General solicitation refers to the act of promoting a capital raise publicly.
General solicitation is prohibited under Regulation D Rule 506(b). The statutes and rules do not define general solicitation. Instead, the Securities and Exchange Commission takes a case-by-case approach to general solicitation.
General solicitation can be described as telling potential investors in a newspaper about the terms of an offer and inviting them to buy securities.
Startup companies are still subject to securities laws. Failure to comply with general solicitation laws can result in the company losing exemption status. Securities Act of 1933 stipulates that companies cannot sell securities without a registration statement. Before pitching their company, founders should know Regulation D and other general solicitation requirements.
Regulation D includes several components, including Rule 504, 505, 506, and 505. Rule 504 and 505 are less frequent because issuers must adhere to securities laws in every state where they sell securities. Rule 506 allows companies to raise unlimited capital from accredited investors.
What is general solicitation?
The short answer is public advertising, where you sell securities.
The longer answer started in 1933. Congress passed the Securities Act in 1933.
The Securities Act was created to ensure that all who bought securities (the money given to a company to buy shares in that company or similar arrangements) received sufficient and accurate information before making the purchase. The Securities Act also required the SEC to make sure that this happened. All securities that are sold must be registered with the SEC after the Act is passed unless the seller (or the issuer) of the securities can prove it is exempted from registration under Section 4(a),(2) of the Act. This exemption is commonly known as the “private place” exemption.
Regulation D (17 C.F.R.) outlines the current registration rules. SS230.501 was established by the SEC in 1982. Although there are many ways to avoid registration, Rule 506 is the most popular.
Rule 506 allows you to sell as many securities and raise as much money as you like, provided you answer buyers’ questions and provide financial statements. You can also sell ” restricted Securities,” which are difficult to sell shares. Part B of the rule, 506(b), allows you to sell those securities to unlimited accredited investors and up to 35 non-accredited investors.
This was how it stood until the new rules (Rule 506(c)) allowed general solicitation under certain conditions. These will be discussed later.
If you want to sell securities but don’t wish to register with the SEC, you can do a private placement and not engage in general solicitation.
Let’s return to the original question: What is general solicitation?
The SEC states that general solicitation is defined in Rule 502. c).
“Any advertisement, notice, or article published in any newspaper, magazine, or similar media, broadcast over television, radio, or broadcast over the air.”
Or (enjoyably circulated) “Any seminar or meeting whose attendees were invited by any general solicitation.
Later guidance stated that using a public website to offer securities (without passwords) is a general solicitation.
Although there is no comprehensive definition of “general solicitation,” it is prudent to assume that any public statement that you are selling securities or raising capital could be considered a general solicitation.
Advertising in the NY Times, writing blog posts about your offering, tweeting about your fundraising plans. Creating Eventbrite events or advertising seminars inviting people to hear about your offer… all are general solicitations.
Other things, such as emailing your entire contact list, emailing angel investors from a list you have found online, tweeting about the process of raising capital, and hiring others to do this for you, are either clearly general solicitation or so debatable it is dangerous that you would not fully understand the implications of general solicitation.
Avoid general solicitation by ensuring that securities are offered only to persons with whom the issuer has a pre-existing, substantive relationship.
This raises the question of “pre-existing” relationships. What length of time must the relationship have existed? This is the clear answer: you must have known each other before the securities offering started. (Brokers and investment advisers who have specific rules.
Similar question: What is a “substantive relation”? This is a more complex answer, but the SEC offers guidance in its Compliance and Disclosure Interpretations.
An issuer must be able to assess whether the buyer’s financial situation and sophistication are sufficient to make them accredited investors or a sophisticated investment. This sounds like a close relationship.
It is challenging to be eligible for a 506 (b) exemption, as you can probably guess. It is possible to qualify for a 506(b) exemption if you don’t have any pre-existing, substantial relationships with accredited angel investors eager to invest in companies at the early stages of their development.
If you don’t believe the 506 (b) rules are for you or have other reasons, you can try a 506 (c) offering.
The JOBS Act of 2012 required that the SEC create a pathway to allow issuers to use general solicitation while still being exempt from registration. Rule 506(c), and the related rules, were created in 2015.
Rule 506(c) states that you can raise money by general solicitation (advertising for anyone) as long as it only takes money from accredited investors and you take “reasonable measures” to ensure that all who invest are accredited.
This is a trade-off. You can advertise to anyone you don’t know or with whom you have only a new, recent, and/or tenuous relationship; in return, you must ensure that the person who buys your securities is accredited.
