This summer, there was a seismic shift within the private securities landscape. On July 10th, the Securities and Exchange Commission voted 4-1 to lift an 80-year old ban on general solicitation, allowing those seeking capital to advertise their securities to the general public. This was a huge leap forward in wealth creation for this country as it allows those looking for money to position themselves right in front of people who not only have capital but, more importantly, are willing to invest it. These individuals - those with at least $200,000 of annual income and/or over $1,000,000 in assets - are classified as accredited investors.
Before September 23rd (the date these new rulings took effect), entrepreneurs seeking investment were forced to go the route of "back-door dealings" in order to gain the attention, and eventually the money, from accredited investors. Entrepreneurs had to personally know and have an existing relationship with the investors they brought on as there was no other method of attracting capital. With the introduction of general solicitation, entrepreneurs will be able to use a new exemption (Rule 506(c)) to target a large number of qualified investors at once via all manners of promotion and advertising. Everything from TV ad spots to Facebook updates to blog posts like this one are fair game for entrepreneurs to utilize during their fundraising rounds.
While this is game changing for entrepreneurs seeking funding as it increases their access to capital, the nuances of these regulations are likely to cause confusion. Prior to July 10th, the SEC turned a blind eye to general solicitation, allowing entrepreneurs to participate in demo days, pitch competitions and public meetings without fear of being regulated. With the laws now in effect, that blind eye will be replaced with enforcement around general solicitation. However, the definition of general solicitation is broad and open to interpretation - it can be anything from a conversation in a coffee shop to an official pitch. Therefore, even entrepreneurs who don't intend to generally solicit and advertise their investment, risk accidentally and unintentionally doing so - and if they do generally solicit they will need to abide by the new rulings.
For entrepreneurs who choose to file under rule 506(c) and generally solicit, there is now the responsibility to verify the accreditation status of any investor who participates in the funding round. Under the old rulings, investors could sign on a dotted line to self-certify that they were in fact accredited. But with the new rulings self-certification is no longer sufficient. Entrepreneurs raising capital through general solicitation must now take "reasonable steps" to ensure their investors are accredited.
The SEC outlines two non-exclusive ways to go about verifying an investor's accreditation status. One option is to simply ask an investor to pass along his or her IRS documents and tax filings so the entrepreneur can verify that the investor meets the required criteria. This process is fundamentally flawed however as sophisticated investors will be unwilling to disclose their personal information. Another method of verification is for the entrepreneur and investor to rely on third-party verification. This involves the use of the investor's CPA, broker-dealer, or investment advisor to verify the accreditation status on behalf of the investor. Websites such as Crowdentials have taken measures to streamline the third-party verification process while requiring no sensitive financial information. This gives entrepreneurs the safe harbor they need in order to stay compliant while giving investors the privacy they require.
These safe harbors are vitally important for those using Rule 506(c). Without them, entrepreneurs risk exposing themselves to the harsh penalties outlined by the SEC. Those that are found to be non-compliant while generally soliciting will be forced to return all the capital they raised in that particular fundraising round. While this in itself would have crippling effects for any company, the SEC won't stop there. The SEC has proposed a rule that states that if an entrepreneur brings on an investor without taking "reasonable steps" and that investor turns out to be unaccredited, the company could be banned from raising any capital for an entire year. These penalties are the SEC's attempt at protecting unsophisticated investors from being taken advantage of by scheming individuals only looking to make a quick buck. While the penalties are harsh, they are not only understandable, but easily manageable as well with a little outside help.
The SEC has not finalized all of the rules that are to be adopted regarding this legislation. In fact, all of the proposed rules are open for comment and those individuals that will be affected by this legislation are encouraged to go to the SEC website and voice their opinions. A lot of buzz has been surrounding the proposed rules as they seem to neuter the purpose of lifting the ban on general solicitation. If the proposed rules are adopted, businesses will have far more bureaucratic work to maintain a relationship with their investor and stay compliant. This extra workload would prevent any business from being agile and competitive.
The lifting of the ban on general solicitation has a lot to offer entrepreneurs and could very well create wealth for the startup community. Entrepreneurs are no longer limited to approaching the few accredited investors they may know - instead they can reach accredited investors wherever they may be. These rulings have removed the geographic barriers to startup capital. However, the rulings are very nuanced, open to interpretation, and carry significant penalties if they are not followed. Additionally, the ruling is not yet completed as the proposed rules have not yet been decided upon. It is absolutely essential that those raising capital stay fully educated about their options and the latest legal news in order to stay compliant. The times are changing and those that don't change with them will be left behind.