There has been a huge uproar over the last few days about whether the implementation of new Rule 506(c) under Title II of the JOBS Act to allow general solicitation to accredited investors so long as the issuer takes “reasonable steps to verify” accredited investor status will have serious negative consequences for angel investing.
The key concern is that certain critical actions common in the fundraising world today such as demo days, business plan competitions, pitching to angel groups, angel group syndication, will now be deemed to be general solicitation requiring Rule 506(c). As David Rose eloquently stated, “unless a funding round is being done with completely, legitimately no solicitation at all (ie, no angel-focused web sites, no angel groups, demo days, etc. etc.) … every counsel will be advising clients to go the Title II route.”
If most startups opt to go with 506(c) offerings due to this ambiguity, then angel investors and groups would then have to submit to the new “reasonable steps to verify” standard, which could include things like turning over tax returns, W-2’s, credit reports, net worth statements, etc. or getting a certification from a lawyer, CPA or broker-dealer. Traditional angel investors might be wary of providing this type of financial information and may therefore shy away from making investments. As Marianne Hudson, Executive Director of the Angel Capital Association (ACA) states, this would “literally kill angel investment” and “many entrepreneurs may not be able to get the investment they need.” The danger here is that angel investors could withdraw from the market in mass (whether or not the concern is warranted), causing capital disruption for early stage companies.
On page 18 of the Final Rule Release lifting the ban on general solicitation, the Commission states that:
“Issuers will continue to have the ability under Rule 506(b) to conduct Rule 506 offerings subject to the prohibition against general solicitation. As we noted in the Proposing Release, offerings under existing Rule 506(b) represent an important source of capital for issuers of all sizes, and we believe that the continued availability of existing Rule 506(b) will be important for those issuers that either do not wish to engage in general solicitation in their Rule 506 offerings (and become subject to the requirement to take reasonable steps to verify the accredited investor status of purchasers) or wish to sell privately to non-accredited investors who meet Rule 506(b)’s sophistication requirements. Retaining the safe harbor under existing Rule 506(b) may also be beneficial to investors with whom an issuer has a pre-existing substantive relationship. In this regard, we do not believe that Section 201(a) requires the Commission to modify Rule 506 to impose any new requirements on offers and sales of securities that do not involve general solicitation. Therefore, the amendment to Rule 506 we are adopting today does not amend or modify the requirements relating to existing Rule 506(b).”
Changes to General Solicitation Under 506(b)?
This statement seems to indicate that the SEC did not intend to change the way things have been done prior to this date and, therefore, the principles of general solicitation applied previously under Rule 506 continue to apply to Rule 506(b) offerings going forward. If the Commission did not bring enforcement actions for demo days, pitch events, business plan competitions, angel group pitches, angel group syndication, etc. in the past under Rule 506, then applying this logic, they presumably would not do so under Rule 506(b) going forward.
I think the upshot here is that, if you are trying to stay within 506(b), then you will need to be careful that you are actually following the previously guidance on 506(b), meaning that you should confirm that your demo day/pitch event is ACTUALLY private and that your angel group ACTUALLY has substantial and substantive pre-existing relationships, etc.
The SEC has clearly said many times that posting of information behind a password protected site (like SeedInvest) only available to accredited investors, subject to some other conditions, will not constitute general solicitation so that may be safe ground for angel groups and other that may be concerned.
“Reasonable Steps to Verify” under 506(c) in Angel Group Context
Utilizing the “factor” test laid out in 506(c), it seems that “reasonable steps to verify” for a member of a legitimate angel group would be less than that of a random person on the street, which is seemingly who the safe harbors appear to be designed for.
In the context of an angel group with membership application standards consistent with those of the industry and approved by an industry group, things like a personal referral from an existing accredited investor member, automated background and identity checks, and the use of an expanded investor suitability questionnaire, might be deemed to satisfy the “reasonable steps to verify” test under Rule 506(c).
What other steps could angel groups take, short of providing financial information, that could strengthen the argument towards “reasonable steps to verify?
This post was written by James Han on September 15, 2016
General Solicitation Rules: The Old Way Preserved Under 506(b), Or is it?