Choosing between a Rule 506(b) or Rule 506(c) impacts your capital raise significantly. It determines what advertising you can do, and which types of investors will be allowed to invest. It also determines how you’ll have to to verify your investors’ accreditation status.
We’ll be covering a lot of information in this post, but it’s important to remember that this is just a small piece of the french silk pie that is SEC Regulation.
You should always consult your SEC Attorney before taking any action where SEC Regulations might comes into play. This should go without saying, but I’d really like to get some sleep tonight and I don’t think that would be possible if I didn’t include at least some kind of disclaimer.
I’m going to break this down into three sections. First, we’ll discuss the history of Rule 506(b) and Rule 506(c). Then, we’ll look at the major differences between the two. Last, we’ll ask some questions about your company to give you insight about which of these exemptions might be better suited for your next raise.
Let’s jump right into it.
What is Regulation D?
In 1929, “The Great Depression” happened. When President Franklin D. Roosevelt was elected to office, stimulating the US Capital Markets was a top priority and “The New Deal” was quickly passed.
Part of “The New Deal,” called, “The Securities Act,” focused on protecting investors from securities fraud.
Regulation D is part of “The Securities Act” that allows companies to file for an exemption from SEC Registration – something that is otherwise required in order for a company to sell securities.
What do you mean when you say, “Security?”
Generally speaking, any time financial gain for many passive people depends upon one person’s (or company’s) efforts, it constitutes a security.
In the context of real estate syndication, a security is the equity that an investor purchases in your company based upon which a regular distribution and return of capital are typically paid.
So what’s an “Exemption” then?
Normally, if a company wants to go public and trade securities, they must register with the SEC. This costs millions of dollars and takes several months. Exemptions allow smaller companies to sell securities without registration.
Rule 506(b) is one way a company can be exempt from registering with the SEC.
No fee. No wait.
How about Rule 506 (c)?
Rule 506(c) came about as a part of the “Jumpstart Our Business Startups Act” (JOBS Act) which went into effect in 2013.
The collapse of the US Housing Market in 2008 coupled with emergent internet technologies played a huge role in this new exemption.
Crowdfunding and FinTech Lawyer, Mark Roderick said this about Rule 506(c), “This is just the internet coming to the capital formation business.”
He goes on to ask, “What did the internet do when it came to the retail industry? Or to the music industry? Or to the travel industry? The taxicab industry? Or match.com? What it does is allows buyers and sellers to connect directly without all those middlemen.”
Technology makes connecting (at least on a surface level) easy. Additionally, the internet also opened up an entirely new space for digital advertisements.
Rule 506(c) clearly outlines new guidelines for navigating this digital forest to raise capital and sell securities while still bypassing SEC Registration. Some have heralded it as one of the greatest things to happen to real estate syndication in several decades.
But is that really true?
Should this article end here?
Pack up. Go home. Problem solved?
In the market today, Mauricio Rauld, an SEC Attorney with over 18 years experience, estimates that 90% of private offerings in multifamily real estate raised capital under Rule 506(b).
Major Differences Between Rule 506(b) And Rule 506(c)
Let’s look at some of the big ticket items that set the two apart.
Doesn’t advertising have something to do with it?
Yes. I’m so glad you asked.
Advertising and general solicitation is the major difference between Rule 506(b) and Rule 506 (c). You CANNOT advertise or generally solicit a 506(b) offering. An investor must have a previous, “substantiative” relationship with the sponsor.
In a Rule 506(c) offering, you absolutely can. In fact, you should advertise. If you’re raising for a 506(c) offering and not advertising, you are missing out. You can plaster your offering all over Facebook, Reddit, Podcasts, Conferences, and anywhere else.
This makes it a great option for funds and larger raises.
How about Investor Accreditation and Verification?
Another great question!
Generally, “Accredited” is taken to mean that an investor is wealthy enough to protect themselves from securities fraud.
Specifically, it means that they make (and are expected to continue making) equal to or greater than $200K per year in annual income if single, $300K per year with a spouse, or have a Net Worth of $1M (or greater) not including their primary residence. There are also accreditation criteria for Corporations, Trusts, LLCs and Partnerships.
Rule 506(b) offerings allow for a maximum of 35 non-accredited investors provided they are at least, “sophisticated” – a word which here means that they have sufficient experience to understand the risks and merits of an investment opportunity.
Additionally, a Rule 506(b) offering allows investors to self verify which does does make the “sophisticated” distinction a little fuzzy. Lawyer Mark Roderick once said, “…I have never, in my career of doing this for a long time, had someone say, ‘No, I’m not sophisticated, you know. I’m the dummy in the room.”
When raising capital under Rule 506(b), you must have a preexisting, substantiative relationship with your investors prior to soliciting an investment. The SEC provides guidelines for this such as having multiple phone calls, emails, an investor questionnaire, meetings, etc. All of these conversations should be clearly documented in the event that the relationship come under scrutiny.
One important thing to add here, is that the relationship must have “preexisted the offering,” stresses SEC Attorney, Mauricio Rauld. You can’t simply establish a “substantiative” relationship and then immediately solicit an investment in a current deal. You can only begin to solicit investments for future deals.
There are also additional disclosures that must be provided to non-accredited investors and you cannot withhold information from non-accredited investors that was otherwise provided to accredited ones. For this reason, some syndicators prefer to only work with accredited investors regardless of exemption.
Rule 506(c) offerings require all investors be “Accredited.” They also require that an investor’s accreditation status be verified using federally prescribed, “Reasonable Steps.” An SEC Attorney will help make sure you are taking necessary steps.
