The “Pre-Existing, Substantive Relationship”

The SEC recently issued guidance on what constitutes a “pre-existing, substantive relationship.” The guidance is helpful for companies raising money for a number of reasons.

The SEC guidance is especially helpful because there has been a fair amount of uncertainty about how to make sure a securities offering is not considered to have been generally solicited or generally advertised. If you are considered to have generally solicited or generally advertised your offering, you have to verify the accredited investor status of your investors. This means asking your investors for personal financial statements or their personal tax returns. Most companies want to avoid this, and thus want to make sure that their offerings fit snugly into Rule 506(b).

But how do you do this exactly? How do you make sure your offering is not considered to have been generally solicited or advertised? Well, one way is to be super scrupulous about not doing anything in the media or at public events to announce your offering.

This is why you do not see companies at Demo Days talking about their offerings. This is why you see companies exercise a lot of care during the middle of an offering when talking to the media.

But, what happens if you slip up? What if you mention in a meeting at which members of the general public were invited that you are raising money? What if a reporter catches you off guard and reports that you are raising money? Are you sunk? Do you have to go and change your offering from a Rule 506(b) to a Rule 506(c), and ask all of the investors in your round so far to give you their personal financial statements or personal tax returns?

Maybe not. At least, that is what the new SEC guidance indicates.

Here is what the SEC guidance says, exactly:

“The existence of such a pre-existing, substantive relationship is one means, but not the exclusive means, of demonstrating the absence of a general solicitation in a Regulation D offering.”

How Do You Establish a Pre-Existing, Substantive Relationship?

How do you establish a “pre-existing, substantive relationship” with your investors? Well, first, your relationship with the investor has to pre-date the start of your offering.

Second, you have to do the following:

A “substantive” 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. Self-certification alone (by checking a box) without any other knowledge of a person’s financial circumstances or sophistication is not sufficient to form a “substantive” relationship. [August 6, 2015]

The CitizenVC ruling is helpful in showing you how to establish a pre-existing, substantive relationship.

Do You Have To Have a Substantive Relationship With All of Your Investors?

Do you have to have a “substantive, pre-existing relationship” with all of your investors in order for your offering to qualify as a Rule 506(b) offering?

No. There is no requirement in order to conduct a Rule 506(b) that you have to have a pre-existing, substantive relationship with all of your investors. Having such a relationship is just one means, and “not the exclusive means of demonstrating the absence of a general solicitation.”

The best way to keep your offering within the confines of a Rule 506(b) offering to super scrupulous to generally solicit or generally advertise the offering. Just don’t slip up. Why? Because it is not possible if you already started your offering when you meet a prospective new investor for the first time to have a pre-existing relationship. And also because the substantive relationship test is not necessarily an easy one to meet. If you want to see the lengths to which one company went, the CitizenVC letter is a good read.

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Online Portals, Rules 506(b) & (c), and CitizenVC

The SEC recently issued an important no-action letter for online portals, and for other issuers of securities (including startup companies), trying to raise money in compliance with the SEC’s new 506(b) and 506(c) rules.

We can thank Dan DeWolf from Mintz Levin and his colleagues for obtaining this guidance from the SEC. Dan wrote a post about the meaning of CitizenVC here.

You can find the no-action letter here.

Citizen VC is an online portal. It forms special purpose LLCs to invest in early stage companies.

CitizenVC did not want to be considered to have generally solicited their offering of these special purpose LLC interests. Instead, it wanted to be able to rely on Rule 506(b) for the offering of those interests. To rely on Rule 506(b), a company cannot generally solicit or generally advertise its offering. If a company has a pre-existing, substantive relationship with its investors, that is one means of showing that general solicitation or general advertising did not occur.

But how does a company like CitizenVC establish a pre-existing, substantive relationship with investors who sign up to use its Internet platform?

Here is how CitizenVC posed the above question the SEC:

The Site is hosted on the publicly accessible Internet and CitizenVC is cognizant of the fact that prospective investors may search the Internet and land on its Site. CitizenVC wants to be prepared to accept membership applications from prospective investors with whom-a pre-existing relationship has not yet been formed, but with whom it will establish a relationship prior to offering Interests.

Here is how the CitizenVC site goes about establishing a substantive, pre-existing relationship with folks who show up on their web site wanting to join.

First, prospective investors have to to fill out a generic accredited investor questionnaire. Once they have done that, and have averred that they are accredited, Citizen VC puts the prospective investors through a process designed to establish a “substantive relationship.”

