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Accredited Vs. Non-accredited Investors: Avoiding The Pitfalls

When seeking investors, entrepreneurs and business owners may be approached by individuals, including friends and family, who do not qualify as “accredited investors” under securities laws. Depending on where a business is in its lifecycle, accepting funds from these types of individuals may range from appealing to essential, or a business owner may simply desire to include them in the investment opportunity. However, CEOs and business owners should understand that accepting investments from non-accredited investors is often impractical for a few reasons. We explain the basics below.

Background

Any offering or sale of securities (e.g., shares of stock or LLC membership interests) in the United States is subject to the requirements of the Securities Act of 1933. Under the Securities Act, the offering must be registered with the SEC unless it qualifies for an exemption from registration. A registration statement is impractical for most private companies due to the onerousness of the required disclosure documentation and the associated expenses. Therefore, most companies typically rely on Rule 506 of Regulation D (Reg D) of the Securities Act, which provides the most commonly used exemptions to registration. However, Rule 506 provides for heightened disclosure requirements, similar to what is required in a public offering, if you sell securities to non-accredited investors.

What is an Accredited Investor?

Accredited investors are generally high-net worth individuals or institutions. Accredited investors are normally good for businesses raising capital because they typically have experience making investments in the past, have the financial means to make the investment, and are less likely to raise as many issues or concerns as less experienced or less financially sophisticated investors might.

Under Rule 501 of Regulation D of the Securities Act, an accredited investor is:

  • an individual with a net worth of at least $1 million, not including the value of his or her primary residence;
  • an individual with income exceeding $200,000 in each of the two most recent calendar years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year;
  • certain qualifying trusts, banks, insurance companies, registered investment companies, business development companies, small business investment companies, employee benefit plans, and tax exempt entities;
  • a director, executive officer, or general partner of the company selling the securities; or
  • an enterprise in which all the equity owners are accredited investors.

On August 26, 2020, the SEC adopted amendments that expand the definition of “accredited investor”. These changes will take effect 60 days following publication in the Federal Register. Once the amendments are implemented, accredited investors will include:

  • Couples meeting the requirements of “spousal equivalents”, who will be permitted to pool their assets for purposes of satisfying the accredited investor joint income or joint net worth thresholds.
  • Individuals holding professional certifications, designations, or other credentials, as designated by the SEC by written order. The SEC has so far designated holders in good standing of Series 7, Series 65, and Series 82 licenses as qualifying individuals.
  • Individuals who meet the definition of a “knowledgeable employee” (as defined in the Investment Advisers Act) of a private investment fund, such as a private equity or venture fund, with respect to investments in that fund.
  • SEC- and state-registered investment advisers, exempt reporting advisers, and rural business investment companies.
  • Indian tribes, governmental bodies, funds, and entities organized under the laws of foreign countries, that own “investments” (as defined in the Investment Company Act) in excess of $5 million and that were not formed for the specific purpose of investing in the offered securities.
  • Any “family office” with at least $5 million in assets under management and its “family clients” (as those terms are defined in the Investment Advisers Act).

The Challenges Presented by Non-accredited Investors

Private companies, in particular startups and other early-stage companies with cash flow constraints, benefit from being able to raise money in reliance on an exemption under the Securities Act in order to avoid the burden and expense of registering the offering with the SEC and state securities commissions. However, companies selling securities in an offering that includes non-accredited investors must, in order to comply with SEC regulations, provide those investors essentially the same information that would be required under Regulation A or registered offerings, which means the requirement that comprehensive disclosure and offering materials must be provided to investors that includes extensive financial and other company information (similar to what would be required for an IPO to be registered with the SEC). So, while opening up investments to non-accredited investors such as family and close friends can seem like a good idea to entrepreneurs looking to bolster their early-stage companies’ capital resources, the time, effort, and expense involved in complying with SEC requirements can be cost-prohibitive and, simply, not worth it. 

A Note on Crowdfunding

Since May 16, 2016, the SEC has permitted companies to offer and sell securities through certain crowdfunding platforms under Regulation Crowdfunding. Although accredited investor status is not required, certain requirements must be met to qualify for the crowdfunding exemption, including investment limits based on investor net income and net worth and filing Form C with the SEC (as well as continuing annual reporting requirements). While the costs of meeting these requirements may steer some startups and early-stage companies away from the crowdfunding exemption, it can be an attractive option for companies seeking to raise smaller amounts from alternative or broader-reaching financing sources, including non-accredited investors.

Contact Us

Linden Law Partners understands the challenges entrepreneurs experience when attempting to raise capital. The legal representation we provide to businesses is thorough and focused; through it all, however, we never lose sight of the ultimate goal, which is to put your company in the best position to succeed and provide you with the advice, strategy and approach to do so. Contact us here or call us at 303-731-0007.

© 2020 Linden Law Partners, LLC. All rights reserved.

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Linden Law Partners

Linden Law Partners is a boutique law firm that represents clients throughout their business life cycles, from formation to exit. We are business and transactional law specialists with extensive experience in all aspects of corporate law and governance, partnerships, joint ventures, emerging companies, private equity and venture capital, private and public securities offerings, and mergers and acquisitions. We offer clients big firm experience at a better price.

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