Rule 506(b) vs. 506(c)

Understanding the differences between Regulation D issuances under Rules 506(b) vs. 506(c) is vital for any startup and founder considering initial fundraising. While legislative efforts in the last decade have made it considerably less challenging for early-stage companies to raise capital, the process nevertheless remains complex, and companies are encouraged to engage competent legal counsel to assist on these matters. Nevertheless, what follows is a basic primer on some of the larger issues at stake in Rules 506(b) vs. 506(c).

By default, per the Securities Act of 1933 (the “33 Act”), a securities offering must be registered with the US Securities and Exchange Commission (SEC) unless it fits into one of several exemptions. The SEC’s Regulation D (“Reg D”) provides exemptions for securities offered via a “private placement.” A private placement can best be understood as an offering to a select group of investors, rather than a public offering on the open market (sort of, as we’ll explain later). The important questions to consider here are the who and the how, e.g. who is being offered securities and how are they being offered said securities. Also, it’s important to note that there are other pathways for offerings under Reg D, but we’re focusing on 506(b) vs. 506(c) here as these are, in our experience, the exemptions most commonly used by startups and similar companies.

Before we get into the distinctions between Rules 506(b) and 506(c), let’s cover their similarities:

• Unlimited funds: There’s no dollar limit on how much an issuer can raise via either 506(b) or 506(c).
• Public and private issuers: Issuers can be public (i.e., SEC-registered) or private, and US or foreign-domiciled. 
• Restrictions on resale: Securities sold via either Rule 506(b) or 506(c) must bear restrictions on resale.
• “Bad Actors” disqualified: Offerings cannot be made if a “Bad Actor” is involved on the issuing side, and issuers must take “reasonable care” (e.g., a questionnaire) to exclude Bad Actors (defined in Rule 506(d)).
• Intermediaries: Issuers under Rules 506(b) or 506(c) are not required to use an intermediary, however, any intermediary involved in the issuance must be a duly registered broker-dealer or exempt from broker-dealer registration (e.g., certain private funds).

Now, onto the core of Rule 506(b) vs. 506(c)…

The main point of distinction between Rules 506(b) vs. 506(c) is how the offering can be marketed. For 506(b), issuers are limited to direct marketing only to known investors–that is to say, those with whom issuers have a “substantial pre-existing relationship”–and no general solicitation is permitted. For 506(c), there is no limitation on how issuers may solicit investment. 506(c) doesn’t give issuers true public offering power, however, because of the next set of distinctions between Rules 506(b) vs. 506(c): investor financial profiles.

Rule 501 of Reg D defines what’s known as an “accredited investor,” and while the full definition is rather extensive, for simplicity’s sake, we can understand it as: a sophisticated / experienced investor; and/or b) a wealthy investor. The “why” of defining accredited investors–like much of securities regulation–has to do with investor protection (i.e., protecting vulnerable potential investors from scam investment opportunities skating by under the SEC’s radar), and both Rules 506(b) and 506(c) have restrictions on who can purchase securities pertinent to accredited investor status. 

For offerings under Rule 506(b) (which are more restricted in terms of marketing), non-accredited investors may participate, though no more than 35 may do so. In Rule 506(c) offerings (those which can be much more widely marketed), however, no non-accredited investors may participate at all. Furthermore, in a 506(c) offering, the issuer must take significantly greater steps to verify the “accredited” status of its accredited investors, whereas under 506(b), a simple self-certification questionnaire filled out by the putative accredited investor tends to suffice. 

So, how does this all break down? For companies looking to do a more “friends and family” style of financing round, a 506(b) offering allows sales to some investors who might want to “get in early” but don’t qualify as accredited investors. On the other hand, for companies looking to raise an aggressively-sized round from various top VC firms, but with an issuing team that may not be the best networked, a 506(c) offering allows a much wider, more omnichannel outreach, but with the above-mentioned limitations on who can ultimately be an investor, and moreover, greater cost and risk with respect to verifying the accredited status of investors. There are, of course, other smaller distinctions between Rules 506(b) and 506(c), and startups and other companies interested in conducing a Rule 506 issuance are strongly encouraged to engage competent legal counsel to advise on the matter.