As the SEC has written:

A “substantive” 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. Self-certification alone (by checking a box) without any other knowledge of a person’s financial circumstances or sophistication is not sufficient to form a “substantive” relationship. [August 6, 2015]

As described in its request letter to the SEC, Citizen VC does the following, after receiving a generic accredited investor questionnaire from a prospective investor:

  • Contacts the prospective investor offline by telephone to introduce representatives of CitizenVC and to discuss the prospective investor’s investing experience and sophistication, investment goals and strategies, financial suitability, risk awareness, and other topics designed to assist CitizenVC in understanding the investor’s sophistication,
  • sends an introductory email to the prospective investor,
  • contacts the prospective investor online to answer questions they may have about CitizenVC, the Site, and potential investments,
  • utilizes third party credit reporting services to confirm the prospective investor’s identity, and to gather additional financial information and credit history information to support the prospective investor’s suitability,
  • encourages the prospective investor to explore the Site and ask questions about the Manager’s investment strategy, philosophy, and objectives, and
  • generally fosters interactions both online and offline between the prospective investor and CitizenVC.

After CitizenVC does all of the above, here is what else it does:

After CitizenVC is satisfied that (i) the prospective investor has sufficient knowledge and experience in financial and business matters to enable it to evaluate the merits and risks of the investment opportunities on the Site, and (ii) it has taken all reasonable steps it believes necessary to create a substantive relationship with the prospective investor, only then will CitizenVC admit the prospective investor as a Member of the Site. Thereafter, CitizenVC will provide the new Member access to the password protected sections of the Site, where the new Member can investigate investment opportunities curated by CitizenVC and the offering materials related thereto. The relationship with a new Member will exist prior to any offering of securities to such new Member.’

Here is how the SEC responded:

We agree that the quality of the relationship between an issuer (or its agent) and an investor is the most important factor in determining whether a “substantive” relationship exists. As the Division has stated before, a “substantive” 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. See, e.g., Bateman Eichler, Hill Richards, Inc. (Dec. 3, 1985). We note your representation that CVC’s policies and procedures are designed to evaluate the prospective investor’s sophistication, financial circumstances and ability to understand the nature and risks of the securities to be offered. We also agree that there is no specific duration of time or particular short form accreditation questionnaire that can be relied upon solely to create such a relationship. Whether an issuer has sufficient information to evaluate, and does in fact evaluate, a prospective offeree’s financial circumstances and sophistication will depend on the facts and circumstances.

In expressing these views, we note your representation that the relationship with new Members will pre-exist any offering, consistent with the Division’s previous guidance. In this regard, we note that a prospective Member is not presented with any investment opportunity when being qualified to join the platform. Any investment opportunity would only be presented after the prospective investor becomes a Member. Further, we understand that CVC creates SPVs for investment in particular Portfolio Companies and not as blind pools for a later investment opportunity.

What Is the Significance of CitizenVC?

What is the significance of the CitizenVC ruling? It provides a road map on how to develop a substantive relationship with a prospective investor. As the SEC has said,  “a ‘substantive’ 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.”

The CitizenVC no-action letter contains good guidance for all issuers of securities trying to rely on Rule 506(b). You don’t have to be an online portal for this guidance to apply to you. If you are a startup company, and you are trying to raise money from investors, do you need to have a “substantive, pre-existing relationship” with those investors to avoid being considered to have generally solicited your offering?

The SEC has said a “substantive, pre-existing relationship” is one means, but not the exclusive means of demonstrating the absence of general solicitation:

“The existence of such a pre-existing, substantive relationship is one means, but not the exclusive means, of demonstrating the absence of a general solicitation in a Regulation D offering.”

The fact that a “substantive, pre-existing relationship” can demonstrate the absence of a general solicitation in a Regulation D offering is really significant. Especially when the rules around what constitutes general solicitation and general advertising are imperfect and make it relatively easy for a company to inadvertently generally solicit or advertise an offering.

As Dan DeWolf summarized in his blog post:

As set forth in the CVC Letter, an issuer can now develop a specific set of policies and procedures that will take the offering outside of being considered a “general solicitation.” The key is that certain procedures are created and followed which enable the issuer and the potential investor to develop a “pre-existing, substantive relationship” before any securities are offered. These procedures are designed to enable the issuer to evaluate the prospective investor’s financial sophistication, circumstances, suitability, and his or her ability to understand the nature and risks of a potential investment. If there is no general solicitation, then the issuer is not required to obtain independent verification of the accredited status of the investor.

Thank you Dan and team for helping to obtain some clarity on difficult issues for issuers trying to raise money from investors.

