On July 10th, 2013, the Securities and Exchange Commission (SEC) created a new rule that will allow entrepreneurs to advertise their investment proposal to the world. Rule 506(c) is not effective until mid-September, and the SEC may add more rules burdening its use (see here). Nevertheless, being able to pitch your business idea through social media is a huge opportunity, and of course there are risks involved.
To understand these risks, it is helpful to have some context. In the wake of stock market crash of 1929, a securities offering must be registered with the SEC, unless the offering complies with a specific exemption. Registering an offering is a serious and costly undertaking requiring you to disclose a tremendous about of information.
The most used exemption from registration is Rule 506 of the Securities Act. The SEC estimates that in 2012, $899 billion was raised through Rule 506 transactions. Since 1982, Rule 506 offerings were banned from open advertisement: they could only be privately offered to investors. While companies were able to raise money from a limited number of unaccredited investors (if you make less than $200,000/year or have less than $1million in assets, excluding your primary residence, then you are an unaccredited investor), the enhanced due diligence and disclosure requirements that went along with accepting money from unaccredited investors caused most entrepreneurs to focus on accredited investors, a group of people that make up only 8% of the United States. While accredited-investor-only raises do not have the same level of disclosure requirements as registered offering and offerings to unaccredited investors, they are subject to stringent anti-fraud rules.
This ban on general solicitation is why entrepreneurs have avoided using social media to reach potential investors. The SEC vote lifted that ban for accredited-investor-only raises, but it did not change the anti-fraud rules. In a securities context, fraud is a misleading statement of a material fact, or simply failing to disclose something that is necessary to make what you’ve already disclosed not misleading. Bit of a brain teaser, but ultimately what this means is that if you don’t provide potential investors with a complete and honest picture of your business, then you could be liable.
Fraud liability has unique implications for entrepreneurs. New businesses routinely pivot to survive. If your young venture is in the middle of an investment advertising campaign, and you pivot your business model in any way and fail to update the public, that’s securities fraud. And remember that completeness is a measure of fraud, so your tweet better be thorough.
Lastly, consider that nothing dies on the internet, so that video that you posted two months ago is permanently open to scrutiny.
The entrepreneur is also responsible for making sure that only accredited individuals invest. There are steps an entrepreneur can take to establish a reasonable basis for believing an investor is accredited. This includes checking IRS records, brokerage records, and written confirmation from licensed third parties, such as lawyers, CPAs, and broker-dealers.
A new industry is waiting to assist entrepreneurs in using this rule. This is especially important considering that the SEC also approved the Dodd-Frank Act “bad actor” rules. Any felony or misdemeanor in a securities context, including fraud, can result in a 10-year ban from the securities market. This is a forward-looking rule, so past violations only need to be disclosed. But this disclosure requirement doesn’t pertain solely to the entrepreneur’s past, but also his/her team’s and the team of any intermediary he/she chooses to advertise through.
The securities market is tightly regulated, but perfectly negotiable, when handled with care. That is why a well functioning industry of due diligence professionals is good for the market as a whole, allowing for greater deal flow and the creation of more businesses every year.
This is not legal advice. You should always consult a legal or business professional before making a securities offering.