Revised Rule 504: Another Tool in the Toolkit to Raise Capital

If there is one common theme that entrepreneurs tend to have, it is fire – meaning, many entrepreneurs are passionate about an exciting idea that they seek to turn into a business. However, entrepreneurs often quickly realize that, in order to make their fire glow high and bright for the world to see, they need fuel – meaning, capital. While bootstrapping is a smart practice that can keep the embers burning for a period of time, even fantastic ideas will likely sooner or later need a major capital injection – thereby adding fuel to the fire – to take the venture to the next level. This is where the newly revised Rule 504 of Regulation D may be a good option for early stage companies. For qualifying companies, Rule 504 provides an exemption from the registration requirements of the Securities Act of 1933, thereby facilitating the ability of start-ups to raise capital. Often well-suited for friends and family or seed rounds of funding, Rule 504 provides flexibility to smaller companies seeking assistance with capital formation.

The Rule and the Changes

On October 26, 2016, the SEC adopted final rules that amend Rule 504, thereby increasing the maximum offering amount permitted to be raised from $1 million to $5 million, which will be effective as of 60 days following publication in the Federal Register. The SEC noted in the adopting release that Rule 504 had been underutilized due to the previous low offering amount limitation. The main benefit of this new increase is that more small businesses will be able to rely on Rule 504, as it will now be in the consideration set for certain companies seeking funding of up to $5 million. Entrepreneurs may then find themselves asking: Is our company eligible for exemption under Rule 504, and does Rule 504 make sense for us?

The Fine Print

In order to be eligible for Rule 504, a company must not yet be required to file reports under the Securities Exchange Act of 1934, and must not be a “blank check company,” meaning that most early-stage companies with a plan for an operating business are eligible. What is unique about Rule 504 is that it provides (i) significant freedom in how one goes about raising the capital, and (ii) permits resales of shares with less friction. Offerings under Rule 504 permit, under certain circumstances, general advertising and solicitation; and, further, the requirement that the securities be restricted from subsequent resale will not apply to offers and sales of securities when following certain requirements.

Is Rule 504 the Right Choice?

While potentially a new tool to raise capital, Rule 504 should be evaluated in comparison to other options for exemption. Over the last decade, the use of Rule 504 offerings had been in decline, both in absolute terms and relative to Rule 506 of Regulation D. Rule 506 provides two potential exemptions from registration. First, Rule 506(b) has no limit on the amount of money that may be raised or the number of accredited investors that may be purchasers, though general solicitation or advertising may not be used and a company may not sell securities to more than 35 non-accredited investors, among other requirements. Second, under Rule 506(c), the SEC eliminated the prohibition against general advertising, provided that all purchasers are accredited investors and the issuer takes reasonable steps to verify so, among other requirements.

What Does It Mean for You, and How Can We Help?

The increase in the maximum amount that may be offered and sold under Rule 504 allows for more companies potentially to leverage Rule 504 for their capital raising needs. In light of this recent development, Rule 504 may be a good choice for many early stage companies. It is another tool in the toolkit to consider when raising capital. Please consult with your legal advisor at Mintz Levin to discuss if Rule 504 makes sense for your next capital raising event.

Subscribe To Viewpoints