What are the “reasonable steps?”
Self-certification is not sufficient. Investors can only check the box to confirm their accreditation. (For example, the enforcement example will show that “despite collecting accreditation questionnaires and representations of investors certifying their accredited investor status, Respondent failed to take reasonable steps to ensure that the Fund’s investors were accredited, investors.
These are just a few acceptable “reasonable steps” verifications the SEC has provided.
Review the tax records of the investor to verify the income over the past two years. Ask them for a written statement stating they can reasonably expect to earn the required income this fiscal year.
To verify your net worth, you will need to review your credit report for liabilities and statements from banks, brokerages, and other statements for assets.
A letter from a professional who knows the investor well (a registered broker-dealer or an SEC-registered investor adviser) that confirms that the investor is accredited
You can use a third-party platform to do this for you.
506 (c) tradeoffs
We mentioned that 506(c), like all other forms of use, involves trade-offs.
It was a lot of fun for us to promote the fund and expand our relationships. We also got to generate buzz about the fund through articles in the local media like this.
It was tedious, however, to collect brokerage account statements and credit report information to verify net worth or to review historical tax returns and W2s for verification of net income.
It wasn’t just the administrative work involved in analyzing and seeking out the documents. Many interested in investing passed the test after they understood the more invasive disclosures required to prove their accreditation. This information was not required by the SEC. Potential investors were and still are reluctant to disclose it.
These trade-offs are equally applicable to companies seeking to raise money. You have to do all the work. It is difficult enough to convince someone to $25,000 to invest in your company. It is difficult to ask them to provide enough documentation to prove their net worth.
506(c) could limit your ability to raise capital through traditional sources. An AngelList rolling fund manager might be able to invest.
What’s an offer of securities?
Publicly stating, “We are raising money,” is the same as soliciting securities sales.
If you’re not selling securities, you can say that you are raising money without being subject to these regulations. You could use a crowdfunding platform or Gofundme campaign to raise money or any charitable donation.
However, if you’re raising money through the sale of securities, simply saying, “we are raising capital,” is equivalent to making an offer of securities. Even if your documents include disclaimers such as “this isn’t an offer to buy securities,” it is still legal).
Selling securities often includes debt. Convertible notes are a standard option for early-stage fundraising. They are considered security. Also, warrants can be used in conjunction with debt.
The gray areas of the world can be made more grey depending on how you phrase them. “Here’s a link for my investor presentation,” “We are seeking partners to help us grow our business,” “we are searching for a lead,” and “Here are our financial projections over the next three years” Although you might not say explicitly “here is an offer of securities,” it is evident that you are doing so.
Similarly, funds and companies seem to avoid the general solicitation rules when they announce the “first close” of an investment round or fund by publicizing it. Although it does not say explicitly that you are selling securities, ” the fact that you have had a closing of an investment round or fund again does not mean you are. We believe you are violating 506(b).
We are leading investors in investment rounds and recommend that portfolio companies refrain from making public comments on fundraising. This includes not sending out press releases and not talking to the media at all while you are fundraising. An enterprising reporter can combine your Form D information with your general comments. This will make it appear you are trying to get fundraising benefits that are not allowed. Once they know who is interested in this stuff, our companies will listen.
Who cares about general solicitation?
Let’s say you raise money and solicit investors more than you should. Who cares?
These are the three types of groups that do.
1) Financial regulators.
They should be notified if you violate the rules. The penalties for violating the rules could be severe.
These are not all general solicitation violations. The SEC is mainly concerned with general solicitation because it is central to its mission to prevent inappropriate transactions. The SEC was against general solicitation when the JOBS Act was under discussion. They stated that “general solicitation can easily become a tool of deception and misinformation.”
Suspected violations lead to investigations. The SEC is a powerful investigative and subpoena power and can pursue remedies. Or civil actions, which can land the accused in jail. We will review the penalties more in-depth shortly, but let’s say they can be significant – or even existential.
2) Knowledgeable investors.
Smart investors will ask who else is participating in your current round. If you broken general solicitation rules and have unaccredited investors participating, you can make sure that the smart money won’t follow.
3 ) Disgruntled Investors.
Disgruntled investors are a third group that can care.
Startups never go according to plan. Almost every startup has investors who wish they could recoup their investment.
Investors involved in securities-related fundraisings can use the “right to rescission” to obtain the right to have their position (plus interest) bought back by the company.
