646.970.0610
August 31, 2022 | By Patrick T. McCloskey
The softening market for IPOs and SPACs may cause startups to explore a merger or acquisition during the lull to enhance their market position for an eventual exit.1 With interest rates rising and pre-money valuations plunging,2 the ability to use stock as deal consideration instead of cash can be a powerful strategic advantage.
Although not a capital raising transaction, an unregistered issuance of securities in an acquisition must still qualify for an exemption under the Securities Act of 1933, as amended (the “1933 Act”).3 Rule 506(b) is by far the most popular exemption relied upon by issuers in exempt transactions. According to the Securities and Exchange Commission (“SEC”), in 2018 issuers sold approximately $1.5 trillion of securities in reliance upon Rule 506(b), compared to $211 billion in reliance upon Rule 506(c).4 Despite its popularity, Rule 506(b) can be difficult to satisfy in the startup acquisition context (and Rule 506(c) impossible) because the equity holders of most startups typically include non-accredited investors.5
Although up to 35 non-accredited investors are permitted under Rule 506(b),6 all such “purchasers” (or their representatives) must be financially sophisticated within the meaning of Rule 506(b).7 Even if an acquiring issuer gets comfortable that the non-accredited target equity holders satisfy the sophistication requirement, the “sale” to even one non-accredited purchaser triggers an onerous disclosure requirement that can be prohibitively time-consuming and expensive.8 Rule 506(c) prohibits non-accredited investors altogether.9
Private companies exploring a startup acquisition should not overlook the significantly underutilized Rule 504.10 First, Rule 504 has no purchaser qualification requirement, meaning the target equity holders can be non-accredited and unsophisticated.11 Second, there are no specific disclosure requirements as a condition to the Rule 504 exemption,12 although, as with any securities offering, acquiring issuers can still have liability under Rule 10b-5 for deficient or misleading disclosures.13
The primary drawbacks to Rule 504 have historically been the 12-month dollar limit and the lack of state blue sky preemption.14 However, these challenges may now be surmountable in the acquisition context. It was not long ago that Rule 504 issuers were limited to selling $1 million every 12 months,15 but this cap was recently doubled from $5 million to $10 million as part of the SEC’s harmonization amendments that became effective in March 2021.16 With respect to blue sky preemption, non-accredited investors of a target tend to be employees or members of the management team, who may be residents of one or a few states. Depending upon the state(s) involved, blue sky compliance may be easier to navigate in a startup acquisition than it would be in a capital raising transaction.
As a reminder, Rule 504 is only available to private companies with an operating business.17 As with Rule 506(b), subject to limited exceptions,18 a general solicitation is prohibited.19
____
This post is for general informational purposes only and does not constitute legal advice. No one should rely on the information in this blog post without seeking appropriate legal, accounting, tax or other appropriate advice from an attorney, accountant or other professional properly licensed in the applicable jurisdiction(s).
1See
Analysis: IPOs Hit Skids; Has Market Reached SPACuration Point?, Preston Brewer, Bloomberg Law, April 7, 2022.
2See
Dreaded ‘down rounds’ shave billions off startup valuations, by Manya Saini, Reuters, August 9, 2022.
3See 17 CFR § 230.145 (Preliminary Note. “Rule 145 embodies the Commission’s determination that these transactions are subject to the registration requirements of the Act, and that the previously existing no-sale theory of Rule 133 is no longer consistent with the statutory provisions of the Act.”) See also 17 CFR 230.500(e) (“Regulation D may be used for business combinations that involve sales by virtue of Rule 145(a) or otherwise.”)
4See SEC Release No. 33-10649 at 19 (June 18, 2019).
5Startups frequently issue securities to compensate employees and consultants. Unless such individuals qualify as accredited under the net worth or income test (see 17 CFR §§ 230.501(a)(5) & (6)), they will most likely be non-accredited.
6See 17 CFR §§ 230.506(b)(2)(i) & 230.501(e)(1)(iv). The presence of a single non-accredited purchaser would render Rule 506(c) unavailable.
7See 17 17 CFR §§ 230.506(b)(2)(ii).
8See CFR § 230.502(b).
9See 17 CFR §230.506(c)(2)(i).
10Compared to the $1.5 trillion and $211 billion raised during 2018 under Rule 506(b) and 506(c), respectively, just $2 billion was raised under Rule 504 during that year. See Note 4, supra and accompanying text.
11See 17 CFR § 230.504(b).
12Id.
13See 17 CFR § 240.10b-5. See also 17 CFR § 230.500(a) (“Regulation D relates to transactions exempted from the registration requirements of section 5 of the Securities Act of 1933 . . . Such transactions are not exempt from the antifraud, civil liability, or other provisions of the federal securities laws.”)
14Because Rule 504 was promulgated by the SEC pursuant to its exemptive authority under Section 3(b)(1) of the 1933 Act (not as a safe harbor for the Section 4(a)(2) exemption), securities issued in a transaction exempt under Rule 504 are not “covered securities” under Section 18(b)(4)(F) of the 1933 Act and therefore do not preempt state registration. See 15 USC § 77r(b)(4)(F).
15See SEC Release No. 33-10238, at 1 (October 26, 2016) (“The amendments to Rule 504 will increase the aggregate amount of securities that may be offered and sold in any twelve-month period from $1 million to $5 million . . .”)
16See SEC Release No. 33-10884, at 139 (November 2, 2020) (“[W]e are amending the rules as proposed to raise the offering limit from $5 million to $10 million”).
17See Rule 504 is not available to (1) companies subject to the reporting requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934; (2) investment companies; or (3) development stage companies that either have no business plan or purpose or have indicated that their business plan or purpose is to engage in a merger or acquisition. See17 CFR § 230.504(a).
18A general solicitation is only permitted under Rule 504 if the offering is registered in a state requiring the use of a substantive disclosure document or sold only to accredited investors under a state exemption. See 17 CFR § 504(b)(1)(i)-(iii).
19 Rule 506(c) permits a general solicitation but, as mentioned above, every “purchaser” receiving securities must qualify as an accredited investor (and the issuer must take reasonable steps to verify such status).
