Rule 506(b) vs. Rule 506(c)

Before you launch your own fund, you must consider whether you want to seek an exemption to registering with the SEC under Regulation D. To do that, you must learn to differentiate between Rule 506(b) and Rule 506(c).

Raising capital under Rule 506(b) vs. Rule 506(c) will make a big difference, and only by studying both can you make this critical decision.

Here at Fund Launch, we help fund managers thrive, and we have hundreds of success stories under our belts. 

Today, we’ll tell you what you need to know to make this critical choice. 

Overview of Regulation D

In November of 2020, the SEC adopted new amendments to their original Securities Act of 1933. These amendments impacted Regulation D, a series of rules that provides several exemptions from the registration requirements originally required by the Securities Act.

Created under Reg D as part of the JOBS Act, Rules 506(b) and 506(c) both provide a legal framework for private placements.

According to the SEC: 

Companies that comply with the requirements of Regulation D do not have to register their offering of securities with the SEC, but they must file what’s known as a "Form D" electronically with the SEC after they first sell their securities.

Gaining Regulation D exemptions provide fund managers with key benefits: 

• Speed to fundraising. While SEC registration can take several months to complete, an exception can be applied for quickly. Exemption in hand, you can start fundraising right away.
• Reduced administrative burdens. While you do have to fill out a simple form, there’s no need to fill out extensive paperwork and jump through the necessary hoops to register with the SEC. 
• Steep cost savings. Registering with the SEC can be expensive, with legal and accounting fees—not to mention the time and effort required to prepare the necessary disclosures. In a world where time is money, this aspect cannot be overlooked.
• Greater flexibility in fundraising. Exceptions open the door for a wider variety of ways to raise capital, opening to door both to private placement and—depending on the exemption—the ability to advertise and solicit investments as well.
• Broader pool of investors. Depending on the exemption, you may be able to attract both accredited and nonaccredited investors.  

Perhaps best of all, because Rule 506(b) and 506(c) offerings also do not require issuers to register with individual states, funds under these exemptions are not regulated by state blue-sky laws, giving them even more freedom to navigate without keeping track of or adjusting to appease varying state-by-state requirements. 

While both rules allow state exemptions, they’re different in other ways. 

Learning to differentiate them is key to deciding whether Rule 506(b) or Rule 506(c) is the right way to go. 

What Is Rule 506(b)?

Under the Rule 506(b) exemption, companies can raise an unlimited amount of capital from investors, who are in turn not limited in how much they can invest. 

Rule 506(b) allows both accredited and nonaccredited investors to participate in offerings, although fund managers are under no obligation to accept non-accredited investors if they do not choose to do so. While there are no limits on the number of accredited investors who can participate under this rule, the number of nonaccredited caps out at 35. 

Accredited investors are individuals or entities that have had a net worth of at least $1 million (excluding the value of their primary residence) or who have enjoyed an annual income of at least $200,000 ($300,000 for joint income with a spouse) for their last two years along with a reasonable expectation of the same income level in the current year.

Naturally, non-accredited investors are ones who do not meet the above qualifications but who are nevertheless prepared to invest. 

It should be noted, however, that any non-accredited investors who participate under Rule 506(b) must be sophisticated investors. That is, they must be individuals with a proven investment track record or deep working knowledge of the markets. 

Even then, working with nonaccredited investors will increase a fund manager’s workload, since these individuals must be provided with additional disclosures. Therefore, even if you do choose this exemption, limiting your involvement with nonaccredited investors may be in your best interests. 

But here’s where things can get tricky. 

Under Rule 506(b), it is not the responsibility of the fund manager to verify an investor’s accreditation. Technically, the burden is on the investor to verify their own accreditation. 

Investors can prove their accreditation via proof of income or net worth, via a professional license, or through giving evidence that they work directly with funds and investments. 

Because Rule 506(b) prohibits general advertising and public solicitation, fund managers largely attract initial investors via pre-existing relationships and networking. 

In choosing this rule, fund managers must be sure to meet all requirements of the exemption to stay in complete compliance:

• Preparing a clear and accurate Private Placement Memorandum (PPM)
• Submitting SEC Form D within the correct time frame
• Consistently updating financial reports
• Continuously maintaining proper records 

What Is Rule 506(c)?

While Rule 506(c) also exempts from registration with the SEC, the main ways in which it differs from 506(b) is that 

1. Only accredited investors may participate
2. General solicitation and advertising is permitted 
3. Funds must take reasonable steps to verify investor accreditation

The process of verifying accreditation can prove time-consuming and costly; however, the ability to market and advertise still often results in a larger pool of investors. 

Fund managers currently market via

• Social media (posts, content, blogging, etc.)
• Live events (public speaking and networking)
• Email campaigns
• Traditional media spots

While this approach may sound exciting, remember that with great (advertising) power comes great (verification) responsibility. 

Because GP’s are responsible for verifying investors accreditation status and associated compliance requirements, they absolutely must have a plan and streamlined system in place to handle a large pool of potential investors. 

Investor verification methods may include:

• Asking investors to provide a signed statement or certification confirming their accreditation status
• Requesting tax returns, bank statements, or brokerage statements 
• Obtaining written confirmation from a registered broker-dealer, an SEC-registered investment adviser, a licensed attorney, or a certified public accountant (CPA) 
• Working with a third-party verification service to conduct due diligence on behalf of your fund

Key Differences Between 506(b) and 506(c)

When mulling over whether to apply for Rule 506(b) vs. Rule 506(c), here are a few distinctions to keep in mind.

