In the last two years, regulations set by the Security and Exchange Commission (SEC) have undergone several changes. These changes were the result of the 2012 Jumpstart Our Business Startups Act. The JOBS Act, as it is more commonly known, was intended, in part, “to reduce barrier to capital formation, particularly for smaller companies.” In other words, the JOBS Act is meant to help companies attract investors more easily through the establishment of Rule 506(c), and a push to regulate equity crowdfunding.
Prior to the JOBS Act, companies were exempt from registering their transactions, as long as there was no public offering involved. One of the conditions was that the company was not allowed to use “general solicitation to market the securities.” Essentially, companies weren’t allowed to advertise or use crowdfunding to attract investors.
So what does Rule 506(c) do? It gets rid of the prohibition of general solicitation, as long as investors resulting from that solicitation follow a few rules.
How is that different from crowdfunding, you might ask? Investopedia’s definition of crowdfunding highlights the restrictions on crowdfunding, namely, how much can be invested. This restriction is meant to protect individuals from losing the money they invest, especially since 25 percent of new businesses fail in their first year (the rate of those still in business after four years ranges between 37 to 58 percent, depending on the industry).
Let’s examine the basic framework for 506(c) and crowdfunding:
You can think of 506(c) offerings and crowdfunding as cousins. Both aim to make it easier for companies to tap into a diverse network of investors, and both harness the potential of new technologies to raise capital quickly and cheaply.
But, there are some crucial differences between the two. A basic guideline is that, in most cases, a 506(c) offering has fewer restrictions than crowdfunding, except when it comes to who can invest, where the rules are stricter for a 506(c).
1. Who can invest?
This is the one area where crowdfunding offers a more flexible opportunity to cast a wide net. 506(c) offerings must be made only by accredited investors, whereas crowdfunding ventures are free to accept backing from nonaccredited investors as well.
On top of that, Rule 506(c) investors must be verified as accredited investors. Companies can use a third party service, such as Verify Investor, or take the risk of performing the accreditation in house. The trouble is that investors are often reluctant to provide sensitive financial information about themselves to a company they’re agreeing to back, so going with a third party service is often the quickest and easiest way to get past the verification hurdle.
2. How much capital can you raise?
This is where crowdfunding’s most significant limitation comes in. While 506(c) offerings have no limit on their potential capital raise, crowdfunders are restricted to a yearly cap of $1 million. While this often works for musicians, authors, and some businesses, it may not be useful for a business that needs a lot of capital up front in order to get going.
3. Is advertising allowed?
Here’s something that might surprise you: while 506(c) offerings are marketed and advertised freely now, the rules overseeing crowdfunding solicitation are much more restrictive. General advertising is severely limited, and primary disclosure has to occur on an established “funding portal,” meaning one of the crowdfunding websites we’ve all seen on our social media feeds.
4. What is legal now?
506(c) is legal now; crowdfunding is kind of legal. The SEC has yet to put forth final recommendations, and only 11 states so far have legalized equity crowdfunding for businesses. Even so, those states do not allow the use of social media to attract investors, since the internet is obviously not restricted to state lines. Although there is a suggested framework in place, equity crowdfunding (unless it’s through Rule 506(c) to accredited investors) is largely not yet legal.
What is right for your company?
A range of factors come into play when deciding whether to go with 506(c) offerings or crowdfunding.
- The size and scope of your company: Is $1M enough for you, or do you need more than that to get started? If you need more money up front, you should go with the 506(c) offerings. If your financial needs are less at the beginning, consider crowdfunding.
- You product or service and its audience: Remember, your audience also includes your potential investors. Are they likely to have the financial security to be accredited? If so, go with 506(c). If you’re looking for a wider variety of investors, crowdfunding may be more appealing.
- Your timeline: Do you need capital now, which would require you to use Rule 506(c), or can you wait as money trickles in?
- Legality: Remember that crowdfunding still involves some legal pitfalls regarding how much can be invested. Accredited investors have a sense of the risk they are taking when they invest, whereas small amount investors on a crowdfunding site may not. Consider the potential for backlash in your plan going forward, and remember to play it safe and consult your securities attorney.
Still unsure which option works best for your business? Ask us your questions in the comments below.