When you’re founding a start-up one of the things you have to figure out is how are you going to get funding for specific stages of development.
While the subject of funding itself is a deep well, we’re going to focus on the topic of securities, or to put it simply - shares in your company.
Selling securities is one of the most common ways of obtaining funds from investors.
In order to do that, you have to register with the US Securities and Exchange Commision (SEC), which is an independent federal agency created to protect investors and maintain order and efficiency of the markets.
The registration is costly and time-consuming and it is opening the offering up to public scrutiny. A lot of small businesses can’t really afford it and have more than one reason to stay private until they decide otherwise, so going through with the SEC registration isn’t exactly optimal.
That’s why Regulation D was created.
The Securities and Exchange Commission (SEC)’s Regulation D allows your startup to raise capital by issuing stocks and bonds, while doing the minimal amount of paperwork—so long as you follow certain rules.
Typically, when you want to sell securities to investors, you have to register them with the SEC. This is an intense and lengthy process. Reg D lets you skip it, but you have to make sure both you and your investors meet certain requirements.
Heads up: The Federal Reserve Board (FRB) also has a Reg D, pertaining to bank reserves. Reg D (SEC) and Reg D (FRB) are very different. Don’t get them mixed up.
Why file a Reg D?
You should file a Reg D if:
- You run a new, small company—not a large, well-established business
- Need seed funding for your startup
- Are looking for a quick, nimble fundraising solution
- If you believe it’s time for a public offering, Reg D is not the place to turn. For that, you’ll need to begin the long process of filing Form S-1.
Who can you sell securities to under Reg D?
Reg D lets you sell securities to both accredited and non-accredited investors. However, depending on the exemptions you claim, you may only be able to sell to a limited number of investors who are non-accredited.
What is an accredited investor?
An accredited investor is someone who:
- Has had an income of $200,000 per year for the last two years ($300,000 if they’re married), and can confidently claim they’ll earn the same this year
- Has a net worth of at least $1 million, not including the value of their primary residence
Whether an investor is accredited or not, you must provide them with the information they need to make an informed investment. You cannot withhold information based on an investor’s accreditation.
The three big Reg D exemptions
If you’re planning to file Reg D, there are three major exemptions you need to understand. Which ones you opt for will depend on your particular situation. As always, before taking a deep dive into the fine print, it’s wise to get the help of an attorney.
Rule 506(b): Private Fundraising
- You are able to raise capital by selling securities without solicitation, aka public facing advertisements. Usually, that means selling only to investors you already know
- You may sell securities to an unlimited number of accredited investors, and to no more than 35 non-accredited investors
- There is no limit to the amount of capital you can raise
- Best for: Raising money from friends and family who may not be accredited, while also bringing on investors from your professional network
Rule 506(c): Public Fundraising
- You are able to advertise the securities you sell, so long as you take reasonable steps to ensure you only sell to accredited investors
- You do not need to have prior relationships with investors, but you do need to make sure that only accredited investors are involved
- Best for: Courting new investors outside your immediate circle
Rule 504: Offerings Under $5 million
- You may sell up to $5,000,000 in securities over a 12 month period.
- All securities are restricted, meaning they can’t be resold without registering. However, if the owner meets certain requirements, these securities can be sold up to six months or a year after registering
- Best for: Raising seed capital quickly
Heads up: While Reg D saves you from having to comply with certain SEC rules, you’re still required to follow securities laws pertinent to the state in which you operate.
2) Form D
After you decide which exemption applies to your fundraising vision, you file the Form D with the SEC. Form D is a brief notice that needs to be filed with the SEC up to 15 days after the sale of the securities. You can do it electronically and it is free. The form also preempts most state securities laws so that startups don’t have to file in state jurisdictions.
The form itself requires some little information about the company, besides basics like the names and addresses of the company's executives and directors and essential details regarding the offering.
Yeah, except there is one little but.
The Form D Controversy
When you file Form D that information is uploaded to the EDGAR database and becomes a public record.
Why is this problematic?
There are plenty of reasons why start-ups want their funding information to remain private, for example:
● Failure to raise an anticipated amount of funds can crush the positive momentum behind a business and instill doubt in employees and other investors.
● Rounds can sometimes take a long time to close and new investors might come on board months after the sale of first securities.
● Investors may not want to disclose their engagement right away, especially if they’re big, public companies - they tend to release their investment portfolio quarterly.
Now, here’s the interesting part - many companies delay or avoid filing the Form D all together, because they don’t want the publicity, for any number of reasons.
How is that possible?
Theoretically, there are large penalties if you don’t file your Reg D, but the american courts and the SEC have confirmed that a startup doesn’t lose its security exemption in those cases.
In practice nobody is actually required to file a Form D if they have a case for an exemption from registration. So if you’re raising a private round and you don’t publicly solicit investment - you don’t have to register it.
You have to remember though, without the Form D, there is no preemption of the state law, so depending on where you’re raising the money - you’re going to have to comply with those regulations.
How to file a Reg D
To file a Reg D, you or your representative must register for EDGAR (Exchange Commission Electronic Data Gathering, Analysis, and Retrieval). You’ll get a central index key (CIK) number, which you’ll use in all your dealings with the SEC through EDGAR.
To register for EDGAR:
- Check the time. EDGAR is open for filings between 6am and 10pm EST, Monday to Friday (except federal holidays).
- Visit the registration page and begin a new registration.
- Make sure you understand your EDGAR filing type—whether you are a regular filer, filing agent, investment company, etc.
- Collect the info you need for your Form ID application:
- Your full name
- Contact information
- Tax Identification Number (TIN)
- Complete a Form ID application.
- Print, sign, and notarize a copy of your application
- Scan and upload a copy of your signed and notarized application.
- Complete the application process through EDGAR
- Once you’ve registered for EDGAR, you can fill out Form D and file it.
While filing Form D is considerably simpler than filing an S-1 with the SEC, it’s still a complex document. To make sure you’re filling it correctly, it’s wise to work with an attorney.
The SEC Reg D deadline
The Reg D filing for any securities you sell is due 15 days after the securities in question are sold. Should the due date fall on the weekend, your deadline is the next work day.
When not to file Reg D
Increasingly, new startups are forgoing Reg D filings in favor of crowdfunding on platforms like Patreon.
Once concern that some startups have about Reg D is a lack of privacy. All Reg D filings are made public through EDGAR. Anyone interested in your company—like competitors or the press—can search your business name and immediately get access to all the information included as part of your filing.
- The identities and locations of all your executives, directors, and promoters (“Related Persons”)
- Your elected business structure
- The amount and type of securities you are issuing
- The year your company was formed
- The number of people invested in the offering for which you are filing
Finally, the fact that you’ve filed a Reg D can signal to competitors or other organizations in your industry that you’re issuing securities at all. If your aim is to fly under the radar—raising funds, investing in R&D, and putting together a competitive marketing strategy—filing for Reg D could let the cat out of the bag.
To sum it all up - Reg D and SEC registration is a free and easy way to get your funding legalised and if you don’t need to be super private about it - it gives you extra security and leeway with the state law, which, all things considered, is a pretty good deal.