Comparing 506b vs 506c for Private Fundraising

Navigating the complexities of raising capital as a founder requires understanding legal frameworks like Regulation D of the Securities Act of 1933. This regulation includes Rule 506(b) and Rule 506(c), two essential pathways for startups to raise capital without the need to register securities with the Securities and Exchange Commission (SEC).

As a founder, choosing between Rule 506(b) vs 506(c) can significantly impact your capital raising strategy in the United States. Both rules offer exemption from securities regulations for private placements of securities. However, each rule comes with its own set of requirements and restrictions that can significantly affect your fundraising process.

This blog covers the key differences between Rule 506(b) vs 506(c) to help you make informed decisions about structuring your offerings and approaching potential investors. Let’s get started.

What is Regulation D?

Regulation D is a set of rules established by the SEC that provides exemptions from the registration requirements of the Securities Act of 1933. Its primary purpose is to facilitate capital formation for smaller companies by simplifying offerings of securities through private placements. 

Within Regulation D, Rule 506 is vital for startups. It provides a safe harbor for private placement exemptions under Section 4(a)(2) of the Securities Act. This means that if you comply with the requirements of Rule 506, your offering will be deemed to comply with Section 4(a)(2). 

Rule 506 is further divided into two subcategories, 506(b) and 506(c), which outline distinct pathways for conducting private securities offerings. General requirements that apply to both 506(b) and 506(c) offerings include:

• Form D filing: You must file a Form D with the SEC within 15 days of the first sale of securities.
• Restricted securities: Securities sold under Rule 506 are restricted. This means they cannot be resold without registration or an applicable exemption.
• Bad actor disqualification: Companies are ineligible to use Rule 506 if they or certain related parties have experienced disqualifying events, such as certain criminal convictions or SEC disciplinary orders.
• Integration: The SEC has rules about integrating separate offerings, which can affect how you structure your fundraising rounds.
• State law compliance: While Rule 506 offerings are exempt from state registration requirements, you may still need to comply with state notice filing requirements and pay filing fees.

Overview of Rule 506(b)

Rule 506(b) under Reg D is a popular choice for private securities offerings, especially for startups that rely on relationship-based fundraising. One of its defining features is the prohibition on the use of general solicitation, meaning you cannot advertise or publicly promote your offering. This requires you to rely on a pre-existing substantive relationship with potential investors or work through trusted networks.

This rule allows you to accept investments from an unlimited number of accredited investors and up to 35 non-accredited investors. Accredited investors can self-certify their accreditation status, reducing your business's administrative burden.

For non-accredited investors, you must determine that they have sufficient knowledge and experience in financial and business matters to evaluate the risks and merits of the investment. This evaluation is crucial for compliance with SEC rules.

Advantages and Limitations of 506(b)

Let’s have a look at the benefits and challenges associated with 506(b):

Advantages

• Flexibility in investor relations: This rule allows you to develop deeper relationships with a select group of investors. This leads to engaged stakeholders who also provide valuable industry insights and connections.
• Lower regulatory scrutiny: Since 506(b) offerings are not publicly advertised, they typically attract less regulatory attention compared to 506(c) offerings. This can mean fewer compliance requirements for your startup.
• Privacy friendly: If you are working on a disruptive technology or business model, 506(b) allows you to raise funds without alerting competitors through public advertisements.

Limitations

• Network dependency: Your fundraising success heavily relies on the strength and reach of your existing network. This can be challenging for first-time founders or those outside major startup hubs.
• Potential for miscommunication: The prohibition on general solicitation practices means you must be extremely careful in how you discuss your fundraising efforts. Even casual mentions at public events or on social media could be seen as non-compliant.
• Future fundraising complications: If you include non-accredited investors in a 506(b) round, it may complicate future rounds, especially if you are looking to transition to 506(c) or consider a public offering down the line.

Overview of Rule 506(c)

Rule 506(c) under Regulation D allows startups to raise capital through general solicitation and advertising, a significant shift from the restrictions of 506(b). This rule will enable you to publicly promote your offering, making it possible to reach a broader pool of potential investors, provided they meet specific accreditation standards. 

To comply with Rule 506(c), every investor must have an accredited investor status. You are required to take reasonable steps to verify the accredited status of these investors, which goes beyond the self-certification allowed in 506(b) offerings. Unlike 506(b), this rule excludes non-accredited investors entirely, streamlining the process for engaging with high-net-worth individuals and institutional investors.

How can 506(c) investors verify LP accreditation?

The SEC provides several methods for verifying Limited Partner (LP) accreditation under 506(c):

• Income verification: Review tax returns and W-2s for the past two years. Individuals must prove they registered an annual income of $200,000 ($300,000 jointly with a spouse) for the past two years. They must also provide a written statement of expected income for the current year.
• Net worth verification: Examine financial documents like bank statements, brokerage statements, and credit reports dated within the past three months. They must provide evidence of assets exceeding $1 million, excluding their primary residence.
• Third-party verification: Obtain written confirmation from a registered broker-dealer, SEC-registered investment advisor, licensed attorney, or CPA who has verified the investor’s accredited status within the past three months.

Thorough documentation of the verification process is crucial, as, according to SEC guidelines, you bear the burden of proof.

Advantages and limitations of 506(c)

Let’s have a look at the benefits and risks associated with 506(c):

• Global investor access: With the increasing digitalization of finance, 506(c) offerings allow startups to tap into a global pool of accredited investors. This borderless approach can lead to more diverse funding sources and potentially higher valuations.
• Integration with emerging technologies: The ability to solicit generally opens doors for innovative fundraising methods. Startups can leverage blockchain technology for transparent cap table management or use AI-powered platforms to match with suitable investors, which can help enhance the fundraising process's efficiency.
• Synergy with secondary markets: As secondary markets for private company shares continue to evolve, 506(c) offerings can provide a foundation for future liquidity options. This can make your startup more attractive to investors looking for potential exit strategies before an IPO.

Challenges

• Cybersecurity and data privacy concerns: As 506(c) offerings are public, startups must invest heavily in robust cybersecurity measures to protect sensitive investor information during the verification process. This can be particularly challenging as data privacy regulations become more stringent globally.
• Regulatory adaptation: As financial regulations evolve to keep pace with technological advancements, startups must stay agile. Continuous monitoring and adaptation to regulatory changes can be resource-intensive, especially for early-stage companies.
• Valuation scrutiny: Public solicitation can invite increased scrutiny of your startup's valuation. In an era of data-driven decision-making, you must be prepared to justify your valuation with reliable metrics and projections. This can be challenging for early-stage companies with limited operating history.

Key differences between 506(b) and 506(c)

Here are the key differences between Rule 506(b) vs Rule 506(c):

Solicitation and advertising

Rule 506(b) maintains a traditional approach, prohibiting general solicitation and advertising of your offering. This means you rely on existing networks and relationships to find potential investors. You might leverage private meetings, invite-only events, or personal introductions to connect with prospective backers.

In contrast, Rule 506(c) opens up new avenues for investor outreach. You can advertise your offering publicly, use social media campaigns, or even present at pitch events. This broader reach is beneficial for startups in niche industries or those looking to tap into a wider investor pool.

Investor requirements

Rule 506(b) offers flexibility in your investor base. You can include up to 35 non-accredited investors, provided they are sophisticated enough to evaluate the investment opportunity. This can be beneficial if you have knowledgeable individuals in your network who do not meet the accredited investor criteria but could still bring value to your startup.

Rule 506(c), on the other hand, restricts your investor pool to accredited investors only. While this might seem limiting, it can streamline your fundraising process. Along with capital, accredited investors also offer industry expertise, valuable connections, and a higher tolerance for risk.

Verification processes

The investor verification process marks a significant difference between the two rules. Under 506(b), you can rely on investor self-certification. Essentially, investors can declare their accredited status without providing extensive documentation.

506(c) takes a more stringent approach. You must take reasonable steps to verify each investor’s accredited status. This could involve reviewing financial statements, getting third-party verifications, or using other SEC-approved methods.

Disclosure Requirements

For 506(b) offerings involving non-accredited investors, you need to provide extensive disclosures similar to those in a registered offering. This includes detailed financial statements, risk factors, and information about your business and management team. The level of detail required can be substantial, potentially increasing your preparation time and costs.

506(c) offerings, limited to accredited investors, generally have more relaxed disclosure requirements. While you still need to provide sufficient information for investors to make an informed decision, the exact content and format are more flexible. This can allow for a more streamlined offering process, potentially reducing your legal and administrative costs.

Irrespective of which exemption you choose between 506(b) vs 506(c), you are still bound by anti-fraud provisions. This means all information provided must be accurate and not misleading.

When to choose 506(b) vs 506(c)?

Selecting the proper exemption between 506(b) vs 506(c) depends on several factors unique to your startup's fundraising goals and circumstances.

• Target audience: If your ideal investor pool includes a significant number of non-accredited investors, Rule 506(b) might be a more suitable option. However, if you primarily seek to attract accredited investors, 506(c) could be more advantageous.
• Advertising needs: If you believe that actively marketing your offering through broader channels is crucial for attracting investors, Rule 506(c) offers the flexibility to do so. However, this requires meticulous investor verification procedures.   
• Compliance capacity: 506(c) generally requires more robust compliance procedures, including thorough investor verification and potentially more stringent record-keeping. If you have the resources and expertise to manage these requirements, 506(c) could be a viable option.   
• Fundraising goals: Consider the amount of capital you aim to raise and the timeline for your fundraising efforts. 506(c) can potentially accelerate the fundraising process due to the ability to reach a wider audience.

While choosing, you must also consider how your choice might impact future fundraising, as switching between exemptions in subsequent rounds requires careful planning.

The future of Rule 506

The regulatory landscape surrounding Rule 506 is constantly evolving. The SEC has recently expanded the definition of accredited investors to include individuals with specific professional certifications, such as registered architects and certified public accountants. This could broaden the pool of eligible investors for both 506(b) and 506(c) offerings.   

The SEC may implement stricter filing requirements and harsher penalties for non-compliance. For instance, there have been discussions about imposing a one-year ban on using Regulation D exemptions for issuers that violate the rules. Given the increased scrutiny and verification requirements, these potential changes might make some General Partners hesitant about using 506(c).

Compliance checklist for 506(b) and 506(c) offerings

Navigating the complexities of Rule 506 offerings can be challenging. This compliance checklist serves as the roadmap to ensure you are meeting all requirements for your 506(b) or 506(c) offering. 

This checklist helps you stay on track by outlining critical steps, from filing Form D and verifying investor accreditation to ensuring proper disclosures and record-keeping. By following this resource, you can streamline the fundraising process and minimize legal risks. 

Download Link: 506(b) and 506(c) Compliance Checklist (2025 Edition)

Conclusion

Understanding the differences between 506(b) vs 506(c) is crucial for your startup's fundraising success. The final choice depends on your goals, investor network, and willingness to undertake additional verification processes. 

At Qapita, we simplify this complex journey with our comprehensive equity management solutions. Our equity management platform, rated as #1 by G2, is trusted by over 2,000 companies. We offer a suite of tools designed to streamline your equity management from inception to IPO. 

Our CapTable Management system helps you track ownership, run scenarios, and effortlessly engage stakeholders. We also provide expert advisory and consulting services to guide you through the intricacies of compliance with Rule 506. Our team can help you structure your offerings to align with SEC regulations, whether you are opting for the traditional 506(b) route or exploring the general solicitation allowed under 506(c).

With ISO 27001 and SOC2 certifications, we ensure the highest level of data security for your sensitive financial information. Book a 1:1 demo today and learn more about our solutions.