SEC Rule 506 in 2016: Advertising and Raising Money From Unaccredited Investors Explained

advertising-and-raising-money-from-unaccredited-investorsIn 2012, the JOBS Act amended the rules for private placement offerings (aka “PPMs”) to allow companies to advertise and solicit their offerings to prospective investors. Under prior law, a PPM could not be marketed or solicited to people whom the offeror did not have an existing relationship with.  Hence, the use of the word “private offering” in the labeling of these types of investments.

This new type of offering allows advertising and general solicitation and is known as a Rule 506 (c) Offering. Under Rule 506 (c), the company raising money could create a website soliciting the funds, or they could hold seminars or meetings with potential investors and could solicit the investment of funds from those in attendance. This is a significant change to the prior offering rules that clearly prohibit such activities.

Under the new Rule 506 (c) Offering there is one hitch: the person raising funds may only accept funds from accredited investors. An accredited investor is someone who has $200K in annual income ($300K if married) or $1M in net worth (excluding equity in home). The accredited investor status must be documented by the investor or certified by a third party such as an accountant or financial planner. This verification rule is a new requirement for Rule 506 (c) Offerings and is ALWAYS required if you make general solicitation and marketing efforts for investors.

Under the traditional Rule 506 offering, now known as Rule 506 (b), you may not make general solicitations for investors and that is the major downside. However, you may raise money from up to 35 unaccredited investors per offering and that is something you cannot do under the new Rule 506 (c). Keep in mind, the offering must remain private. So, moving forward, those seeking to raise money under Regulation D approved offerings have two options. First, raise money under the current rule and you can accept up to 35 unaccredited investors but are restricted from advertising. Or, second, only accept money from accredited investors but be allowed to advertise the offering. You don’t get both options in one (advertising and unaccredited investors) but at least you now have another option in being allowed to advertise and solicit under the new rules.

Here’s a quick chart the outlines the two Rule 506 Options. The key differences are highlighted below.

 

Rule 506 (b)Rule 506 (c)
 

Total Amount You Can Raise

 

UnlimitedUnlimited
Offering Docs Required

 

Offering Memorandum, Sec Form D Filing, State Securities Filing, Company LP or Operating Agreement, Investor Suitability Quest. 

Offering Memorandum, Sec Form D Filing, State Securities Filing, Company LP or Operating Agreement, Investor Suitability Quest.

 

Accredited Investors 

 

Un-limited accredited investors and up to 35 unaccredited investors who are sophisticated enough to invest.

 

Accredited investors only. Unlimited accredited investors. Must verify they are accredited.
Marketing of OfferingMust remain private. Can only market to persons with an existing relationship. 

 

Marketing and general solicitations are allowed. You amy market via websites, e-mail campaigns, and at events or meetings.

When Does Raising Money in an LLC, Joint Venture, or Partnership Violate Securities Laws?

We’ve all heard the buzz words of crowdfunding, PPMs, and IPOs, but there are less complicated ways to raise money and start a business and one of the most reliable and most used methods is that of partnerships or joint ventures.

If you ‘re raising money from others in an LLC, partnership, or joint venture, you must take specific precautions in structuring your documents so that the investment of money from any member, partner, or joint venturer does not constitute a violation of federal or state securities laws. Failure to comply with the securities laws can result in civil and criminal penalties. Many real estate investments, real estate developments, and emerging companies rely on numerous strategies to raising capital that are outside of publicly traded stock and that do not require registration with a state securities division or the federal Securities and Exchange Commission. This article addresses those strategies and outlines some of the key issues to consider when raising funds through an LLC, partnership, or joint venture arrangement. This article addresses the legal considerations that should be analyzed when bringing in “cash partners” or “investors” into your LLC, partnership, or joint venture.

IS THE LLC MEMBER, PARTNER, OR JOINT VENTURER CONTRIBUTING MORE THAN JUST MONEY?

The courts have widely held that an investment in an LLC, joint venture, or partnership is a security when the investor is investing solely cash and has no involvement, vote, or say in the investment. In these instances where the investor just puts in cash (sometimes called “silent cash partner” arrangements), the investment will likely be deemed a security. In a famous securities law case called Williamson, the Fifth Circuit Court of Appeals held that a joint venture contract investment is a security if the investor has little say or voting power, no involvement in the business or investment, and no experience that would provide any benefit to the business or investment. Williamson, 645 F.2d 424. As a result, to avoid triggering these factors and having your investment or business deemed a security we strongly recommend that all investors in Joint Venture agreements, LLCs, or partnerships have voting rights and that they participate in the key decision-making functions of the investment or business. Investors do not have to be part of the management team but they do need to have voting rights and need to have real opportunities to use those voting rights. For example, they could have voting rights on incurring additional debt, on management compensation, and/or on buying or selling property.

DON’T GIVE YOURSELF UNLIMITED CONTROL AS MANAGER

In most LLCs with cash partners, the person organizing the investment and running the operations is often the manager of the LLC, partnership, or joint venture and has the ability to bind the company or partnership. When making this selection as the manager, it is key that you do not give yourself unlimited control and authority. If you do give yourself unlimited control as manager, your investors may be deemed to have purchased a security since their voting rights will have been extinguished by placing to much control and power in the manager/management. What is recommended is that the members have the ability to remove the manager by majority vote and that the manager may only make key decisions (e.g. incurring debt, selling an asset, setting management salaries, etc.) upon the agreement and majority vote of the investors. While key decisions and issues should be left to the members, day to day decisions can be handled by the manager without a vote of the members/investors.

DON’T COMBINE TOO MANY PEOPLE INTO ONE LLC, JV, OR PARTNERSHIP

The Courts have consistently held that even if an investor is given voting rights and has an opportunity to vote on company matters that the investor’s interest can be deemed a security if there are too many other investors involved in the LLC, JV, or Partnership. Holden, 978 F.2d 1120. As a general rule of advice, you should only structure investments and partnerships that include 5 or less cash investors as the securities laws and the involvement of more individuals than this could potentially cause the investment to be deemed a security. When there are more than 10 investors it is critical for clients to consider structuring the investment as a Regulation D Offering and that they complete offering documents and memorandums and make a notice filings to the SEC. Many people refer to this type of investment structure as a PPM.  When there are a lot of investors involved, a Regulation D Offering provides the person organizing the investment with exemptions from the securities laws and can allow someone to raise an unlimited amount of money from an un-limited amount of investors.

In sum, there are many factors and issues to consider when raising money from others in an LLC, JV, or partnership and it is crucial that you properly structure and document these investments so that they can withstand thes challenges of securities law violations. For help in structuring your investments please contact the law firm at 602-761-9798.

 

By: Mat Sorensen, Attorney and Author of The Self Directed IRA Handbook