When it comes to startup funding, there are many sources. For most really early-stage companies, though, options are pretty much limited to accelerator programs, angel investors, and what in the biz is known as “friends & family (& fools).”
Yes, your friends and family may be your biggest supporters and maybe even your first customers, but unless you come from a wealthy family or have rich friends it probably doesn’t make sense for your eccentric aunt or your high school best friend to cut you an investor check. Even if they really want to invest in your early-stage startup, accepting money from non-accredited individual investors is probably not a great idea. It can cost them, your startup, and potentially yourself a lot of extra time that could have been spent building the company or raising from accredited investors, and billable hours with your lawyers and accountants (which is money that could have been spent on hiring, equipment, and other necessities).
There has been a lot written about the subject of startup companies raising money from non-accredited investors, and the message they deliver is pretty clear: It is probably not a good idea to raise money from non-accredited investors. And while Capbase is not a law firm and does not provide legal advice on securities transactions or SEC compliance, we just want to state for the record that we agree with the general consensus. To repeat: friends, family, and folks you meet along the way can love you and support you as a person all they want, but unless they’re accredited investors, you should keep a firewall between their money and your company.
In this article, we’ll explain what an accredited investor is, the legal (but extremely cumbersome) process involved with accepting investment from non-accredited investors in the context of Regulation D, and a brief discussion of the pros and cons of raising money through a Regulation CF (also known as Regulation Crowdfunding) exempt offering.
What is an accredited investor?
An accredited investor is a person or business that can purchase or exchange securities in unregistered securities transactions (also known as “private offerings”). In order to have this privilege, accredited investors must satisfy at least one requirement regarding their income, net worth, asset size, governance status, or professional experience.
U.S. accredited investors are governed by the Securities and Exchange Commission (SEC) and refer to investors who are deemed “financially sophisticated” and therefore less need to for protection provided by mandatory disclosure requirements. Different jurisdictions define and regulate accredited investors in different ways, in this article we will focus on how the U.S. government regulates accredited investors through federal securities law.
A person may be considered an accredited investor if their annual income exceeds $200,000 ($300,000 for joint income) for the past two years with the expectation that their current income is the same or higher. All three years of income, the past two years plus the current year, must be evaluated solely by individual income or joint income. The requirement cannot be fulfilled by, for example, 1 year of individual income and 2 years of joint income.
A person can also be considered an accredited investor if their net worth (excluding the value of their primary residence) exceeds $1 million individually or jointly. If a person is a general partner (such as of a venture capital pr private equity fund, executive officer, or director for a company that issues unregistered securities, they can also be considered an accredited investor.
Lastly, a business is considered an accredited investor if it has more than $5 million in assets. Businesses can also be considered an accredited investor if its equity owners qualify as accredited investors. The catch here is that a business or organization cannot be formed with the sole purpose of purchasing specific securities.
What is the compliance burden of having non-accredited investors?
Let’s say, hypothetically, that you really, really wanted to raise money from a non-accredited investor. What then?
The bulk of startup fundraising happens under the legal umbrella of Rule 506(b) of Regulation D (aka “Reg D”) of the Securities Act of 1933, which creates a “safe harbor” under Section 4(a)(2) of the same Act for so-called “private placement” transactions. That sounds like a lot of legalese but it basically means that private companies can raise from private, accredited investors without a rigorous disclosure process and ongoing reporting requirements to securities regulators—like what a company would have to undergo in an initial public offering (IPO) to sell its shares on a stock exchange to the general public.
In that context, it’s important to remember that a non-accredited investor is indeed part of the “general public” which private investor regulations are ostensibly there to protect. This will be important to keep in mind when we discuss the compliance requirements for raising from non-accredited investors.
Rule 506(b) allows for an unlimited number of accredited investors, and up to 35 non-accredited investors to participate in a 506(b)-exempt offering. Even then, non-accredited investors must also meet certain requirements such as being an officer of a company that is offering securities. This is to ensure that non-accredited investors are financially and legally knowledgeable to evaluate the risks of an investment.
However, even if you raise money from just one non-accredited investor, your company’s reporting and compliance requirements explode. Accredited investors may request a lot of detailed information over the course of their due diligence process to aid in making their investment decision, but from a regulatory perspective very few of those disclosures to accredited investors are codified as actual legal requirements. When it comes to protecting the general public, however, legal requirements and their corresponding compliance burden increase exponentially.
When you raise money from a non-accredited investor you are subject to disclosure requirements outlined in Rule 502(b). You are required to disclose non-financial and financial information. These requirements kick in when you sell to any purchaser that is not an accredited investor, regardless of the amount of money they invested. Non-financial information disclosure includes: the management team, industry, the characteristics of the securities offered, any third-party broker-dealers facilitating the offering process, and the risks involved in the type of security being offered.