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General Solicitation & Startup Capital Raising

Once again I had the fun opportunity to work on a writing project with Lauren Hakala from Practical Law.

This time we updated the previous piece we had written on General Solicitation, to take into account the recent SEC guidance.

General Solicitation: What Are the Highlights of the SEC’s New Guidance?

The SEC provided helpful advice on the following fronts:

  • Confirmation that use of an unrestricted web site constitutes general solicitation (no surprise here).
  • Helpful guidance on what constitutes a “substantive, pre-existing relationship.”
  • Helpful guidance on angel groups, and how angel groups can help avoid general solicitation.

Where Can You Find the New SEC Guidance?

The SEC issued the new Compliance & Disclosure Interpretations on General Solicitation on August 6, 2015. I have included links to each of the new C&DI questions below.

C&DIs – Securities Act Rules (UPDATED 08/06/2015)
Section 256. Rule 502 — General Conditions to be Met

New Question 256.23
New Question 256.24
New Question 256.25
New Question 256.26
New Question 256.27
New Question 256.28
New Question 256.29
New Question 256.30
New Question 256.31
New Question 256.32
New Question 256.33

Where to Download the Article

You can download the Practical Law article here:

General Solicitation and Startup Capital Raising Guidance and Questions (5-548-2425)

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The Importance of Angel Groups, Per the SEC

Angel groups are important for all sorts of different reasons. But the SEC has recently elaborated on a particular aspect of their importance that is worth calling out.

In particular, can angel groups help you with your Rule 506(b) offering without blowing the non-generally solicited nature of your offering?

The SEC says yes, they can.

Here is the backdrop:

  • To conduct a non-generally solicited Rule 506(b) offering, you can’t generally solicit your offering. You have to work contact-to-contact, through your “pre-existing, substantive relationships.”
  • But what happens if a friend introduces you to a friend who is a sophisticated angel? You don’t have a “pre-existing, substantive relationship” with this new person. So, if you pitch that person, have you blown your 506(b) offering by generally soliciting it? The answer should be no. The SEC’s recent guidance is quoted below. Of course, the SEC hedges a bit–it is ultimately a question of fact–but the below guidance is helpful. An encouraging acknowledgment of the importance of angel groups in the startup company, fundraising ecosystem.

Question: Are there circumstances under which an issuer, or a person acting on the issuer’s behalf, can communicate information about an offering to persons with whom it does not have a pre-existing, substantive relationship without having that information deemed a general solicitation?

Answer: Yes. The staff is aware of long-standing practices where issuers and persons acting on their behalf are introduced to prospective investors who are members of an informal, personal network of individuals with experience investing in private offerings. For example, we acknowledge that groups of experienced, sophisticated investors, such as “angel investors,” share information about offerings through their network and members who have a relationship with a particular issuer may introduce that issuer to other members. Issuers that contact one or more experienced, sophisticated members of the group through this type of referral may be able to rely on those members’ network to establish a reasonable belief that other offerees in the network have the necessary financial experience and sophistication. Whether there has been a general solicitation is a fact-specific determination. In general, the greater the number of persons without financial experience, sophistication or any prior personal or business relationship with the issuer that are contacted by an issuer or persons acting on its behalf through impersonal, non-selective means of communication, the more likely the communications are part of a general solicitation. [August 6, 2015]

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How to Make the Washington Crowdfunding Law Better

Washington State passed one of the first state-level equity crowdfunding laws in the nation in 2014, to great fanfare.

The regulations implementing the law went into effect November 1, 2014.

You can find a good summary of the rules at this link: http://www.dfi.wa.gov/small-business/crowdfunding

The trouble is–despite the rules being in effect now for almost a year, no one has used the law to raise money for a business.

Why? My belief is the law is too difficult to use. The law contains too many conditions and ongoing requirements.

Of course, the purpose of securities laws is to protect investors, as well as facilitate capital formation. But capital formation is not occurring.

I have some suggestions on how to make the law easier to use, so that it will actually be used. Here they are:

Do away with the escrow requirement for offerings under a certain size. Right now the law requires you to retain an escrow agent. The purpose of this requirement is to ensure that if you need to raise a certain amount of money before you can accomplish a business goal–e.g., buy a food truck–the securities regulators don’t want investors who put in money before the minimum is hit to lose their money if the minimum is never hit. This makes sense when there is a true minimum to accomplish something, like buying a food truck.

But what if you are building a software product and you can literally get started building a minimum viable product with as little as $25,000?

