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What is 506(c), and What Does It Mean for Fundraising?

recorded capital commitments

Regulation D is a set of rules under which an issuer can sell its securities without having to register with the SEC. Rule 506 under Regulation D has been the most widely used means of raising capital in the US. Rule 506 was basically bifurcated into two separate rules — 506 (b) and 506 (c) — after the passing of Title II of the Jumpstart Our Business Start-ups (JOBS) Act in September 2013. 506 (b) is merely the extension of the old Rule 506, and 506 (c) is the new section that has completely revolutionized the world of private investing.

Under rule 506 (b), companies are free to accept backing from accredited investors and 35 non-accredited investors for an unlimited amount. Under rule 506(c), companies can sell to accredited investors only. On top of that, they need to verify that each investor is accredited.

An accredited investor is one who has a net worth of $1,000,000 excluding his primary residence, or if he has made $2,000,000 on an annual basis in the past two years.

So what is the advantage of this new rule? It allows for general solicitation.

506(b) does not permit general solicitation. The issuer needs to prove a pre-existing relationship with investors. This reduces the pool of investors a company can target. With general solicitation allowed under 506(c), start-ups can leverage the internet, TV, radio, and other media to attract a larger base of investors. This has “democratized” investing and the ability to raise capital. A company offering securities need not have any prior relationship with investors. Rather, they can publicly promote their capital-raising offer.

Crowdnetic, now FinMkt, tracked 6,063 investment crowdfunding private offerings under JOBS Act Title II 506(c) rules, which have combined recorded capital commitments (“RCC”) of approximately $870.0 million in the two years between September 23rd, 2013 (when Title II rules went into effect) and September 23, 2015 (the date of the report).

recorded capital commitments

There is not an ounce of doubt that Rule 506(c) has brought a lot of upside for the issuers as they can broaden their reach by advertising their offering. The issuing company can raise more capital at a much faster pace without relying on the traditional gatekeepers that earlier helped them to find suitable investors. From the perspective of the investor, under rule 506(c), the advertised offering benefits them, as well. They now have a much larger choice available and can get on board a startup much earlier in its life as compared to waiting for an IPO.

Effect of 506(c) changes

There is an additional burden of verifying investors and making sure they meet the SEC’s definition of “Accredited Investor.” Many companies have sprung up to help start-ups outsource this tedious legal due diligence.

Startups have been using social media to attract users and customers since at least a decade. Now, they are able to leverage their skill set to attract money for their ventures. We are used to hearing about CAC (i.e. Customer Acquisition Cost); we will soon be reading about CAI – Cost of Acquisition of Investor. This metric will become a key success factor for start-ups looking to grow aggressively, and it allows them to even sidestep venture capitalists for funding.

Research by Crowdnetic shows that investors are comfortable investing in startup equity, thus highlighting that markets and investors have accepted this new rule with open arms.

Offerings and capital commitments by security type-1

What does it mean for alternative lenders?

This rule is a boon for marketplace lenders. They have proved adept at bringing thousands of lenders onto their platforms. P2P lenders have generally been a happy lot due to higher risk-adjusted returns they’ve been able to generate through platforms. The company should be able to tap this base for equity fundraising, as well. If you’ve invested $50,000 through SoFi, you might be predisposed to invest $10,000 in its equity.

And not only start-ups, even VCs and accelerators are taking note of the rule and its implied implications. 500 Startups has recently filed a Form D under 506( c ) for a fintech fund targeting a raise of $25 million. It is a prominent accelerator and has invested over $350 million in 1800 companies. This shows that the entire ecosystem of fundraising is poised for an upheaval with the 506(c) rule.

Conclusion

Rule 506 will break the hegemony of investment bankers and VCs over the fundraising process. A startup doing well can target its own user base for accredited investors rather than having to pay sky-high fees or dilute control to VCs. The startup community has been extremely receptive to the change, and you can see multiple platforms launched for the sole purpose of helping thousands of start-ups raise funding from a wider pool of investors. It is easy to see that 506(c) has been a win-win for all involved.

Author:

Written by Heena Dhir.

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Allen Taylor

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