If you’re a startup founder just stepping into the world of securities law, you’re in the right place. Raising money from investors is a pivotal milestone, but it’s complicated. To raise money, you’ll be selling “securities.” It could be a SAFE, a convertible note, preferred stock—all securities—or one of the many other types of securities. No matter the form, if it’s a security you’ll have to deal with securities laws.
While your lawyer will do the heavy lifting, you’ll need a grasp of the basics of securities laws to avoid obvious pitfalls. That’s the objective with this post.
The Problem: Why Registered Offerings Don't Work for Startups
We start with the basic rule. If your startup sells securities, the sale (also known as an “offering”) has to be either (1) registered with the SEC, or (2) exempt from registration.
Here’s the problem. The time, cost, and complexity involved in full SEC registration (option 1) make it an unrealistic for startups. That leaves startups stuck with needing to find an exemption from the registration requirement.
The Solution: The Exemptions of Regulation D
Enter Regulation D. The exemptions in this regulation are most favored by startups. In particular, Rule 506(b) stands out as the dominant exemption for startups, and it’s the one we’ll focus on first. However, Rule 504 and Rule 506(c) also have their use cases and will be considered as well.
Rule 506(b): The Most Popular Exemption
Let’s look first at the exemption most startups use: Rule 506(b). Under Rule 506(b), a startup can raise an unlimited amount of money from an unlimited number of accredited investors. The ability to raise an unlimited amount from investors, while not unique to Rule 506(b), is a powerful draw and distinguishes it from other exemptions, like Rule 504, that do impose dollar caps.
Tip: While up to 35 non-accredited investors can participate in a Rule 506(b) offering, their inclusion substantially increases complexity and costs, and so it’s generally advisable to limit Rule 506(b) offerings to accredited investors
Rule 506(b) is also popular with startups because it preempts state securities laws. This means startups don’t have to go through the hassle and expense of complying with state securities laws. All they have to do is comply with federal securities law, i.e., Rule 506(b). Preemption is particularly important when startups are raising money from investors in multiple states. The time and cost it would take to comply with securities laws across even a handful of states—let alone dozens—makes preemption a critical feature of this exemption.
Rule 506(b) is ideal for most startup financings. However, as we’ll see, there are situations in which other Regulation D exemptions may be better suited to a startup financing.
Rule 506(c): the Advertising Exemption
Some startup founders have a rolodex full of investor contacts. For this type of founder, it’s not hard to find investors when raising money. But that’s not the case for all founders. And some founders, whether due to their lack of investor contacts or a goal to reach a broader potential audience of investors, want to advertise and/or engage in “general solicitation” of their financing efforts.
Here's the problem: you can’t do this under Rule 506(b).
Fortunately, though, a different Regulation D exemption—Rule 506(c)—does allow startups to engage in general solicitation and advertising. Like Rule 506(b), Rule 506(c) allows startups to raise an unlimited amount of money from accredited investors (though non-accredited investors cannot be included). And like Rule 506(b), Rule 506(c) preempts state securities laws.
At this point you might be wondering why Rule 506(b) is so popular when Rule 506(c) appears to offer the same core benefits--but with the added benefit of being able to broadly advertise. As it turns out, there’s a catch.
For startups relying on Rule 506(b), they only need investors to “attest” to the fact that they are accredited. This is a low bar that doesn’t require meaningful diligence from the startup or disclosure from the investor. Rule 506(c) raises the bar significantly. Rule 506(c) mandates that issuers take “"reasonable steps” to verify the accreditation of all investors. This verification process can include reviewing financial statements, tax returns, or obtaining third-party certifications. As you might imagine, this can be a real hassle, take more time, create more friction with investors (who may not want to divulge sensitive financial information), increase fees, and otherwise make the financing process more painful. Not only that, startups (unsurprisingly) tend to have a higher likelihood of success in finding investors they’ve developed relationships with.
Although the broad potential reach of a 506(c) offering may be superficially appealing, it’s no guarantee of better outcomes. These realities have helped preserve Rule 506(b) as the much more popular exemption for startups, though that’s not to say that Rule 506(c) goes unused.
Rule 504: A Niche Exemption
Unlike Rule 506(b) and Rule 506(c), Rule 504 is tailored for smaller offerings, capping the amount of money companies can raise at $10 million within a 12-month period. And unlike its counterparts in Regulation D, there are no limits on including non-accredited investors in a Rule 504 offering. At first glance, this makes Rule 504 appear to be a good fit for startups that are raising modest amount in friends and family rounds where at least some potential investors aren’t accredited.
There’s a problem, though. Rule 504 doesn’t preempt state securities laws. Remember that each state has its own distinct securities laws, which can substantially increase costs and administrative burdens. So, a startup relying on Rule 504 would not only have to ensure compliance with that rule but also with the state securities laws in each state in which securities were offered. That might not be an insurmountable obstacle if all the investors are located in the same state, but it almost certainly will if investors are scattered across multiple states. As a result, the utility of Rule 504 is limited mostly to startups with investors in one or perhaps two states.
If anything, Rule 504 reinforces the fact that the practical costs of including non-accredited investors in a startup financing are usually too high to justify. In the Rule 504 context, the costs come from the need to comply with state securities laws due to lack of preemption. In the Rule 506(b) context, the costs come from the substantial disclosures that must be made if non-accredited investors are included.
Key Differences at a Glance
Feature | Rule 506(b) | Rule 506(c) | Rule 504 |
|---|
| Maximum Offering Amount | Unlimited | Unlimited | $10M in 12 month period |
| Eligible Investors | Unlimited accredited and up to 35 non-accredited | Accredited only | Accredited and non-accredited |
| General Solicitation | Prohibited | Permitted | Prohibited, with certain exceptions |
| Verification for Accredited Investors | Self-certification | Startup must take reasonable steps to verify | None |
| Preemption of State Laws | Yes | Yes | No |
| Filings | Form D within 15 days of first sale; state notice filings | Form D within 15 days of first sale; state notice filings | Form D within 15 days of first sale; state notice filings |
Conclusion
Navigating securities laws can feel like a daunting task for startup founders, but understanding the key exemptions under Regulation D can empower you to make informed decisions tailored to your fundraising needs.
For most startups, Rule 506(b) is the most practical exemption. Its flexibility to raise unlimited funds, simplicity in allowing self-certification for accredited investors, and the critical advantage of preempting state securities laws make it the go-to choice for founders.
Ultimately, though, the choice of exemption depends on your specific circumstances, including your investor base, fundraising goals, and willingness to navigate additional compliance hurdles. Working with an experienced securities attorney is essential to ensure your fundraising efforts are optimized for success and compliant with applicable regulation.
