In the early stages of your startup, as you raise funds, you need to understand what an accredited investor is. Most important is the line between “accredited investor” and “everyone else.”
Raising funds from non accredited investors can be expensive, thanks to disclosure requirements. And it can create new administrative caseloads as you deal with many small investors.
Accredited investors, on the other hand, can be the lifeblood of your early funding rounds. Here’s what you need to know about accredited investors, and what they mean for your startup.
What is an accredited investor?
According to the SEC, an accredited investor is an entity “sophisticated” enough to make potentially high-risk investment choices—such as investing in a company still in its earliest stages of fundraising.
“Sophisticated” in this case translates to “wealthy.” An accredited investor must achieve certain minimums in terms of net worth and regular income.
How do you become an accredited investor?
There is no process for becoming an accredited investor; you don’t have to apply for a special certificate, or pass any tests.
If you’re raising money from accredited investors, it’s your job to perform due diligence, and ensure they’re accredited.
Why should I care about accredited investors?
Public registration of securities isn’t feasible for most early-stage companies. So startups choose exemptions that allow them to issue shares without registering. Shares in private companies are typically unregistered securities. These shares can only be sold by the issuer to investors and others by making use of exemptions that allow them to be sold legally.
Every state has different exemption rules, but the US Securities and Exchange Commission (SEC) lets you override them all by meeting SEC requirements and making a Regulation D Rule 506(b) offering. By taking advantage of this exception, your company can issue stock to accredited investors without a registration of public securities.
That being said, under Rule 506(b), you can issue shares to non accredited investors—up to 35 of them—but only if you meet certain disclosure requirements. Those requirements are so arduous that, for most startups, the cost of meeting them isn’t worth it.
So, if your startup is just getting off the ground, you’ll likely rely on accredited investors to raise the capital you need.
Why does the SEC care about accredited investors?
In brief, the SEC cares how “sophisticated” investors are because they want to save regular people from losing everything they own on risky investments.
The 1929 market crash financially destroyed millions of Americans who had purchased shares in companies, many of which were new, untested, and unstable.
After that, the SEC was formed to protect investors. One of the ways they do that is by requiring that investors in early stage (and high risk) companies have a financial cushion protecting them in case the investment fails. This is why the accredited investor definition was invented, as well as restrictions on the sale of unregistered securities.
Non accredited investors cannot take advantage of certain investment opportunities (like investing in startup stock, hedge funds or private equity funds) due to these rules. In some cases, they may be able to invest only through a certified financial advisor, broker-dealer or other financial professionals.
How does someone qualify as an accredited investor?
Rule 501 of Regulation D of the Securities Act of 1933 (Reg. D) first defined what it means to be an accredited investor. These rules were modified as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), passed in 2010.
Accredited investor questionnaires are used to make a determination of whether potential investors meet the requirements of Regulation D of the Securities Act of 1933, which allows private companies like startups to sell equity without the need for registering with the SEC.
As an individual or natural person, to qualify as an accredited investor, your income or net worth must meet certain thresholds based on at least one of these criteria:
- Not including the value of your primary residence, your net worth is over $1 million. The value of a primary residence is not used when calculating your assets.
- For each of the last two years of your federal tax returns, your earned income was more than $200,000, and you can reasonably expect a similar income this year
- You and your spouse’s joint income for each of the past two years exceeded $300,000, and you have a reasonable expectation to earn a similar income in the current year
An organization qualifies as an accredited investor if:
- It is a trust whose total assets exceed $5 million, and the investment is being planned by an individual with enough knowledge and experience in business that they can accurately evaluate the risks and rewards of the investment
- All of its equity owners meet the qualifications required for individual accredited investors
- It is a charitable organization, partnership, or corporation whose assets exceed $5 million
Many high net worth individuals qualify as accredited investors even if they are not investment professionals and may not be actively investing in venture capital funds or angel investments. By virtue of having substantial wealth, the SEC deems these individuals as capable of making independent investment decisions.
Is raising money from non accredited investors worth it?
In short, no. While Rule 506(b) lets you bring on up to 35 non accredited investors without making public financial disclosures, most startups find doing so isn’t worth their time, especially for smaller angel investments.
There are few good reasons why.
Disclosure is hassle
Depending on the type of offering, you may be required to provide a non accredited investor with a balance sheet, income statements, statements of shareholder equity, and related financial statements—all of them audited, and going back two years.
This is much more than you typically provide in a private placement memorandum to investors who have accredited investor status.
According to Matt Bower, an investment adviser at Varnum, disclosure to non accredited investors can easily exceed $50,000. That’s a high price considering how little you are likely to raise from them.
You won’t raise much money
Compared to an unlimited number of accredited investors, each with a net worth over $1 million and annual income in excess of $200,000, the amount you’re likely to raise from 35 or fewer non accredited investors who don’t meet these requirements is likely to be small.
They’ll put high demands on your time and energy
To an accredited investor, an investment of $30,000 may be no big deal. To someone with considerably less money than an accredited investor, $30,000 could represent a substantial percentage of their total assets.
In that case, they’re much more likely to get in your face, demanding to know how your company is performing, and when they’ll get a return on their investment. While $30,000 is a drop in the bucket when you’re raising a $10 million round, the amount of attention your non accredited investor eats up is not.
Crowdfunding and accredited investors
The 2012 JOBS allowed non accredited investors, for the first time since the Great Depression, to buy shares in early stage companies. It did this by introducing equity crowdfunding.
Equity crowdfunding lets companies sell equity to many small investors. This opens up access to many investors who wouldn’t otherwise qualify, but it comes with a few catches.
Requirements for equity crowdfunding
- Size of offering. You cannot raise more than $5 million in securities offerings sold through equity crowdfunding over a 12 month period.
- Investor requirements. While investors do not need to be accredited, they must meet some net worth requirements.
- Resale. Crowdfunding equity cannot be sold by the buyer until one year has passed since purchase.
- Eligibility. You cannot use equity crowdfunding if you are not a US company, if you file reports under the Securities Exchange Act of 1934, or if you fall within certain categories of investment companies.
- Online portals. You must make the offering through an online broker or crowdfunding platform registered with the SEC and monitored by the Financial Industry Regulatory Authority.
- Disclosure. You’ll have to fulfill some pretty extensive disclosure requirements: Filing a Form C, which includes extensive info about your company and your offering, including risk factors and an analysis of your financial performance. You’ll have to make additional information filings after you reach 50% and then 100% of your fundraising target.
Additionally, crowdfunding can compromise your privacy. Your company information is made available via online crowdfunding portals. That can draw unwanted attention when you’re trying to fly under the radar. Plus, if your round underperforms, it will become a matter of public knowledge, potentially damaging your reputation.
Whether you’re considering crowdfunding or planning to go the VC route, Capbase can help. Our partnership with Republic helps you find investors at every scale.
- Accredited investors have over $1 million net worth (not including their primary residence) or earn at least $200,000 a year
- Raising money from accredited investors lets you issue shares without registering, thanks to Regulation D Rule 506(b)
- It is much easier for startups to raise money from accredited investors than non-accredited investors
- Crowdfunding lets you bring on large numbers of non-accredited investors, while avoiding the hassles taking on non-accredited investors can create.
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Written by James Hottensen
James joined Capbase after working at Great Oaks Venture Capital in New York where he worked on various fin-tech and consumer investments as an Associate, including Capbase and Golden. He previously worked at Tentrr, a Series A startup in New York, leading Strategy and Partnerships.
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