A growing number of startups in the cannabis space are engaging brokers and online platforms to assist in their fundraising. This makes sense: as we’ve written previously, most investors (particularly institutional capital) are staying on the sidelines and taking a wait-and-see approach to the cannabis industry. Thus, cannabis startups will always target a smaller, more dispersed, more specialized investor base, and going through experts is a logical way to reach them. Note that 506(c) is one of the relatively new options for company financing, implemented as part of the JOBS Act of 2012. It allows for companies to engage in a more public “general solicitation”—but with strings attached, as we’ll detail below.
From a securities law perspective, the engagement of a broker-dealer or online platform converts the offering exemption from the ever-popular 506(b) offering to a 506(c) offering – changing this one letter has a number of significant consequences:
1 – You must ensure that the broker-dealer is registered, or else.
Section 3(a)(4)(A) of the Securities Act generally defines a “broker” broadly as “any person engaged in the business of effecting transactions in securities for the account of others.” This broad definition includes any “finder,” “fundraising consultant,” or anyone else receiving any transaction-based bonus or commission in return for introducing or engaging an investor. You should always consult your securities counsel when a third party is assisting the company on fundraising. Once it is established whether broker-dealer registration is required, FINRA provides an online Broker-Dealer Check. The penalties for using an unregistered broker-dealer are extremely harsh, so it’s always wise to err on the side of caution.
2 – You are limited to accredited investors, and you must take additional steps to confirm an investor’s accredited status.
In a 506(b) offering companies have the flexibility to raise from an unlimited number of accredited investors, as well as up to 35 unaccredited investors. Only around 2% of the US population would meet the accredited investor conditions (in short: at least $1 million of assets not including one’s home, or a recurring annual income of at least $200,000 (or $300,000 if married)). The loss of the unaccredited investor option may eliminate some of the classic “friends and family” seed investors, that write smaller—but often critical—checks to keep the company afloat in the early going.
Further, raising under 506(c) puts a higher burden on the company to complete its own diligence to confirm an investor’s accredited status. Under 506(b) you can essentially take the investor’s word for it. The SEC has laid out the types of records one would examine under a “principles-based verification method” and they include the investor’s bank statements, brokerage statements and records of securities holdings, tax returns and tax assessments or appraisal reports prepared by third-parties. Looking at these records may not seem like such a big deal, but the hurdle of developing this method and implementing for each investor can be a significant undertaking for startup company.
3 – You can engage in a general solicitation under 506(c), but with greater visibility comes…greater visibility.
The advantage of expanding your potential investor base beyond those with whom you have a “substantial pre-existing relationship” (which is required under 506(b)) may seem to open a world of possibilities. But putting your company out in the open may have drawbacks: any proprietary info in your investor materials will get passed around, you may pick up shareholders that cause you problems down the line, you may attract attention from the not-in-my-backyard types, and some investors prefer their cannabis investments to keep a lower profile.
Finally, it bears repeating: seek an experienced corporate and securities attorney. With these choices you need principled and consistent counsel, because there is a final consideration: once you’ve engaged a broker-dealer or otherwise engaged in a general solicitation, you are committed for the entirety of your financing round. Any unaccredited “friends and family” are out—they can’t write checks under any circumstances—and you cannot revert to the more relaxed requirements of 506(b).