How about we change the law to not require an escrow for small offerings, say, $250,000 or less?

Right now I believe the escrow requirement is a big impediment to the use of the law.

Oregon’s law does not require the use of an escrow at all.

Do not require advance approval for offerings under a certain size. Right now you cannot proceed with your equity crowdfunding offering until the DFI approves your crowdfunding form. 

Oregon does not require advance approval of its securities regulator to proceed. In Oregon, you file your paperwork, and a week later you are ready to go–approved or not.

Why not adopt this approach in Washington for offerings not greater than $250,000?

Do away with the public reporting of executive officer and director compensation.

Right now the Washington law requires public disclosure of executive officer and director compensation.

For a lot of companies, the idea of having to disclose executive and director compensation to the public at large is a non-starter.

The whole theoretical justification for disclosure like this to the public at large this falls away if you can’t publicly advertise your offerings–which you really cannot do under the Washington law except very carefully without violating federal law.

So, I would recommend we require these disclosures to actual shareholders–but not the public at large.

Allow convertible debt to be sold under the law

Convertible debt is one of the most popular ways for startups to raise capital. Yet the Washington crowdfunding law cannot be used for a convertible debt offering.

I would recommend we change this.

Allow the law to be used for real estate investments.

Wouldn’t it be nice if you could buy partial interests in rental properties under the act?

Allow accredited investors to invest an unlimited amount of money.

The per investor limitation under the law makes sense for non-accredited investors, but not for accredited investors. Under the federal law, in Rule 506 offerings, an accredited investor can invest an unlimited amount of money. It seems to me that accredited investors ought to be able to invest any amount under the law.

But the broader point is this–we should take take a look at our crowdfunding law and make some modifications to it so that companies will use it.

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Stock Options: ISOs vs. NQOs

Q: Can a member of the board of directors receiving a stock option as compensation for board member service receive an incentive or statutory stock option (an “ISO”)?

A: No. A board member who is just a board member, and not otherwise an employee of the company cannot receive an ISO. Only employees can receive ISOs.

Here is how the IRS puts it: “A director of a corporation is not an employee with respect to services performed as a director.”

The Differences Between an ISO and an NQO

In case you are not aware of the primary differences between an ISO and a non-qualified stock option “(NQO”), here are the primary differences:

  • Incentive stock options can potentially generate better tax consequences for the employee, if certain conditions are met. But the spread on the exercise of an ISO can give rise to significant alternative minimum tax consequences.
  • NQOs can be better for the issuer, because the spread on exercise is a deduction to the company.

If you would like to read more about the differences between ISOs and NQOs, below are some other blog posts I’ve written on this topic:

Incentive Stock Options vs. Nonqualified Stock Options

Top 6 Reasons to Grant NQOs Rather Than ISOs

 

 

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Is a Demo Day General Solicitation?

Is a Demo Day a general solicitation of securities putting your company in Rule 506(c) as opposed to 506(b)?

The SEC has issued new guidance on this question.

Per the SEC’s new guidance, a Demo Day is not necessarily a general solicitation.

However, it depends on what you do at the Demo Day.

If you offer your securities, then it may be–unless “attendance at the demo day or venture fair is limited to persons with whom the issuer or the organizer of the event has a pre-existing, substantive relationship or have been contacted through an informal, personal network as described in Question 256.27.” You can see Question 257.27 quoted in full below.

If you want to avoid this quandary–of determining whether attendance was limited as described above and in new SEC Guidance Question 256.27–what should do you?

Do not involve an offer of a security in your presentation. But how do you do this?

Keep your presentation limited to “[i]nformation not involving an offer of securities.”

But how do you do this? Talk about only factual business information that does not “condition the public mind or around public interest” in your offering.

What is “factual business information”? Here is what the SEC said it was:

Answer: What constitutes factual business information depends on the facts and circumstances. Factual business information typically is limited to information about the issuer, its business, financial condition, products, services, or advertisement of such products or services, provided the information is not presented in such a manner as to constitute an offer of the issuer’s securities. Factual business information generally does not include predictions, projections, forecasts or opinions with respect to valuation of a security, nor for a continuously offered fund would it include information about past performance of the fund. (Release No. 33-5180). [August 6, 2015]

I have quoted some of the SEC guidance in full below, because it is helpful in this context.

New Question 256.24

Question: What information can an issuer widely disseminate about itself without contravening Rule 502(c)?

