VC Funds and Regulation D's Rule 506(c): Challenges and Opportunities for Small Issuers

Introduction
Raising capital as a small issuer or fund manager is often daunting, especially for those without access to established networks or significant resources. The introduction of Rule 506(c) under Regulation D aimed to democratize fundraising by permitting general solicitation and providing emerging managers and underrepresented groups with new pathways to secure investment. However, recent research highlights that the rule remains underutilized and faces barriers that hinder its effectiveness. For small issuers and fund managers navigating these challenges, understanding the limitations and potential reforms of 506(c) is essential to maximizing its benefits.

Summary of the Report

On November 13, 2024, Dr. Sabrina Howell, Professor of Finance at New York University's Stern School of Business, and Dean Parker, a doctoral student at Stern, presented their report titled: VC Funds and Regulation D's Rule 506(c): Did Permitting General Solicitation Open the Door for Emerging and Underrepresented Managers? (“Report”) to the SEC's Small Business Capital Formation Advisory Committee.

The Report focused on the challenge faced by securities regulation: enabling broad and inclusive capital formation while safeguarding investors. It reflects on the impact and limitations of Rule 506(c) under Regulation D, which permits general solicitation.

In their study, they found that, despite its intent to democratize fundraising, Rule 506(c) remains underutilized, accounting for only a small fraction of venture capital (“VC”) fundraising activity. While it is disproportionately employed by underrepresented fund managers, such as women, minorities, and first-time managers, its overall adoption has been limited. Several factors contribute to this outcome, highlighting the challenges and mechanisms that impede its broader use.

A key challenge identified is the 'track record paradox.' General solicitation under 506(c) offers an alternative for those lacking strong personal networks, but it requires a solid track record to mitigate information asymmetry. This creates a paradox, as building a strong track record often depends on access to the very networks that 506(c) aims to bypass. Additionally, regulatory barriers limit the usability of 506(c), particularly for new or smaller-scale managers. These barriers include investor caps for small funds and complex compliance requirements. Another significant hurdle is the burden of verifying investor accreditation under 506(c). This process involves additional costs, legal liability concerns, and potential negative signaling that can deter managers from using the exemption.

The Report suggested that to improve the accessibility and effectiveness of 506(c), the SEC could implement targeted changes to alleviate these barriers. Simplifying investor verification requirements and allowing fund managers greater flexibility to switch between 506(b) and 506(c) exemptions could make the rule more practical. Furthermore, shifting some compliance responsibilities to investors could reduce the deterrence experienced by managers. While these regulations aim to protect investors, the current framework may overly prioritize this objective at the expense of enabling broader participation, particularly from emerging and underrepresented fund managers. Addressing these challenges, the SEC could enhance the rule's effectiveness, fostering greater inclusivity and innovation in venture capital fundraising.

Conclusion
For small issuers and fund managers, particularly those from underrepresented groups, the challenges of navigating Rule 506(c) highlight a critical gap in the regulatory framework. As suggested in the report, the SEC's willingness to consider reforms could transform 506(c) into a more effective tool for broadening participation in venture capital fundraising. In the meantime, fund managers must weigh the costs and benefits of using 506(c) while exploring strategies to address its limitations.

At FinTech Law, we are committed to helping small issuers and fund managers navigate these complexities and capitalize on opportunities within the regulatory framework. Whether you're exploring your first offering or looking to optimize your fundraising strategy, our team guides you every step of the way.