A disgruntled shareholder could try to force you out of your company (or seek revenge). It will have a strong case if it can find securities law violations. It is easy to locate a general solicitation because the internet doesn’t forget, and form Ds can be found publicly – it is usually not challenging to find violations if they are made.
Everyone cares; regulators include potential investors and your investors.
What are the exemptions?
You cannot use Rule 506(b), which will allow you to register if you engage in general solicitation. It doesn’t matter if the sale is made through general solicitation. All that matters is that it was an offer made through general solicitation. You can now sell unregistered securities if you lose your exemption.
For anyone raising capital, this is terrible news. The best-case scenario is to stop fundraising. If you need to raise funds, it could mean the end for your business.
The worst-case scenario is even worse. There are many examples of enforcement actions by FINRA and the SEC against unregistered investors. One example is this 2017 opinion by the SEC, which confirms a disciplinary proceeding against an issuer. FINRA assessed the issuer and assessed a $73,000 fine.
A crypto investment fund was being created that had raised more than $600k from 22 investors. It was supposedly a 506(b) offering. It solicited investments and posted information about the fund on its website. The fund was unwound, and work stopped. Principals were also fined $50,000 even though investors got their capital back.
If they believe the Securities Act or related rules have been violated, they can impose additional punishments such as higher fines, suspension of management teams, license revocations, and other sanctions. The SEC can charge higher fines, suspend management teams, strip brokers of their licenses, or impose other punishments if they find that the Securities Act or related rules are being violated.
Are these rules applicable to investors seeking venture capital funds or investment funds?
Anyone selling securities is subject to the rules that we have laid out. These are usually companies, but they can also include investment funds, usually Limited Partnerships or Limited Liability Companies. The SEC opinion letter we linked to concerned a broker-dealer who raised capital for a residential realty fund. Anyone raising capital for a micro-venture capital fund, SBIC, mezzanine or PE fund, or any other type of fund must follow these rules.
Professional investors are well aware of these rules for many reasons. Not least because we risk our reputations and careers if we break them, even if we forget for a moment, we will need to verify that we are accredited investors and will be able to review the next set of documents.
The VentureSouth Angel Fund III was not publicized until it was fully raised. All securities (in this instance, LP interests) were also sold.
This is not the case for everyone. Your search results for the first closing likely contained investment funds being raised. Some of these funds might have been fine. Perhaps they were not selling to US investors, or they used general solicitation under 506 (c). If you’re considering investing in any fund, make sure you do your research.
Reverse solicitations: How can I respond to a solicitation?
If someone asks entrepreneurs for investment opportunities and the entrepreneur does not know them, will they blow the exemption under 506(b)?
We recently read a tweet that stated:
“I’d love to see your deck if you are currently raising $1-$1.5M and have a Product available. Send me a DM .”
Could they have established a relationship if an entrepreneur had responded to the tweet?
Suppose an entrepreneur replies publicly by saying “Sent,” as many entrepreneurs have done when raising money. How can they claim that it was not publicly announcing (to at least the Twitter crows) an active fundraising and offer of securities?
They are unlikely to comply with 506(b), so let’s hope everyone raises under 506 (c).
Our suggestion is not to respond to reverse solicitations such as this. You can also document your knowledge of the investors and keep communications private.
You can’t do these other things:
No matter what fundraising rules you use, there are certain things you cannot do when you sell securities. Here are some:
You can say that everything is “risk-free” and “guaranteed.”
While you can give facts (like security is secured against company assets), subjective language about risk is dangerous. An attorney should review your securities offering documents and any advertising or press releases to ensure that the risks are accurately described.
Any advice or recommendation, such as telling potential investors that this security suits their situation.
You can pay others to raise money for your cause. If the flat fee is paid, regardless of how much money is raised (e.g., Paying a PR company to create press releases for you if you’re doing a 506 (c) or (b), the payment is to registered broker-dealers, who are permitted (after a thorough licensing process to do so) to earn commissions on securities sales. No one else can. You must attest that you did not pay anyone in any deal.
Do not lie, mislead or exaggerate.
We hope some of this is obvious.
You should now be more informed than we are about the fundraising regulations that you can use (506(b), 506(c, and other), who cares, what happens if you are found fundraising improperly, how these rules affect venture capital funds, how investors can be educated to avoid the fundraising methods used by companies seeking funding and many other perils, pitfalls, and prohibitions in fundraising.
We strongly recommend you speak with an attorney experienced in securities law if you consider selling securities or fundraising. You will not succeed if you blow your exemption and don’t speak with an attorney.
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