Answer: Information not involving an offer of securities may be disseminated widely without violating Rule 502(c). For example, factual business information that does not condition the public mind or arouse public interest in a securities offering is not an offer and may be disseminated widely. Information that involves an offer of securities through any form of general solicitation would contravene Rule 502(c). [August 6, 2015]

New Question 256.33

Question: Does a demo day or venture fair necessarily constitute a general solicitation for purposes of Rule 502(c)?

Answer: No. Whether a demo day or venture fair constitutes a general solicitation for purposes of Rule 502(c) is a facts and circumstances determination. Of course, if a presentation by the issuer does not involve an offer of a security, then the requirements of the Securities Act are not implicated. Where a presentation by the issuer involves an offer of a security, the presentation at a demo day or venture fair may not constitute a general solicitation if, for example, attendance at the demo day or venture fair is limited to persons with whom the issuer or the organizer of the event has a pre-existing, substantive relationship or have been contacted through an informal, personal network as described in Question 256.27. If potential investors are invited to the presentation by the issuer or a person acting on its behalf by means of a general solicitation and the presentation involves the offer of a security, Rule 506(c) may be available if the issuer takes reasonable steps to verify that any purchaser is an accredited investor and the purchasers in the offering are limited to accredited investors. [August 6, 2015]

New Question 256.27

Question: Are there circumstances under which an issuer, or a person acting on the issuer’s behalf, can communicate information about an offering to persons with whom it does not have a pre-existing, substantive relationship without having that information deemed a general solicitation?

Answer: Yes. The staff is aware of long-standing practices where issuers and persons acting on their behalf are introduced to prospective investors who are members of an informal, personal network of individuals with experience investing in private offerings. For example, we acknowledge that groups of experienced, sophisticated investors, such as “angel investors,” share information about offerings through their network and members who have a relationship with a particular issuer may introduce that issuer to other members. Issuers that contact one or more experienced, sophisticated members of the group through this type of referral may be able to rely on those members’ network to establish a reasonable belief that other offerees in the network have the necessary financial experience and sophistication. Whether there has been a general solicitation is a fact-specific determination. In general, the greater the number of persons without financial experience, sophistication or any prior personal or business relationship with the issuer that are contacted by an issuer or persons acting on its behalf through impersonal, non-selective means of communication, the more likely the communications are part of a general solicitation. [August 6, 2015]

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General Solicitation: Can I Generally Solicit My Offering?

There is a lot of confusion in the early stage company ecosystem about general solicitation.

When you are trying to sell shares in your company (or a convertible note, or convertible equity), how much can you say about that in the media? Can you post something on Facebook? On Twitter? On LinkedIn? How about emailing a large group of people who you are connected with through LinkedIn? Can you do that?

How about standing up in a room full of strangers, and pitching your deal to them? Can you do that?

What if a reporter calls? Can you talk to the reporter about your fundraising efforts?

In general, for most companies–the answer is: Don’t do any of these things. For most companies raising money in a securities offering, the answer is–do not generally solicit your offering. Do not post anything on Twitter, Facebook, LinkedIn. Do not email hundreds of people in an email distribution list about your offering. Do not stand up in a room full of strangers and pitch your offering.

The reason? Because most companies raising money are relying on a securities law exemption, Rule 506(b), which prohibits general solicitation. Rule 506(b) is the most commonly relied upon securities law exemption for companies raising money. Why is it so popular? Because as long as you take money from only accredited investors, you can raise as much money as you like without registered offering level disclosure, and you do not have any pre-sale filings to make with securities regulators. Instead, you have one form to file with the securities regulators–the Form D–and it is due within 15 days of taking funds. But the big catch for 506(b) offerings is that no general solicitation is allowed.

Why Not Just Use Rule 506(c)?

Rule 506(c) allows general solicitation. So you might wonder–why not just use Rule 506(c)? There are a few different reasons you might not want to use Rule 506(c)–even if it is a possibility.

  1. You will not have a fall back securities law exemption under Section 4(a)(2) if you generally solicit. Section 4(a)(2) of the Securities Act of 1933, as amended, provides an exemption for offerings that are not public offerings. A generally solicited Rule 506(c) offering cannot, if it fails to meet the 506(c) requirements, qualify as not a public offering under Section 4(a)(2). See Question 260.13.
  2. Rule 506(c) requires you collect additional verification information from your investors. Meaning, you have to ask your investors for copies of their personal tax returns or financial statements if you generally solicit. Most companies want to avoid this.
  3. Rule 506(c) offerings are more likely to draw regulatory scrutiny. You have to tell the securities regulators you are engaging in a Rule 506(c) offering when you file your Form D.

