with whom organizers have substantive, preexisting relationship, and then it is not a general solicitation of the public.  

 

Demo days usually focus on the participating companies' products and services. If participants limit the discussion to their products and services and make no mention of their offerings, depending on the circumstances, it might be reasonable to conclude that participation does not involve the company making offers. However, remember that SEC’s definition of the offer is very broad and includes any and all indirect activities, which may raise interest to the company’s securities. Companies with the assistance of an experiences securities attorney should carefully consider participation in demo days along the same lines they would analyze product advertising and business announcements.

 

SEC Filings

 

Remember, regardless of which exemption was used to structure the private offering and sale of the securities, the companies must file Form D informational statement no later than 15 days after the first sale of securities putting the SEC on notice about the transaction.

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