Essentially, it boils down to this:
- An investor has their own Attorney of CPA provide necessary documents.
- An investor uses a respectable 3rd party verifier such as verifyinvestor.com.
- A sponsor pays for an account with a 3rd party verifier like verifyinvestor.com to cover the cost for their investors.
- An investor can provides specific documents such as a W2 or consumer report directly to the sponsor. Although, verification is usually performed through one of the other options listed above.
Pros and Cons
Let’s aggregate what we’ve talked about so far.
- Traditional investment workflow with less steps and hassle.
- Investors can self-verify.
- Because you must have a prior relationship with your investors, you’ll probably have a better relationship/understanding of what they’re looking for in an investment opportunity.
- You can have up to 35 non-accredited investors, provided they are sophisticated.
- You CANNOT Advertise or generally solicit the offering.
- There are tighter restrictions on how to handle non-accredited (but sophisticated) investors and additional disclosures to provide.
- You can advertise the offering.
- It provides opportunities to investors that are generally reserved for smaller groups.
- You can grow your investor network by providing high quality investment opportunities.
- Since you’re only working with accredited investors, there’s less disclosures that need to be provided.
- No non-accredited investors are allowed.
- Investor’s accreditation status must be verified (there is an extra step in the investment process).
- Since any accredited investor can invest, you likely won’t have as deep of a relationship with all of your investors.
Things To Consider (The Meat And Potatoes)
Let’s get a better understanding of how these exemptions will shape your raise. I’ve broken this down into three categories: Offering, Investors, and Technology.
How much capital are you raising?
Through advertising, raising capital under Rule 506(c) significantly opens your offering up to potential investments. It’s going to come with a trade off of not allowing any non-accredited investors into your deal, but if you’re raising millions, the increased outreach of a 506(c) can be very appealing.
What are the numbers like?
Under a Rule 506 (c), you’ll be pitching your investment opportunity to a wider net of investors. You’ll need to take special care to highlight the benefits of your deal. Depending on your experience and size, you might not be able to lean on your reputation as much as you can with a smaller network of prior relationships. The numbers should speak for themselves.
Many syndicators also make their track record available to provide historical precedence for the types of returns new investors can expect.
How many passive investors do you have a previous, “substantiative” relationship with?
Keeping in mind that a 506(b) offering makes you depend only on prior relationships, can you realistically raise the required capital using your existing investor pool?
For smaller companies looking to scale quickly, Rule 506(c) offerings can be a very lucrative way to quickly increase their AUM. This is especially true for smaller companies that are technologically proficient.
What’s their accreditation status?
If you’re considering raising capital under Rule 506(b) you’ll need to be more aware of your investor’s accreditation status. You can have up to 35 non accredited (but sophisticated) investors in the deal. However, if you have even one non-accredited investors, additional disclosures will need to be provided.
Many sponsors simply opt out of working with non-accredited investors as they grow their company. To quote Mauricio Rauld once again, “only 8% of 506(b) offerings have non-accredited investors.”
How comfortable are you with new technology?
Modern day technologies and softwares make raising capital easier than ever. They lessen the hassle of raising capital under Rule 506(c) and performing accreditation verification.
Today, there are many 3rd party verifiers like verifyinvestor.com that integrate directly with your real estate syndication software.
With Investor Deal Room, for instance, syndicators have access to capital raising templates for both a Rule 506(b) and a Rule 506(c) offering. Investor verification is simply part of the investment workflow for a Rule 506(c) raise. We’ve made it simple for investors to upload their own verification documents or follow a link out to your 3rd party verification software to verify their accreditation status.
What softwares will you be using throughout your raise?
Will you be keeping track of your capital raise using a real estate syndication software or taking a more manual approach?
If you depend on spreadsheets and similar tech, it might make more sense to keep your raise more traditional and raise funds under Rule 506 (b). However, if you have a good mind for technology and a well connected suite of softwares working for you, a Rule 506(c) might actually be the easier of the two.
Real estate syndication software such as Investor Deal Room helps automate your capital raises. An automated capital raise allows you to overcome many of the boundaries presented by raising capital under Rule 506 (c).
What’s your online presence like?
Under a Rule 506 (b) you can’t advertise your investment opportunity, but you can certainly have a website for your company. If you have an established website that is great at lead generation and have a great process for building “substantiative” relationships, then there might not be as much of a need for advertising and general solicitation.
Having a good content marketing strategy can also aid in this endeavor and should be taken into account. It’s always okay to provide valuable resources to your audience such as a podcast or blog so long as you don’t advertise a specific investment opportunity.
Flip-side of the same coin, if you DO have a really established online presence, it’s only going to amplify your advertising efforts.
The Final Verdict
An SEC Attorney can help look at all these aspects of your company and coach you on which exemption is right for you. There are benefits and risks of raising capital under both Rule 506 (b) and Rule 506(c). We can’t say for certain (without additional information) which exemption is best suited for your next raise.
Since we are focusing on Rule 506(b) VS Rule 506(c), we aren’t even taking into account the many other possible exemptions such as Regulation A and beyond.
As we’ve already heard, the split for 506(b) and 506(c) is about 90/10 with Rule 506(b) winning the popularity contest. However, this isn’t homecoming. As technology becomes more accessible, I look to see Rule 506(c) offerings become more frequent in the future.
In closing, I hope that this post helped to give you a big picture perspective into Rule 506(b) and 506(c). We’ve covered their history, looked at the differences between the two, and looked at how different aspects of your business might impact your decision.
Please let us know if you’d like to see more content like this in the future, and as always…
Thanks for reading!