Regulation D Explained

For most entrepreneurs, the best way to raise money, either debt or equity, is to obtain their financing using Regulation D (Reg D) documentation. This is an exemption which allows a limited offer and sale of their company’s securities, stock units or debt without registration under the Federal Securities Act of 1933. It is accomplished through the use of a Private Placement Memorandum (PPM).

By complying with Reg D, it provides the company, its officers, and its directors with an insurance policy of sorts regarding disclosure.

You – the company issuing the securities – have complete control on how you structure the financing. For equity financings, you decide what the price of the stock will be, how much money you want to raise, and how much of the company you want to give away as well as any other terms and conditions. For debt financings, you decide what the interest rates will be and what your plan for the timing and amount of repayment will be.

There Are Six Basic RulesRegulation D consists of six basic rules.

  • The first three are concerned with definitions, conditions, and notification.
  • Rule 501 covers the definitions of the various terms used in the rules.
  • Rule 502 sets forth the conditions, limitations, and information requirements for the exemptions in Rules 504, 505, and 506.
  • Rule 503 contains the SEC notification requirements.
  • The last three rules (504, 505, and 506) deal with the specifics of raising money under Reg D.
  • Rule 504 offers companies an exemption to raise up to $1 million.
  • Rule 505 applies to offerings from $1 million to $5 million.
  • Rule 506 is for securities offerings exceeding $5 million.

Regulation D Rule 504 offers companies:

  • An exemption to raise up to $1 million.
  • No disclosure criteria.
  • Few general solicitation and resale restrictions.
  • No limit as to the number or type of investors.

Rule 504 is considered by many as the perfect answer for the company just starting out OR one that needs to raise less than $1 million.

You Cannot Exceed $1 Million.The total offering amount under Regulation D Rule 504 can be up to $1 million in a 12-month period, less the aggregate offering of all securities sold within 12 months before the start of a 504 offering. So, if a company has raised $100,000 in private money in the previous 12 months, it can still raise up to $900,000 without being accused of breaking the rules, or “integration.”

Generally speaking, Federal Rule 504 is the simplest Reg D document to fill out. It does require the submission of Form D to the SEC and the rule is dependent on the blue-sky laws of each state in which the securities are offered. This means that if a state’s blue-sky rules require disclosure, it must be provided regardless of Federal Rule 504.

A word of caution to the entrepreneurRegardless of the amount of disclosure the issuer is willing to provide, Rule 504 does not dismiss the issuer from the federal requirements, nor is there an exemption from the fraud provisions, including the areas of material omissions or misstatements. The penalties for noncompliance are severe, including monetary fines and mandatory jail sentences.

Number of Investors.With its limited disclosure requirements, Rule 504 also allows an issuer to sell securities to an unlimited number of investors. Theoretically, a company could raise $1 million by selling its stock at a penny a share to 100 million different investors. Obviously, the administrative economics are not too attractive, but there’s no rule that stops an issuer from selling $500 blocks of stock to 2000 investors. Rule 504 is the only rule under Reg D that permits an unlimited number of investors.

The Rule 504 exemption provides for sales of securities of either debt or equity.This opens the door for combinations of both via convertible debentures. By way of explanation, convertible debentures are a debt issue (debenture) that is convertible to a preferred or, most commonly, common stock at some future date. Rule 504 does not require audited financial statements.

Rule 504 exemption is provided for almost any type of organization,including corporations, LLCs, partnerships, trusts, or other entities.

Rule 505: Offerings of $5 million or less

Rule 505 is used for offerings of $5 million or lessin any 12-month period and is restricted to 35 purchasers other than “accredited investors.”

There are a number of required disclosuresif the sale of securities includes investors who are not accredited investors: advertising and a general solicitation are prohibited, one must inform purchasers that they receive “restricted” securities (meaning that the securities cannot be sold for a time period without registering them). You must not violate the antifraud prohibitions of the Federal Security Laws and your financial statements need to be certified by an independent public accountant or at a minimum, the balance sheet needs to be audited.

Companies must give non-accredited investors disclosure documentsthat are the same as those used in registered offerings. If a company provides information to accredited investors, it must make this information available to non-accredited investors as well. The company must also be available to answer questions by prospective purchasers. The issuer must comply with the securities laws of each state in which a person who buys the security is a resident, and must usually file a notice with that state’s commissioner of corporations or similar official, as well as filing Form D.

Rule 506: Offerings with no dollar limit

Under SEC Rule 506;an issuer may issue an unlimited amount of securities, with no dollar limit, to no more than 35 on-accredited investors plus any number of “accredited investors.” There are required disclosures, if a sale of securities includes purchasers who are not accredited investors. All non-accredited investors must be sophisticated and must sign an Investor Questionnaire acknowledging same. Advertising and a general solicitation are prohibited. The securities are “restricted securities” which may not be readily resold.

There is a major advantage to 506,in that it supersedes and preempts the securities laws of all the states. This saves a lot of time, effort, and expense if the issuer is obtaining money from investors in multiple sstates. Form D must be filed with the SEC within 15 days after the first sale of securities and also with the secretary of state of each state in which a purchaser is a resident.

A detailed discussion on the rules and regulations regarding Regulation D is available in the “Free Financing Paper” download.       Download Now


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