Any round of startup financing must begin with determining the pool of potential investors. In early-stage financings, whether a company can only include individuals considered “accredited investors” under Securities Exchange Commission (SEC) regulations is a common issue.
Exempting your financing transactions from SEC registration.
Under federal securities laws, a company seeking to sell or offer to sell securities must either register the transaction with the SEC or find an applicable exemption. Given the heavy disclosure burdens and costs of registering securities (think IPO), exempt transactions are the most efficient way to raise money for an early-stage company.
Several key federal exemptions available to startups require that the company offer securities only to individuals who are accredited investors. So, prior to completing a financing round, a company must identify whether each of its potential investors is an accredited investor. This determination will significantly impact the costs and disclosure obligations associated with the transaction and may influence who the company decides to accept as investors.
An accredited investor is an individual who meets certain net worth or personal income thresholds under Rule 501 of Regulation D. According to the SEC, the primary reason for the accredited investor designation is to “identify persons who can bear the economic risk of investing in these unregistered securities.”
An accredited investor includes anyone in any one of the following categories:
- Earned income exceeding US$200,000, or US$300,000 together with their spouse or spousal equivalent, in each of the prior two years, and reasonably expects the same for the current year
- Has a net worth over US$1 million, individually or together with a spouse or spousal equivalent, excluding the value of the person’s primary residence[1]
- Is a director, executive officer or general partner of the issuer of the securities
- Holds in good standing one or more professional certifications or designations or credentials from an accredited educational institution that the SEC has designated as qualifying for accredited investor status
- Is a “knowledgeable employee” as defined in rule 3c-5(a)(4) of the Investment Company Act of 1940, of the issuer of the securities being offered or sold where the issuer would be an investment company, as defined in section 3 of such act, but for the exclusion provided by either section 3(c)(1) or section 3(c)(7) of such act
Entities and certain family offices (and their family clients) are also considered accredited investors if they hold in excess of US$5 million in assets and are not formed for the specific purpose of acquiring the securities being offered, or if the entity’s equity owners are all accredited investors. In addition, certain banks, insurance companies, trusts, SEC or state registered investment advisers, exempt reporting investment advisers and rural business investment companies are considered accredited investors under existing regulations.
[1] For more information on how to calculate net worth, visit the SEC website at https://www.investor.gov/news-alerts/investor-bulletins/investor-bulletin-accredited-investors.
Rule 506 of Regulation D is the most commonly used federal exemption for startup financings, and many of its benefits hinge upon fundraising only from accredited investors. First and foremost, exclusive use of accredited investors reduces the amount of information companies must provide to investors. Rule 506 offerings remain subject to anti-fraud rules, such that the company must neither issue any untrue statement nor omit any material fact that would render the offering misleading. Nevertheless, the total amount of information companies must provide to investors is far less than a registered offering or comparable Rule 506 offering containing a non-accredited investor, resulting in significant time and cost-savings for the company.
Rule 506(c) provides another important advantage, permitting general solicitation, so long as all investors are accredited investors and the company takes reasonable steps to verify the purchasers’ status as accredited investors. This general solicitation allows a startup to market its securities to a broader audience of potential investors than the company otherwise could reach if it chose to include non-accredited investors in the offering.
Although the Regulation D exemptions allow a limited number of non-accredited investors to participate, the company must provide additional “disclosure documents that are generally the same as those used in registered offerings”[1] (except as noted below). Such disclosure can be time-consuming and expensive to prepare, effectively eliminating any time and cost-savings associated with the Reg D exemption. In addition, Rule 506 also imposes a financial sophistication requirement for any non-accredited investor. The rule states that any non-accredited investor must have “knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment, or the issuer reasonably believes immediately prior to making any sale that such purchaser comes within this description.” Evaluating an individual’s relative financial sophistication can be subjective, and often not worth potentially violating securities laws.
My cousin raised a round and allowed some investors who were not accredited, which he thought was no big deal.
Rule 504 does provide an ability to raise funds from non-accredited investors without disclosing the same level of information as in a registered offering. However, these offerings are limited to an aggregate of US$1 million over the course of a 12-month period, and more importantly, state “blue sky” laws are not preempted in these small offerings. Blue sky laws are different in every state, and may not allow the offering to move forward even if there is a valid federal exemption. Given these issues, avoiding non-accredited investors in a typical financing round relying on Regulation D exemptions is generally advisable.
Ultimately for most startups, the increased compliance costs and complexity associated with adding non-accredited investors outweighs the value of the funds those investors may provide.
