Raising capital as a private company is not easy. It takes time, money and a passion for the business you’re growing. But a new rule lifting the decades-long ban on general solicitation eases the path.
Long-standing securities laws have created constraints on the ability of private companies to publicly promote their capital-raising efforts. Until now.
After years of consideration and many delays, the Securities and Exchange Commission has enacted a new rule lifting the decades-long ban on general solicitation for private offerings. The new Rule 506(c) amends Regulation D of the Securities Act of 1933, which included an absolute ban on general solicitation.
Why does this matter to franchisors and franchisees? Because as of September 23, 2013, these businesses can use general solicitation, or advertising targeted to the public at large to offer securities to investors. While this creates a revolutionary method of fundraising, it’s essential to understand the requirements of the new rule before beginning.
Private companies can now market their 506(c) securities offerings across all kinds of media, such as television, magazines and the Internet. Rule 506(c) will make it easier for franchisors and franchisees to raise money, because they can seek interest from a much larger pool of investors—including their own customers. (That said, with the far-reaching nature of modern media, issuers must remember that investors solicited outside of the United States will require the issuer’s compliance with the investor’s home country’s securities laws.)
Franchise companies—both franchisors and franchisees—are uniquely poised to benefit from the new rule. But they should follow several steps when contemplating a private offering. When relying on Rule 506(c) to issue securities, issuers should prepare detailed disclosure materials, establish a defensible internal process to qualify investors, remain informed on rule changes and prepare a budget for a successful offering.
This sounds a great deal like preparing to franchise, doesn’t it?
When engaging in general solicitation permitted by Rule 506(c), issuers may sell securities to accredited investors only; investors must meet certain income or net worth requirements to be considered accredited. The issuer of the securities must take reasonable steps to verify the accredited status. Companies may no longer rely on investor representations in subscription documents, so having an investor simply check a box in a questionnaire is no longer sufficient.
Many franchisors and franchisees are well accustomed to complying with the "sophisticated" or "large" franchisee disclosure exemptions that various registration states offer. This will be an advantage when verifying accredited investor status, as large franchisee disclosure exemptions require similar diligence as the SEC’s accredited investor verifications.
For example, for investor income verification, franchise companies may rely on certain IRS forms reporting income along with a written representation that the investor has reasonable expectations of reaching the income level necessary to qualify as accredited during the current year.
As is the case with a sophisticated franchisee disclosure exemption, an issuer of securities may establish that an investor has sufficient net worth to qualify as accredited by requiring bank statements, brokerage statements, documentation of liabilities, and confirmation from the investor’s licensed professionals such as SEC-registered investment advisers or licensed attorneys.
Detailed documentation of the methods and records used to establish an investor’s accreditation is necessary. A broad-based solicitation medium like the Internet will require more time and expense for a company to document that each investor is accredited. Using a FINRA broker-dealer, who also must verify investor status, can be helpful to qualify investors. (FINRA is the largest independent securities regulator in the United States.)
Keep in mind, materials used by broker dealers in general solicitations must comply with all FINRA standards relating to disclosures and presentations of performance, and generally prohibit forecasts or related performance. In addition, the materials must be reviewed and approved by a principal of the business prior to use and maintained in its communications file for a period of three years.
The ‘bad actor’ clause
Not all companies will be able to the use the new rule to raise funds. The SEC has adopted a "bad actor" disqualification for Rule 506(c) offerings, if the company or key persons assisting the company have been convicted of, or sanctioned for, securities fraud or other violations of certain specified laws. This also applies to broker-dealers soliciting or marketing the offering as well as certain investors in the offering. Accordingly, companies should maintain documented background information on its key team members.
Franchise businesses exploring general solicitation should expect changes and fine-tuning of the rule. While the SEC did not adopt any rules governing the content and manner of advertising and solicitation for 506(c) offerings, it has proposed a rule that would require companies to include disclosures in the written general solicitation materials and require companies to submit their general solicitation materials to the SEC.
This is analogous to the disclosures that franchisors are required to include in franchise sales advertising. Companies must tell the truth, the whole truth and say it in a way people can understand in all communication with investors. Of course, including your attorneys and investment bankers from start to finish in your capital-raising process is a must.
Rule 506(c) presents franchisors and franchisees with an unprecedented opportunity to raise new capital. But even experienced stock issuers should prepare a comprehensive strategy for a general solicitation raise with input from trusted advisers.
Roger Quinland is a partner in the franchise law practice group of Gordon & Rees. Reach him at [email protected]. Nancy Cass is co-founder of MerchantCass Advisors, an investment banking and global business advisory firm, and she acknowledges the assistance of Camilla Merrick of Shefsky & Froelich in preparing this article. Reach her at [email protected].
