Reg D Rule 504 and 506C: Navigating Initial Fundraising and Future VC Rounds

When a new company raises $500,000 under Reg D Rule 504 and a portion of that funding comes from non-accredited investors, the question arises: Is it legally possible for the company to seek a larger VC round of $1 million in the next three months? This article explores the legal landscape surrounding Rule 504 and Rule 506C, and how these rules can affect a company's future fundraising strategies.

Understanding Rule 504 and Rule 506C

Regulation D (Reg D) under the Securities Act of 1933 offers several exemptions for private placements, with Rule 504 and Rule 506 being the most commonly used. Rule 504 provides for the private placement of up to $5 million of securities in any 12-month period, while Rule 506C allows for offerings that are publicly advertised, targeting only accredited investors.

Initial Fundraising via Rule 504

Suppose a company raises $500,000 under Rule 504, with some of this funding coming from non-accredited investors. This amount can be significant, but the company must carefully consider its future fundraising options, particularly if it aims to secure a larger VC round in the next three months.

It is important to note that Rule 504 is considered a backward-looking exemption, meaning it only applies to the 12-month period it is being used. However, this does not preclude the company from raising additional funds beyond the $500,000 limit as long as the 502(b) integration test is not triggered.

Rule 502(b) and Integration Test

Rule 502(b) of Reg D requires the SEC to use a five-factor test to determine whether two offerings may be considered integrated. These factors include:

Whether the sales are part of a single plan of financing Whether the sales involve the issuance of the same class of securities Whether the sales have been made at or about the same time Whether the same type of consideration is being received Whether the sales are made for the same general purpose

If the same securities are being offered for sale under two different exemptions, and these offerings are found to be integrated, they will be treated as a single offering. If the next round of financing is less than 6 months away, it may be considered integrated, making it difficult to raise additional funds under a different exemption.

Safe Harbor for Future Funding

To mitigate the risk of integration, Rule 504 provides a 6-month safe harbor. This means that if the company’s next financing round is more than 6 months later, it is presumed to be not integrated. Therefore, if the next $1 million VC round is sought more than 6 months after the initial Rule 504 raise, this would likely not be considered integrated.

However, in the scenario presented, since the new funding round is within 3 months, the 6-month safe harbor does not apply.

Strategic Approaches to Initial and Future Fundraising

To navigate the complexities of Reg D exemptions and future fundraising, companies can consider the following strategies:

Beacon Model: Utilize general media such as radio, TV, and the Internet to test the waters for future Reg. A Tier 2 or 3 offerings, which involve advertising and are open to a broader range of investors. Reg. A TTW Ads: Use Tier 2 or Tier 3 offerings under Reg. A to attract and build a prospect list of potential investors. Enable Building a Database: Over time, companies can gather a database of prospective investors to engage in future fundraising efforts.

Final Considerations and Disclaimer

Before taking any action related to fundraising, it is imperative to consult with a licensed attorney in the appropriate jurisdiction. This article is not a substitute for professional legal advice and does not create an attorney-client relationship. For more detailed guidance, please seek the advice of legal counsel.

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