Financial information is disclosed based on your company’s financial statements. The extent of the disclosure depends on the size of the offering, and the larger the offering the more extensive the disclosure requirements are. Typically, the requirements vary in the amount of financial information disclosed and whether the information needs to be audited and certified by company’s executives. The requirements are determined based on three tiers: offerings below $2 million, offerings between $2 million and $7.5 million, and offerings above $7.5 million. All of the nonfinancial and financial information disclosed is considered necessary to help an investor make an informed decision.
Given the extent of disclosure, your company, which is not likely to have a lot of money, has to go through a process that is not entirely different from disclosure requirements for a company going public.
Quick disclaimer: We have only discussed federal exemptions, each state may have their own disclosure requirements (known as “blue sky laws”) and restrictions. So if you really want to raise money from non-accredited investors, make sure you understand state securities laws as well.
What About Equity Crowdfunding?
Access to startup investment opportunities through equity crowdfunding was significantly expanded under the JOBS Act, which President Barack Obama signed into law in 2012. It paved the way for crowdfunding platforms to give entrepreneurs a secure, legally-compliant manner to let the general public participate in their securities offerings. It expanded SEC rules around Regulation A securities offerings, creating a new category of “Reg A+” offerings, which allow for general solicitation of potential investors regardless of their accreditation status.
Reg A+’s close cousin, Regulation Crowdfunding, or Reg CF, allows any investor over the age of 18 to buy securities in private companies. This essentially means that there is no distinction between accredited and non-accredited investors in these offerings. Offerings are publicly posted online and anyone over the age of 18 can buy a portion of your company. Although this sounds great, there are limitations and compliance requirements that come with Reg CF that are not associated with Reg D offerings.
Unlike Reg D offerings, Reg CF offerings must go through intermediaries that are registered with the SEC. The purpose of the intermediaries is to ensure that your offerings are in compliance with securities laws. For example, annual investment limits are capped by law at $2,000-$107,000 across all Reg CF offerings in a 12-month period depending on their income and net worth. Accredited investors under Reg D are not subject to these caps.
Companies that raise funding through Reg CF can only raise up to $5 million annually. You can raise more than $5 million in the aggregate annually if the rest of the money raised comes from non-Reg CF sources. However, this is to illustrate the function of intermediaries and to give you examples of limitations that come with Reg CF offerings.
Reg CF offerings require the company to publicly disclose its financial conditions and ongoing annual reports. The reasoning for these disclosures is similar to the disclosures required for nonaccredited investors under Reg D offerings. The government wants to ensure that investors are provided the opportunity to make an educated decision when they choose to invest in that company. Here, the investors are the public which means the information must be disclosed publicly so that the public has the opportunity to make an educated decision.
Disclosing your information publicly is disadvantageous for two reasons. First, it takes away your ability to work on your product in stealth. If you are concerned that someone is going to steal your idea, Reg CF offerings may not be the best way to raise funds for you. Second, if your crowdfund campaign fails, or worse yet if your company fails, it will fail publicly.
(To learn a bit more about equity crowdfunding, check out our article How Does Equity Crowdfunding Work?)
How else can I give a non-accredited investor a piece of the company?
First off, if your company doesn’t take money from them in exchange for securities, the person in question is not an investor. And this article already explained why raising money from non-accredited investors is going to be more trouble than it’s worth. But what if someone in your network really wants to get some equity in your startup and they aren’t an accredited investor?
If they can provide value to your company, they can get equity the good ol’ fashioned way: doing work for the company either as an employee or advisor.
To learn more about issuing equity to advisors, check out our article Who Do I Need On My Advisory Board, and to learn more about giving options or equity to employees, check out some of the articles in our Employee Equity Compensation category.)
- When you are fundraising for your startup, it is best to raise money from an accredited investor because it lessens your compliance burden.
- However, if you must raise money from an non-accredited investor be ready to disclose your company’s financial statements and nonfinancial information such as: the management team, industry, the characteristics of the securities offered, any third-party facilitators in the offering process, and the risks involved in the type of security being offered.
- The best way to give an non-accredited investor a piece of your company is by having them provide value to your company as an employee or advisor.
- You cannot get around disclosure requirements for non-accredited investors with Reg CF offerings because the Reg CF disclosure requirements are likely just as rigorous.
Written by Beth Zhao
Beth is a second year law student at The George Washington Law School. She is a member of the Public Contract Law Journal.