The Power of Networking in Fundraising: Rule 506(b) Private Placements
So, you have built this amazing product that fits into your target market and has a high potential for scalability. But you also used up all of your initial capital in creating this highly scalable product. Now you need additional funding to achieve the scaling goals. While funding likely is always on the mind of the entrepreneur, the stage of scaling up the start-up is a time when it becomes the main focus for many. Depending on the fundraising strategy, this may be too late to begin taking active steps to achieve funding in a manner that is most effective for your company.
Whenever a company seeks funding through outside investors, it is making an offering of a security in its company. This action requires compliance with federal and state law, most notably, the SEC’s regulations for registration of that offering. The Securities Act of 1933 requires any offering of a security to be registered in accord with the procedures laid out in the statute unless an exemption to registration applies. Okay, so you have to register, no big deal right? WRONG. Registering is extremely expensive, time-consuming, and then makes any information disclosed on the registration public. The costs of having to register alone could be enough to prevent some entrepreneurs to move forward, but also knowing that many of the company’s secrets, including future plans, will be made public, makes it crucial for some to avoid.
A key exemption to the registration requirement is Rule 506(b) Private Placement, which allows for an entrepreneur to offer investment opportunities to certain investors without having to register with the SEC. While your lawyer should help you with the specifics of meeting the requirements of Rule 506(b), there is something you must do as an entrepreneur if you wish to take full advantage of Rule 506(b). Fortunately, it is not something extra beyond what the business world already requires of any successful businessperson. You must network with the investors in your community to establish pre-existing substantive relationships with those investors.
Private Placements exempts from registration any offering of a security made to a possible qualifying investor with whom the offeror (entrepreneur in this case) or the offeror’s agent (typically the business’ lawyer) has an established pre-existing substantive relationship. A relationship is pre-existing if it is formed prior to any offering, and a relationship is substantive if the offeror can judge whether the investor is financially literate enough to understand the risks of investing in private placements. Because this relationship must be formed prior to any offering, waiting until you are ready to start looking for investors is too late.
Networking prior to the stage of looking for outside investors allows the entrepreneur to grow his or her circle of prospective investors. While this task may seem impossible or even easier said than done, Kentucky’s entrepreneur and business ecosystem is constantly described by entrepreneurs as accessible and easily maneuverable. People in this community generally want to see other people in the community succeed and generally are willing to provide a helping hand to those looking to do so. The benefit is not found in every entrepreneur ecosystem and is in fact one of the biggest strengths of Kentucky’s business ecosystem. Because of that, any entrepreneur in this ecosystem should utilize it and utilize it early.
Not only will networking with the community in which you are hoping to find success help you qualify for SEC registration exemptions during the fundraising stage of your business, but it will help you grow in general. In meeting these qualified investors, you will have the opportunity to learn from them, whether that is specific to your product or industry or just in general about doing business in Kentucky’s business ecosystem. Without making offerings to invest, you can talk about achieving product-market fit within an industry, business strategies, past examples of success, and so much more.
Personally, I always thought the saying “your network is your net worth” was a little cliché or even silly, but after becoming more familiar with Rule 506(b) Private Placements, I see that statement is extremely true. While having these pre-existing substantive relationships with qualifying investors is no guarantee for receiving investment funds, it sure does help to have the opportunity to have more qualified people to make the offering to. Further, having those acquaintances that have found success before can provide an opportunity for learning and growth as an entrepreneur.