Many private companies raise money by selling equity to investors. However, to comply with the federal Securities Act of 1933 (the ‘33 Act), the companies have to either register their securities offerings with the U.S. Securities and Exchange Commission (SEC) or meet an exemption.
Registering by going public through an initial public offering (IPO) or through a special purpose acquisition company (SPAC) can be a long and costly process. So, many small companies start with one of the many types of exempt offerings—also called a private placement or unregistered offering—that the ‘33 Act allows. Some larger companies that decide to stay private also raise money through unregistered offerings instead of dealing with the requirements that come with being publicly listed on a stock exchange.
There’s a lot of money flowing through these securities offerings. In fact, the SEC found that in fiscal year 2021, companies raised over $1.9 trillion through Regulation D offerings (a type of exempt offering) and only $317 billion from registered public offerings. Much of this money comes from accredited investors.
Many exempt offerings are limited to accredited investors
The ‘33 Act was passed in the wake of the stock market crash of 1929 to help protect investors. It prohibits fraudulent or deceitful sales of securities and requires organizations that are issuing securities—such as bonds and stocks—to disclose helpful information about the investment when they register the security.
Some types of securities, such as municipal bonds, are generally exempt from the registration requirement and available to all investors. But the private companies that raise money from exempt offerings generally get most of the funds from accredited investors—individuals or entities that are wealthy or financially knowledgeable enough to take on the risk associated with investing in unregistered offerings.
There are exemptions that allow companies to raise money from both accredited and non-accredited investors. However, raising money from non-accredited investors can require lengthy disclosures and some exemptions have fundraising caps. As a result, the limitations aren't practical for startups with big ambitions, which generally turn to angel investors, private equity funds, and other types of accredited investors.
Which exemptions do companies often use?
The ‘33 Act allows for a number of exempt offerings, and defines who can participate and what limits issuers must observe. The six most common types of exempt offerings are:
- Rule 506(b) private placements: The company can accept an unlimited amount of investments from accredited investors and up to 35 sophisticated but non-accredited investors—people who have sufficient knowledge and experience to understand the risk they’re taking. However, the company generally can’t solicit or advertise the offering, must give non-accredited investors disclosure documents, and has to be available to answer non-accredited investors’ questions.
- Rule 506(c) general solicitation offerings: The company can accept an unlimited amount of investments and broadly solicit and generally advertise its securities offering. However, all the investors must be accredited investors and the company has to take reasonable steps to verify their accredited status.
- Rule 504 limited offerings: The company can raise up to $10 million from accredited and non-accredited investors, but can only generally solicit investments in limited situations.
- Regulation crowdfunding offerings: The company can raise up to $5 million during a 12-month period from accredited and non-accredited investors (with limits based on their income). All the sales must be online via an SEC-registered intermediary.
- Intrastate offerings: A company that does a significant amount of its business in the state where it’s organized can use an intrastate offering to raise money from investors who are based in the same state. Accredited and non-accredited investors can participate, but the funding amount is often limited to $1 to $5 million depending on the state’s laws.
- Regulation A offerings: A two-tiered “mini-IPO” process that companies can use to raise up to $95 million from accredited and non-accredited investors.
There are other options as well, such as the statuary accredited investor exemption in Section 4(a)(5) of Act 33. However, some of the exemptions above are more popular because they offer more benefits with similar requirements.
Many of the exemptions also have “bad actor” disqualifications that limit who can use the exemption, and rules that affect when a purchaser can resell the security.
How does the SEC define “bad actors”?
Many exempt offerings are subject to the bad actor disqualification provision that applies if the issuer or a covered person has a disqualifying event. The SEC outlines who is considered a covered person and what’s a disqualifying event.
For example, an issuing company and its affiliates, along with an owner, director, or executive of the issuer are all covered persons. And a disqualifying event can include certain criminal convictions and SEC disciplinary orders related to purchasing or selling securities.
Issuers can apply for a bad actor disqualification waiver from the SEC if they have a good cause (as determined by the SEC) or if the court or agency that oversaw the disqualifying event decides that the issuer shouldn’t be disqualified from the offering.
What are restricted securities?
Investors who purchase securities from an exempt offering often receive restricted securities, which means the investor can’t immediately resell them. This keeps someone from buying a security solely to resell it to someone who wouldn’t otherwise have qualified.
Under Rule 144, accredited investors who purchased securities and aren’t affiliated with the company may be able to sell the securities if they hold onto the security for at least six to 12 months. However, even then, the security can’t necessarily be sold to a non-accredited investor.
Why is there controversy around the SEC’s exemption rules?
Not everyone agrees with the regulations that effectively keep many non-accredited investors from investing in private companies.
Proponents of the accredited investor exemption rules point out that companies offering securities through exemptions may have limited disclosure requirements, and the rules protect people from high-risk investments. But others feel that they only help the rich get richer. They'd prefer a broader definition of accredited investor, or the elimination of accredited investor requirements altogether.
As it currently stands, an individual needs to either make at least $200,000 a year ($300,000 when combined with a partner’s income) or have a household net worth of over $1 million to qualify as an accredited investor. In August 2020, the SEC expanded the definition to include people who hold certain professional certifications or designations. But these requirements might still feel like barriers that keep most people out of an exclusive club.
The SEC exempt offerings allow private companies to offer and sell securities without registering the securities with the SEC. It might seem complex—and the specifics certainly can be—but it's a process that many small businesses and tech startups go through when they get started, and some larger companies continue to use to raise capital.