Securities - How do you know?

Question

I'm working on a deal where I'll definitely need investors. At what point does it become a securities issue? When does looking for investors require a securities attorney? How do I know I know if I need a 506(b), or 506(c)?

Bryan Hancock · Answer

A financial arrangement generally qualifies as a security when you apply the Howey Test from a famous court case on the subject.  The test consists of 4 elements:

• It is an investment of money
• There is an expectation of profits from the investment
• The investment of money is in a common enterprise
• Any profit comes from the efforts of a promoter or third party

If you are borrowing money from someone it generally fails the third element above because there is no common enterprise for those contributing the labor and the capital.  It really doesn't matter that "it is debt and not equity" for determining what a securities arrangement is.  What matters are the elements above.

Reg. D, Rule 506 is a common way to get an exemption from registration for your security and the exemption is at the federal level.  This is the most popular way to raise money for private offerings and the exemption offers many features that make it favorable to others.   I disagree with the advice you received above about the (b) being the better choice for you.  If you're just starting out the (c) exemption will give you more ways to advertise your offering and thus greater exposure to solicit interest in your projects.

Note that there are other exemptions too and thus Rule 506 may not be the best choice for you.  A lot depends on what you're trying to do and thus you should seek the counsel of a qualified securities attorney to assist.  I'm also not an attorney so nothing above should be construed as legal advice.

Jack Martin · Answer

Whether or not you have debt in the capital stack has no bearing.  If you are raising money, whether as debt or as equity, you should be speaking to a securities attorney. Period.

Allow me to say that again a little louder. If you are raising money, whether as debt or as equity, you should be speaking to a securities attorney. Period.

Forums like these are great for context and perspective, but keep in mind I am not an attorney, rather a sponsor that uses a securities attorney for every offering wherein capital is raised. If you plan to be in the business and will be raising capital at some point, you will need to establish a relationship with a securities attorney anyway, so I suggest you do that. They are extremely valuable to you.

Bryan Hancock · Answer

The debt in your capital stack is also technically a security, but lenders have special provisions in the securities law.  I'm too lazy to look them up, but Google is your friend.  Read about Reg. D and the exemptions and it will be pretty easy to find.

Taylor L. · Answer

Do you want to be able to publicly advertise your investment opportunity? If so, then you'll go 506(c). However then you're restricted to accredited investors.

Do you want to be able to bring non-accredited sophisticated investors in, but not be able to publicly solicit? Then go 506(b). There are a lot of rules around each, but generally speaking I think that's the deciding factor for most sponsors. If you already have a relationship with everyone you plan to bring in to your deals, you'll probably go 506(b), but you'll talk that over with your attorney and make the right decision.

@Kim Lisa Taylor has a free e-book on legally raising private money: https://syndicationattorneys.com/how-to-legally-raise-private-money/

You can start learning about the topic from free resources like that, but eventually you'll need an attorney's direct guidance and input.

Michael Schumpert · Answer

Thanks @Jack Martin and @Bryan Hancock! Sorry if I've been obtuse...

Taylor L. · Answer

I can't, but if we tag @Kim Lisa Taylor maybe she can help out?

Jack Martin · Answer

@Michael Schumpert just to be clear, there is a huge difference between using a lender and raising capital as debt. You can syndicate debt as well, so if that's what you have in mind that would NOT avoid the securities issue.  What I was referring to is if your capital stack included debt from a bank, hard money lender, or other lending source wherein you are NOT creating an offering, plus the capital from the principals in the deal.

Amy Wan · Answer

You can, but 506b and 506c are the easier ways to do it. Those are two exemptions for private placements, which means its a private offering to investors. 95%+ of private capital in the U.S. is raised through Rule 506b alone.

Other ways include going public (likely not what you want to do), using in intrastate offering exemption (meaning you can only have investors from that one state), Reg CF (which currently still limits you to $1M a year and needs to be done through a licensed portal, though the dollar amount is set to increase to $5M in the future), and Reg A+, which is a mini-IPO and likely too complicated for what you're trying to do.

It may be possible to get ONE check from ONE investor and have it not be a security, but that depends on what jurisdiction you're in and you'd still want a lot of the same things/terms spelled out and done as you would in a securities offering to CYA--especially these days.

Jack Martin · Answer

@Michael Schumpert hard money lenders or private lenders would not require syndication as those are debt instruments, rather than equity interests. As long as your capital stack includes only capital from the principals in the deal, plus the debt.

Cameron Rockwell · Answer

@Michael Schumpert I completely agree with @Taylor L. I just finished reading that book and it completely changed my approach. Certainly worth the read!

Securities - How do you know?

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