Financing Your Small Business

The Rise of Rule 506 of Regulation D

In 1982, the SEC adopted Regulation D, which provided three exemptions from registration under the 33 Act—Rules 504, 505, and 506. If the guide­lines are followed, these rules collectively provide a safe harbor to sell secu­rities in a private transaction without having to file a registration statement with the SEC.

In 1996, Congress passed the National Securities Market Improvement Act (NSMIA). NSMIA brought some semblance of uniformity to the widely variant state exemptions from registration. It created a federal preemption over state registration for what it called covered securities. Essentially, it pro­vided that Rule 506 offerings were to be recognized as valid exemptions in all states, thus preempting state securities law for this type of offering.

Today, virtually all young companies will issue their securities in accor­dance with Regulation D. Rule 506 is a popular choice because of its acceptance by all of the states.

Rule 506 provides that an offering of securities will be exempt from reg­istration if it meets the following requirements.

• There can be no more than thirty-five purchasers who are not accred­ited in any given offering, but there can be an unlimited amount of accredited purchasers.

• Each purchaser who is not an accredited investor either alone or with their purchaser representative(s) must have such knowledge and expe­rience in financial and business matters that they are capable of evalu­ating the merits and risks of the prospective investment, or the issuer reasonably believes immediately prior to making any sale that such pur­chaser comes within this description.

• Certain financial and nonfinancial disclosure requirements must be met by the company.

• Financial disclosures include financial statements for up to two years, and in some cases they must be audited, depending upon the amount of the offering, and the balance sheet must be dated within 120 days of the start of the offering.

• There can be no general advertising or general solicitation of potential purchasers.

• Resale limitations on the securities must also be disclosed.

• Notice of the sale of securities (Form D) under Rule 506 must be filed with the SEC no later than fifteen days after the first sale of securities. (Form D is a statistical reporting form that is not, at present, reviewed by the SEC.)

Accredited Investors

An issuer typically determines an investor's accredited status by having the investor answer written questions regarding his or her accredited status.

Regulation D defines an accredited investor as a person or business entity meeting the following qualifications.

• Any individual with an individual net worth, or joint net worth with that person's spouse, of $1,000,000, or with an individual income of $200,000 ($300,000 with that person's spouse).

• An officer, director, or general partner of the company issuing the secu­rities.

• A nonprofit company with total assets in excess of $5,000,000 that was not formed for the specific purpose of acquiring the securities offered.

• A bank, saving and loan association, broker, dealer of securities, insur­ance company, investment company, or any employee benefit plan with assets exceeding $5,000,000.

• Any trust with total assets in excess of $5,000,000 that was not formed for the specific purpose of acquiring the securities offered.

• Any entity in which all of the equity owners are accredited investors.

Nonaccredited Investors

Nonaccredited investors are everybody else who falls below or comes outside the qualifications of an accredited investor. Accredited investors are deter­mined by a quantitative test, while nonaccredited investors are determined by a qualitative test. You have to be a bit more careful with nonaccredited investors. The issuer has to make certain that a nonaccredited investor has enough knowledge and experience in financial and business matters to be capable of evaluating the merits and risks of the prospective investment. The issuer must reasonably believe, immediately prior to making any sale, that such purchaser comes within this description.

In addition, although it is not a requirement under Rule 506, the finan­cial capability of the investor should not be ignored. The issuer should pro­vide disclosures that this is a high-risk investment and obtain an assurance that the investor is capable of losing their entire investment.

For purposes of Rule 506, there can be no more than thirty-five nonac­credited investors purchasing securities in any offering. An issuer can, how­ever, count certain groups of investors as one investor. Multiple purchasers who are counted as one purchaser for the thirty-five count include:


Accredited vs. Nonaccredited Investors: Accredited investors are assumed to have knowledge and experience in financial matters. With nonaccredited investors, you have to find out. Typically, you ask the investor a series of written questions regarding their financial and business experience.

• any relative, spouse, or relative of the spouse of a purchaser who has the same principal residence as the purchaser;

• any trust or estate in which the purchaser owns, either alone or together with related persons, more than 50% of the beneficial interest;

• any business entity majority-owned by the purchaser either alone or with (1) related persons as described in the first bullet or (2) a trust or estate as described in the second bullet; and,

• persons or business entities that are, or the issuer reasonably believes to be, accredited investors.

Nonaccredited investors who do not have such knowledge and experi­ence in financial and business matters may rely on a purchaser representative to evaluate the investment to make them capable of evaluating the merits and risks of the prospective investment.

HOW TO.. Determine the Status of Your Investor

Part of a private placement document is a subscription agreement, which all investors must complete. There are questions in the subscrip­tion agreement that determine whether the purchaser is an accredited or nonaccredited investor. In some smaller offerings, investors complete an investor letter.

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