What I am seeing right now is that most companies are not going the Rule 506(c) route. Instead, most are sticking with the old-fashioned pathway–Rule 506(b).

What is General Solicitation?

What is general solicitation?

The SEC has provided guidance on what constitutes general solicitation. Rule 502 of Regulation D contains the following explanation:

(c) Limitation on manner of offering. Except as provided in § 230.504(b)(1) or § 230.506(c), neither the issuer nor any person acting on its behalf shall offer or sell the securities by any form of general solicitation or general advertising, including, but not limited to, the following:
(1) Any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio; and
(2) Any seminar or meeting whose attendees have been invited by any general solicitation or general advertising; Provided, however, that publication by an issuer of a notice in accordance with § 230.135c or filing with the Commission by an issuer of a notice of sales on Form D (17 CFR 239.500) in which the issuer has made a good faith and reasonable attempt to comply with the requirements of such form, shall not be deemed to constitute general solicitation or general advertising for purposes of this section; Provided further, that, if the requirements of § 230.135e are satisfied, providing any journalist with access to press conferences held outside of the United States, to meetings with issuer or selling security holder representatives conducted outside of the United States, or to written press-related materials released outside the United States, at or in which a present or proposed offering of securities is discussed, will not be deemed to constitute general solicitation or general advertising for purposes of this section.

New SEC Guidance

On August 6, 2015, the SEC issued new Compliance & Disclosure Interpretations on General Solicitation. I have included links to each of the new C&DI questions below.

C&DIs – Securities Act Rules (UPDATED 08/06/2015)
Section 256. Rule 502 — General Conditions to be Met
New Question 256.23
New Question 256.24
New Question 256.25
New Question 256.26
New Question 256.27
New Question 256.28
New Question 256.29
New Question 256.30
New Question 256.31
New Question 256.32
New Question 256.33

I have quoted all of this guidance in full in a prior blog post. I would encourage you to read the guidance if you are conducting a Rule 506(b) offering. It is helpful guidance.

What did I like best about the guidance?

I liked how the SEC defined the terms “pre-existing, substantive relationship.”

Pre-existing means the relationship existed before the offering started.

Substantive means you have the ability to judge the offeree’s sophistication. In the words of the SEC:

A “substantive” 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.

Per the SEC, you cannot simply have someone check a box on a form indicating that they are an accredited investor and in that way alone have formed a “substantive” relationship with them, without any other knowledge of that person’s financial circumstances or sophistication. In the SEC’s words:

Self-certification alone (by checking a box) without any other knowledge of a person’s financial circumstances or sophistication is not sufficient to form a “substantive” relationship.

What Should You Do?

If you are raising money in a Rule 506(b) offering, I would recommend you read the SEC’s guidance carefully. Coach your entire team on these rules, so that you don’t inadvertently have someone make a mistake responding to a media call.

General Disclaimer–This blog post is for information purposes, and does not constitute the giving of legal advice or the creation of an attorney-client relationship.

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New SEC Guidance on General Solicitation

Last Thursday the SEC issued guidance on what constitutes general solicitation. This guidance is helpful to companies trying to conduct Rule 506 offerings.

Thanks to the JOBS Act, we now have two types of Rule 506 offerings. Those that cannot be generally solicited and those that can. This might sound harmless but if you generally solicit your offering you have to collect additional information from your investors. Like their personal tax returns and personal financial statements.  Most companies try to avoid this because it is not well accepted in the investment community to provide this information to companies.  This might change over time but right now companies are shying away from generally soliciting their offerings.

If you are conducting a securities offering, exercise extreme caution with what you are doing. Each securities law exemption has its own narrow pathway of compliance. If you have identified Rule 506(b) as your securities law exemption, you cannot generally solicit your offering.

I have quoted the SEC’s new general solicitation guidance in full below, and I have emphasized in bold the parts of the guidance that I think are helpful. But before we dive into the details of the guidance, why does this guidance matter? What is at stake?

This guidance matters because it is fresh and clear guidance from the SEC on what it considers general solicitation. If you have generally solicited your securities offering, or are considered to have generally solicited your offering by the SEC, and you were trying to conduct a Rule 506(b) offering–you may not have a securities law exemption. Not having a securities law exemption is not something you want to discover–because your personal assets are potentially at stake.

If you either have generally solicited your offering, or are considered to have generally solicited your offering, then:

  • You have to collect additional verification information from your accredited investors, so that you can verify that they are accredited investors. This means–you have to ask your investors for copies of their tax returns or their personal financial statements.
  • You can’t have had any non-accredited investors in your offering.
  • If you have already been conducting your offering in line with Rule 506(b), and not been collecting the additional verification information–you will have to go back to investors who already invested in your round and ask them for that additional information. If they are not willing to give it you, you will have to give them their money back.
  • If you have already filed a Form D indicating your reliance on Rule 506(b), you will have to amend the Form D to indicate reliance on Rule 506(c). This may trigger regulatory inquiries.

Here are what I consider to be the key takeaways from the new SEC guidance:

  • You can distribute factual business information, but you cannot condition the public mind of arouse public interest in a securities offering without the SEC considering you to have generally solicited your offering.
  • Factual business information generally does not include predictions, projections, forecasts or opinions with respect to valuation of a security.
  •  Demo Days do not necessarily constitute general solicitation.
  • You have to have “substantive, pre-existing” relationship with someone before you pitch them.
  • A “pre-existing” relationship is one that the issuer has formed with an offeree prior to the commencement of the securities offering.
  • A “substantive” 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.
  • Angel groups are helpful in establishing substantive, pre-existing relationships.

What If You Pitch Someone You Later Find Out Can’t Invest Because They Are Not Accredited? Did You Blow Your Rule 506(b) Offering?

Say you pitch an old friend on your new startup. You believe your friend to be accredited based on his prior startups and jobs, his known angel investments, the house he lives in, his appearance of means. You also know him to be a sophisticated, astute judge of business opportunities.

But, after your friend says yes, he will invest, you find out that he is not accredited. He no longer works–and thus you can’t rely on the income test. And his house can’t count toward the $1M net worth test. Plus, you find out he gave most of his money to his kids, and only has $800,000  in cash in a bank account.

So, your friend can’t invest, because he is not accredited.

However, you didn’t blow your 506(b) offering because: (i) he was an old friend, and (ii) he was sophisticated.

What Should You Do?

Study this guidance carefully if you are trying to conduct a Rule 506(b) offering, and exercise extreme caution. It is relatively easy to inadvertently generally solicit your offering.

Public Policy Recommendation

Congress should repeal the ban on general solicitation, and I mean–really repeal it. The JOBS Act repeal didn’t do the trick because the SEC issued the verification guidance. The world would be better off without the complexities of the Rule 506(b) vs. Rule 506(c) dichotomy. And we need rules that are less complex, and not so restrictive when it comes to startup companies.

This blog post is for informational purposes and does not constitute legal advice.  

Question 256.23

Question: Rule 502(c) prohibits an issuer or any person acting on the issuer’s behalf from offering or selling securities by any form of general solicitation or general advertising when conducting certain offerings in reliance on Regulation D. Does the use of an unrestricted, publicly available website to offer or sell securities constitute a general solicitation for purposes of Rule 502(c)?

Answer: Yes. As the Commission stated in Securities Act Release No. 7856(Apr. 28, 2000), the use of an unrestricted, publicly available website constitutes a general solicitation and is not consistent with the prohibition on general solicitation and advertising in Rule 502(c) if the website contains an offer of securities. However, Rule 506(c) — which does not require compliance with Rule 502(c) — may be available to issuers when offering or selling securities through unrestricted, publicly available websites or other forms of general solicitation. [August 6, 2015]

Question 256.24

Question: What information can an issuer widely disseminate about itself without contravening Rule 502(c)?

Answer: Information not involving an offer of securities may be disseminated widely without violating Rule 502(c). For example, factual business information that does not condition the public mind or arouse public interest in a securities offering is not an offer and may be disseminated widely. Information that involves an offer of securities through any form of general solicitation would contravene Rule 502(c). [August 6, 2015]

Question 256.25

Question: What is factual business information?

Answer: What constitutes factual business information depends on the facts and circumstances. Factual business information typically is limited to information about the issuer, its business, financial condition, products, services, or advertisement of such products or services, provided the information is not presented in such a manner as to constitute an offer of the issuer’s securities. Factual business information generally does not include predictions, projections, forecasts or opinions with respect to valuation of a security, nor for a continuously offered fund would it include information about past performance of the fund. (Release No. 33-5180). [August 6, 2015]

Question 256.26

Question: Does an offer of securities in a Regulation D offering to a prospective investor with whom the issuer, or a person acting on the issuer’s behalf, has a pre-existing, substantive relationship constitute a general solicitation in contravention of Rule 502(c)?