While both exemptions allow for unlimited fundraising amounts, there are key differences in the following categories:

• How investors hear about the offering
• Who is allowed to participate
• How investor qualification is verified

Difference 1: Solicitation and Advertising

As we discussed briefly above, while Rule 506(b) prohibits general solicitation, Rule 506(c) allows for solicitation and advertising. 

This is where it’s important to know yourself as a fund manager. Do you have strong network connections and key relationships? You’ll likely do well without advertising under Rule 506(b). 

On the other hand, with allowances under Rule 506(c), fund managers who are newer to the industry or who may lack key relationships can still do a good job getting the word out about their fund with advertising, solicitation, and leveraging of online marketing opportunities. 

While both approaches will require fund managers to invest time and effort, Rule 506(b) mostly requires investing energy into getting face time with potential investors. 

Compare this with the potentially higher administrative burden of undertaking advertising and solicitation campaigns under 506(c).

Difference 2: Investor Eligibility and Verification Requirements

While Rule 506(b) allows both accredited and nonaccredited investors to participate as long as the number of nonaccredited investors does not exceed 35, Rule 506(c) only allows accredited investors. 

Notably, 506(c) also places the burden of verifying accreditation on the GP’s, who must take “reasonable steps” to authenticate investors’ accreditation. 

This difference in particular sets 506(c) apart. 

First, in order to meet this stipulation, fund managers and their teams will need to set up a streamlined verification system for potential investors. This step, naturally, leads to a longer and more labor-intensive onboarding process. 

When choosing between Rule 506(b) and Rule 506(c), fund managers must consider:

1. Their current network size. The size of your existing network will greatly sway whether you need to advertise your fund or whether you can rely on existing relationships to garner enough investors, making Rule 506(c) a great choice for emerging managers and Rule 506(b) the more likely option for previously established ones. 
2. Their unique administrative capabilities. Both Rules 506(b) and 506(c) carry distinct administrative hurdles. While the allowance for investor self-verification under Rule 506(b) partially lowers the workload on the administrative side, the inclusion of nonaccredited investors triggers the need for more robust disclosures, increasing administrative burdens in other ways. Likewise, under Rule 506(c), GP’s must take reasonable steps to verify accredited investors but would not need to invest in as high a level of disclosures. Both factors must be taken into consideration when assessing administrative capacity.  
3. Their need for flexibility. Whether you need to involve both accredited and nonaccredited investors in order to complete your offer makes a big difference.
4. What it takes to stay in compliance. Each exemption comes with its own level of regulatory scrutiny; however, Rule 506(c) is seen as carrying a slightly higher compliance burden. Some fund managers, however, find that given their current goals and chosen growth strategy, they’re more than up for the challenge.

Practical Considerations for Fund Managers

If you’re still on the fence regarding Rule 506(b) vs. Rule 506(c), here are a few practical considerations. 

One of the greatest strategic advantages of Rule 506(b) is your ability to seek private placements. Because 506(b) doesn't require the same level of disclosures and favors discretion, you can protect your company's strategies and operations from competitors.

This gives you the freedom to move quickly and quietly without showing your hand, all while attracting investors who prefer privacy and discretion when they invest. 

Additionally, with Rule 506(b), the ability to seek a mix of both accredited and nonaccredited investors grants the added advantage of speed, allowing you to complete your offerings more quickly. 

In cases where fund managers value speed and privacy, Rule 506(b) might be more advantageous.

However, speed and privacy aren’t the only values to consider.

Under Rule 506(c), funds can only deal with accredited investors, and while at first this could be viewed as a limit of sorts, it’s also a great advantage. Only dealing with accredited investors means a potentially more wealthy and financially stable investor base. 

Likewise, because Rule 506(c) allows for general solicitation, broad advertising adds a strategic advantage. 

With this approach, fund managers are no longer limited merely to investors in their existing networks. With advertising and marketing campaigns, they can reach new vistas of wealthy investors—and, as a bonus, potentially expand their current network of investors for the next time around. 

For fund managers seeking a wide audience of stable investors to raise large amounts of capital, Rule 506(c) might be the more suitable choice.

Pointing out that each rule comes with its own benefits, however, does not mean there aren’t potential risks inherent in each one.

Risks under Rule 506(b) may include:

• Limited investor reach, which could lead to difficulty completing offerings in a timely way
• Higher burden of maintaining investor privacy and relationships, which could prove burdensome in the long run

Risks under Rule 506(c) may include:

• More public scrutiny as a direct result of advertising 
• A loss of exclusivity surrounding investment and the potential impact of this dynamic on the historically relational nature of investing

Conclusion

In short, if you’re considering applying for an exemption under Reg D, it’s worth taking time to study the key differences between Rule 506(b) and 506(c) in private fundraising, including investor eligibility, marketing strategies, and compliance.

In the end, ending the debate between Rule 506(b) vs. 506(c) comes down to analyzing the goals for your next fund launch and choosing the rule that would best help you meet them.

To move with speed and privacy, consider Rule 506(b).

To attract a wide audience of stable investors, consider Rule 506(c).

Once you’ve narrowed your initial choice, take some time to weigh potential risks against rewards, carefully weighing your options to make your final decision.

If you’re interested in launching your own fund but are stuck on the Rule 506(b) vs. Rule 506(c) question, the good news is that you don’t have to wrestle through this alone. 

Now is the time to reach out to Fund Launch for personalized guidance and support. We have all the information you need to take your fund launch from Step 1 to final closing. 

Book a call with us today! We look forward to meeting you.

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_{DISCLAIMER: This content is for educational and informational purposes only. It is not to be taken as tax, financial, or legal advice. You should always consult a legal professional before taking action. Furthermore, this is not a recommendation to buy or sell any security. The content is solely just the opinion of the authors.}