Selling Securities and Reg D Changes: A 101 Guide for Seed Stage and Growth Companies

by Brian Casserly

You have an idea. You form a company. Now you want to raise money from investors (or even friends and family), maybe through the sale of ownership, borrowing money, or a loan that could convert into ownership in the future. Seems straightforward, right?

Well, all of those interests and rights that you are considering are almost certainly going to be classfied as “securities” under applicable law.  Selling securities, in fact, is a complex process that requires careful navigation and thoughtful representation to not only protect your position from an ownership and contractual standpoint, but to ensure you’re abiding by both federal and state laws, and regulations issued in connection with the same by enforcement arms such the Securities and Exchange Commission (SEC).

When it comes to selling securities, you have essentially three options:

  1. You can undergo a registered initial public offering (IPO), which requires huge capital investment and substantial market and investor traction, making it nearly impossible for small businesses and growth companies to utilize.
  2. You can seek exemptions under the Securities Act of 1933 -- like Regulation D offerings -- allowing some companies to offer and sell their securities without having to register the securities with the SEC.
  3. Or, you can illegally sell securities. This approach can come with severe penalties including massive fines destructive to companies in the crucial growth stages, and potential criminal liability individually.

Obviously, your company should avoid options one and three listed above. However, utilizing exemptions can make for a challenging and complicated process. That’s where we come in.

Regulation D (or Reg D) currently provides four “safe harbor” exemptions under the more general “private offering” exemption allowed pursuant to Section 4(a)(2) of the Securities Act of 1933.  These Reg D exemptions from registration requirements are commonly referred to by their rule numbers: 504, 505, 506(b), and 506(c). In efforts to allow better access to capital for seed and growth stage companies, while still providing adequate protection to investors, these rules (and other similarly purposed regulations) have been a source of constant change in recent years.  Below, I’ve provided a brief overview of these rules, as well as highlighted some of the most recent changes in the law to get you prepared when you’re ready to sell securities.

  • Rule 504 now provides an exemption from the registration requirements of the federal securities laws for some companies when they offer and sell up to $5,000,000 of their securities within a 12-month period. Prior to January 20, 2017, the maximum raise pursuant to Rule 504 was $1,000,000.  Also new to Rule 504 offerings, the “bad actor” disqualifications previously only applicable to Rule 505 and Rule 506 offerings now apply.
  • Rule 505 will be repealed as of May 20, 2017. With the maximum raise increasing to $5,000,000 in Rule 504, and Rule 505’s already limited use, the practical need for this safe harbor has been eliminated.
  • Rule 506(b) is the most widely used exemption for companies raising money through private placements. It allows for an unlimited amount of funds to be raised, unlimited accredited investors (a term you should become familiar with if not already) to participate, and preempts state law, making it ideal for many startup and growth companies looking for outside capital.
  • Rule 506(c) is a more recent addition to the list of Reg D exemptions (and, technically, not a safe harbor under the 4(a)2 “private offering” exemption but a separate exemption altogether). This rule allows for general solicitation and advertising when selling securities, but requires that only accredited investors that the company has taken reasonable steps to verify participate in the offering.  It’s early, but Rule 506(c)’s use has been limited.

So how do you know which exemptions are right for you? How do you navigate the state law preemptions, required filings, and more? If you’re a startup or growth company seeking outside capital from investors, Gutwein Law can help guide you through all aspects of the securities selling process. If you’re ready to get the conversation started, call us at 765.423.7900 or fill out the form on our website.