Answer: No. The existence of such a pre-existing, substantive relationship is one means, but not the exclusive means, of demonstrating the absence of a general solicitation in a Regulation D offering. See Securities Act Release No. 6825 (Mar. 15, 1989), at fn. 12. Accordingly, an offer of the issuer’s securities to the person with whom the issuer, or a person acting on its behalf, has such a relationship would not constitute a general solicitation and, therefore, would not be in contravention of Rule 502(c). [August 6, 2015]

Question 256.27

Question: Are there circumstances under which an issuer, or a person acting on the issuer’s behalf, can communicate information about an offering to persons with whom it does not have a pre-existing, substantive relationship without having that information deemed a general solicitation?

Answer: Yes. The staff is aware of long-standing practices where issuers and persons acting on their behalf are introduced to prospective investors who are members of an informal, personal network of individuals with experience investing in private offerings. For example, we acknowledge that groups of experienced, sophisticated investors, such as “angel investors,” share information about offerings through their network and members who have a relationship with a particular issuer may introduce that issuer to other members. Issuers that contact one or more experienced, sophisticated members of the group through this type of referral may be able to rely on those members’ network to establish a reasonable belief that other offerees in the network have the necessary financial experience and sophistication. Whether there has been a general solicitation is a fact-specific determination. In general, the greater the number of persons without financial experience, sophistication or any prior personal or business relationship with the issuer that are contacted by an issuer or persons acting on its behalf through impersonal, non-selective means of communication, the more likely the communications are part of a general solicitation. [August 6, 2015]

Question 256.28

Question: Is someone other than a broker-dealer able to form a pre-existing, substantive relationship with a prospective offeree as a means of establishing that a general solicitation is not present in a Regulation D offering?

Answer: Yes. We believe investment advisers registered with the Securities and Exchange Commission may be able to form a pre-existing relationship with prospective offerees that are clients of the adviser. As fiduciaries, such advisers owe their clients the duty to provide only suitable investment advice. To fulfill the obligation, an adviser must make a reasonable determination that the investment advice provided is suitable for the client based on the client’s financial situation and investment objective, such that a substantive relationship could exist. [August 6, 2015]

Question 256.29

Question: What makes a relationship “pre-existing” for purposes of demonstrating the absence of a general solicitation under Rule 502(c)?

Answer: A “pre-existing” relationship is one that the issuer has formed with an offeree prior to the commencement of the securities offering or, alternatively, that was established through either a registered broker-dealer or investment adviser prior to the registered broker-dealer or investment adviser participation in the offering. See, e.g., the E.F. Hutton & Co. letter (Dec. 3, 1985). [August 6, 2015]

Question 256.30

Question: Is there a minimum waiting period required for an issuer, or a person acting on its behalf, to establish a pre-existing, substantive relationship with a prospective offeree in order to demonstrate that a general solicitation is not involved?

Answer: No. While there is no minimum waiting period, the issuer must establish such a relationship prior to the commencement of the offering, or, if the relationship was established through either a registered broker-dealer or investment adviser, the relationship must be established prior to the time the registered broker-dealer or investment adviser began participating in the offering. The staff, however, has allowed a limited accommodation for offerings by private funds that rely on the exclusions from the definition of “investment company” set forth in Sections 3(c)(1) and 3(c)(7) of the Investment Company Act. This limited accommodation permits an individual who qualifies as an accredited or sophisticated investor to purchase, after the end of a waiting period, securities in private fund offerings that were posted on a website platform prior to the investor’s subscription to the platform, in view of the fact that private fund offerings are made on a semi-continuous basis (quarterly or annually). See the Lamp Technologies, Inc.letter (May 29, 1997). [August 6, 2015]

Question 256.31

Question: What makes a relationship “substantive” for purposes of demonstrating the absence of a general solicitation under Rule 502(c)?

Answer: A “substantive” 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. Self-certification alone (by checking a box) without any other knowledge of a person’s financial circumstances or sophistication is not sufficient to form a “substantive” relationship. [August 6, 2015]

Question 256.32

Question: Can anyone other than registered broker-dealers and investment advisers form a pre-existing, substantive relationship with a prospective offeree as a means of establishing that a general solicitation is not involved in a Regulation D offering?

Answer: Yes. The Commission has stated that:

Generally, staff interpretations of whether a “pre-existing, substantive relationship” exists have been limited to procedures established by broker-dealers in connection with their customers. This is because traditional broker-dealer relationships require that a broker-dealer deal fairly with, and make suitable recommendations to, customers, and, thus, implies that a substantive relationship exists between the broker-dealer and its customers. [The Commission has] long stated, however, that the presence or absence of a general

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