Entrepreneurs create jobs, but they generally don’t do it out of thin air. Usually, they need investors. These investors are generally very wealthy people who are 1) inherently private and 2) usually very busy doing wealthy person stuff. So, after finding a prospective investor, setting up meetings, creating a relationship, writing up an investment proposal, and securing a commitment to invest capital, the Congress and the Securities Exchange Commission (SEC) now want to make it harder on entrepreneurs to raise money–including in some cases requiring new investors to respond to a checklist of private and probing questions to find out if they are or have been at any time within the last 10 years in some cases, “bad actors.”
If you haven’t had the chance to read the SEC’s proposed rules on “bad actors” disqualifying companies from using the Rule 506 securities law safe harbor exemption, you ought to. The proposed rules, if adopted, will fundamentally change Rule 506 offerings and the startup financing legal landscape.
How, you might ask? By imposing on startups the “did-not-know-and-in-the-exercise-of-reasonable-care-after-factual-inquiry-could-not-have known” standard when it comes to investigating “covered persons” (including prospective 10% or greater investors) who might disqualify a startup from using Rule 506 altogether by virtue of prior bad acts (including in some cases misdemeanors committed within 10 years before the sale of the securities).
“Willful blindness” is a legal concept that is bandied about in scandal from time to time. Remember Watergate? Or last week’s scandal for that matter? It all comes down to the fundamental question of what did the President or CEO know and when did he know it? The opposing question is, of course, how is a President or CEO supposed to know everything about everyone involved in her or his company?
One of the beauties of Rule 506 right now, of course, is that it is easy for startups to use. There is no due diligence requirement currently built into Rule 506. To use rule 506, there are a few requirements, for sure, but the primary requirement–that the company had a reasonable belief that each of the investors was accredited, does not affirmatively require investigation or diligence, like the new “bad actor” rules would.
What Is the Rule 506 Exemption?
Rule 506 is the securities law “safe harbor” exemption that startups most commonly use to raise capital. Under Rule 506 you can raise as much money as your heart desires as long as your investors are accredited (meaning, generally, that they have a net worth of over $1 million (not including primary residence) or at least $200,000 in income for the last 2 years (or $300,000 with spouse) and the expectation of the same during the year of investment) and you follow some rules which are generally pretty easy to follow. This is a big deal. The Rule 506 offering safe harbor exemption is a key piece of the legal framework that has allowed the angel and venture capital industry to thrive. Without it, officers and directors of companies would be exposed to great personal risk when their companies sold securities to raise funds.
Here are some of the key aspects of Rule 506:
- Safe Harbor - Rule 506 is a “safe harbor.” Meaning, if you meet the requirements of the rule, you can be assured that you fit within the exemption from registration allowed by Section 4(2) of the Securities Act of 1933, as amended. If you don’t meet the requirements of the rule, you will not have this assurance, and you will be at greater personal risk as an officer and director of a company.
- Accredited Investors Only - A startup can solicit an unlimited number of investors, and sell to an unlimited number of investors, as long as all investors are accredited. If you sell to any non-accredited investors, then Rule 506 has voluminous specific information requirements.
- Unlimited Dollar Amount – A startup can raise an unlimited amount of capital.
- No General Solicitation – A startup cannot use general solicitation or advertising to market the securities.
- Restricted Securities – The securities sold must have resale restrictions and be “restricted securities.”
What You Should Know Can Hurt You
What the SEC is proposing in its new rules is nothing less than the most strenuous legal standard possible be applied to the last type of business you need to be burdening in a climate of high unemployment–startups! The Rule 506 exemption will still be available, even if a bad actor is in the mix:
“If the issuer establishes that it did not know, and in the exercise of reasonable care could not have known, that a disqualification existed…”
Instruction…An issuer will not be able to establish that it has exercised reasonable care unless it has made factual inquiry into whether any disqualifications exist. The nature and scope of the requisite inquiry will vary based on the circumstances of the issuer and other offering participants.”
What this means is that startups are going to have to go through a new, cumbersome two (2) step inquiry as part of fund-raising. First, they are going to have to identify the universe of “covered persons” (including prospective 10% or greater investors). Next, they are going to have to determine if any of the “covered persons” have engaged, within a defined time period, in a “disqualifying act.” If you discover that you have a “covered person” that is a bad actor that would disqualify your offering, you must not let person be a “covered person” with respect to your company, because if you do you will not be able to rely on the Rule 506 safe harbor securities law exemption. This is new to Rule 506 offerings and this process will not be an easy or brief or abbreviated process.
Click here to view the table.
Contrast this proposed rule with the existing rule on whether you can take money from an investor. In that circumstance, you just need a reasonable basis to belief that the investor is accredited. There is no affirmative factual inquiry required.
What’s Wrong With The New Rules?
- They fundamentally change Rule 506 offerings – The ease of Rule 506 offerings has been a key component of the startup ecosystem for years. No longer will Rule 506 offerings be so easy. Rule 506 offerings will be fundamentally changed if these rules become law. This is extremely unfortunate.
- They are onerous – The SEC’s proposed rules are onerous. They are long. They are complex. Simpler is not always but is frequently better. The SEC would do well to substantially shorten these rules and make them less cumbersome.
- They will slow down the process of raising money – The process of conducting factual inquiries will take time. These aren’t processes that can be completed in a very abbreviated period of time.
- They will make the process of raising money more expensive – Companies are going to have to undertake due diligence investigations. This will cost money.
- They will slow down job creation – Startups create jobs. The faster startups can raise capital, the faster they can hire workers.
Why Is Congress And The SEC Doing This?
Perhaps it is what Howard Lindzon says–”entrepreneur envy.”
“…entrepreneurs are chasing dreams with little bits of angel and venture money. Companies with massive opportunity and now loads of cash are going public and dominating their verticals or mindshare. That’s not a bubble.
We the entrepreneurs believe at some level that we have the next Facebook, Linked In, Google, Pandora and our passion, fear, hunger and envy drives us. First hand let me tell you how humbling it is to have a board meeting with the investors in Zynga and WordPress – to name a couple- and explain our growth.”
I Wish Congress Would Just Repeal This New Rule
As the founder of a startup, just finding investors is hard enough. The thought of the law making it even harder to raise money probably makes you feel like you just drank a tall glass of turpentine and will probably keep you up at night thinking of alternatives. It might be so easy to turn a blind eye and say that you didn’t know, but that would mean you didn’t exercise reasonable care. And finding out about it later and doing nothing (willful blindness) doesn’t make the situation any better. Perhaps it even makes it worse. The past discrepancies of “covered persons” shouldn’t hold you back from realizing your dream of starting an honest and lucrative business. The SEC needs to cut back these rules and make them more reasonable and less cumbersome (for example, the proposed coverage of 10% shareholders should be increased substantially). They should harmonize them with the current operating environment for Rule 506 offerings–with no specific factual inquiry required.
For more information check out: