Generally, Rule 506(c) provides the issuer of securities (a company) with an exemption from registering securities with the SEC if the issuer does two things. The first is only to sell the securities to accredited investors, and the second is to perform reasonable steps verification that the investor is accredited.
Performing Reasonable Steps
The biggest challenge to utilizing Rule 506(c) is to comply with the mandate to perform reasonable steps in verifying an investor as an accredited investor. There is a list of methods provided for in Rule 506(c), often referred to as “safe harbors.” By using one of these methods, an issuer of securities performs reasonable steps.
Potential Difficulties Performing Reasonable Steps
Many challenges can arise when attempting to perform reasonable steps to verify investors yourself. Proper diligence needs to be carried out to make sure the review of all necessary documents occurs. Also, the review must conclude the investors are accredited correctly. The legal counsel for the securities issuer would likely perform this work, which can be very expensive.
However, obstacles can arise in this process. The investor may resist the evaluation and not be willing to provide pertinent information such as a credit check to confirm liabilities or previous two years’ tax returns. In other cases, an owner’s net worth may be largely due to their ownership of a business. The value of that business may be challenging to determine with an appraisal, something which the investor may be unwilling to pay to invest in your opportunity.
When the investor is an entity, other issues can arise. Generally, an entity can be recognized as an accredited investor when:
- Its assets are greater than $5 million USD, and the entity was not created for the singular purpose of investing in the specific investment.
- All of the equity owners possess accredited investor status.
- Any entity not formed for the specific purpose of acquiring the securities offered, owning investments in excess of $5 million USD.
At this point, an issuer must do one of the following:
- Verify the entity possesses $5 million USD or more in assets with a representation confirming the entity was not created for the distinct purpose of investing in the issuer, or
- Adhere to the safe harbors (mentioned above) for every equity holder, or
- Verify the entity’s investments exceeds $5 million USD
Easier Verification Methods
There are a couple of alternative options available for issuers who are already busy entrepreneurs and need to verify the accredited investor status of prospective investors. The first option is to outsource reasonable steps verification to a third-party company specializing in performing this task. Another option is to have a prospective investor submit a letter from his or her attorney, accountant, or other relevant professional with the representation that the professional has conducted reasonable steps to verify the potential investor’s net worth or income and has determined the investor possesses accredited investor status.
