Startup Lawyer | Life is Too Short to Deal with Non-Accredited Investors
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Life is Too Short to Deal with Non-Accredited Investors

Posted 12 Jun 2008

The Securities Act of 1933 provides companies with a number of exemptions from registration with the SEC. Two distinct but related exemptions, Rules 505 and 506 of Regulation D, provide that a company can sell its own securities to an unlimited amount of “accredited investors.” (Please keep in mind there are several other requirements your startup company must follow to properly obtain an exemption from registration under the securities laws.)

The definition of an accredited investor is found in Regulation D’s Rule 501 of the federal securities laws. An accredited investor is:

  • a bank, insurance company, registered investment company, business development company, or small business investment company;
  • an employee benefit plan, within the meaning of the Employee Retirement Income Security Act, if a bank, insurance company, or registered investment adviser makes the investment decisions, or if the plan has total assets in excess of $5 million;
  • a charitable organization, corporation, or partnership with assets exceeding $5 million;
  • a director, executive officer, or general partner of the company selling the securities;
  • a business in which all the equity owners are accredited investors;
  • a natural person who has individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase;
  • a natural person with income exceeding $200,000 in each of the two most recent 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; or
  • a trust with assets in excess of $5 million, not formed to acquire the securities offered, whose purchases a sophisticated person makes.

In addition to accredited investors, Rule 505 and 506 permit raising capital from up to 35 non-accredited investors (i.e., anyone that does not fit the accredited investor definition above). But that doesn’t mean your company should raise capital from non-accredited investors, and for a good few reasons:

(1) Non-Accredited Investors Trigger a Larger Disclosure of Information – If you raise capital from non-accredited investors in a Rule 505 or Rule 506 registration-exempted financing, you must provide a huge amount of information about your startup company. Think IPO-registration huge, thereby leading to larger legal and accounting costs. Such additional costs may not be prudent if your startup company is tight on capital.

(2) Non-Accredited Investors Tend to be More Hostile Than Accredited Investors – Implied by the definition of a non-accredited investor, the investment a non-accredited investor makes to your startup company will mean much more to him or her than an investment an accredited investor makes. A non-accredited investor will be much more emotional. Thus, non-accredited investors are much more likely to sue your company if things don’t go according to plan.

(3) Non-Accredited Investors can Hinder an Acquisition – It may be difficult for your startup company to be acquired after it has completed a registration-exempted financing with non-accredited investors. Non-accredited investors trigger additional rules in the context of an acquisition (e.g., a purchaser’s representative). Sometimes the acquiring entity will require a startup company to perform a buyout the non-accredited investors pre-acquisition.

Therefore, if at all possible, your startup company should refrain from raising money from non-accredited investors. They simply create too many problems during and after your financing.

39 Comments
  • Benefit Consultant &
    Posted at 23:44h, 30 September Reply

    A really good article. Thanks!

  • Benefit Consultant &
    Posted at 18:44h, 30 September Reply

    A really good article. Thanks!

  • Jeff
    Posted at 16:12h, 04 March Reply

    Is it possible to sidestep the complications of taking seed-stage money from non-accredited investors by structuring the deal as a convertible note? Some of my friends and family seem willing to take the chance on an early investment, but I don't want that to hinder potential future rounds with VCs. Any thoughts?

  • Jeff
    Posted at 11:12h, 04 March Reply

    Is it possible to sidestep the complications of taking seed-stage money from non-accredited investors by structuring the deal as a convertible note? Some of my friends and family seem willing to take the chance on an early investment, but I don't want that to hinder potential future rounds with VCs. Any thoughts?

  • Ryan Roberts
    Posted at 09:55h, 05 March Reply

    The deal structure really has nothing to do with the accredited/non-accredited problem. A convertible note is considered a 'security' and you would still have to find an appropriate exemption from registration.

    Even a note without a convertible feature is a 'security.'

  • Ryan Roberts
    Posted at 04:55h, 05 March Reply

    The deal structure really has nothing to do with the accredited/non-accredited problem. A convertible note is considered a 'security' and you would still have to find an appropriate exemption from registration.

    Even a note without a convertible feature is a 'security.'

  • Art
    Posted at 09:46h, 02 April Reply

    What about if you are raising money for a real estate venture. I am trying to raise 3 million for the purchase of residential real estate. I want to give the investors a note and mortgage on the property that I buy and then pay them an 8% annual return with payments made monthly. The term on the note is 5 years. Should I consider trying to use accredited investors or is this something they would'nt be attracted to?

  • Art
    Posted at 04:46h, 02 April Reply

    What about if you are raising money for a real estate venture. I am trying to raise 3 million for the purchase of residential real estate. I want to give the investors a note and mortgage on the property that I buy and then pay them an 8% annual return with payments made monthly. The term on the note is 5 years. Should I consider trying to use accredited investors or is this something they would'nt be attracted to?

  • Ryan Roberts
    Posted at 16:08h, 07 April Reply

    "Accredited" investors is a term defined by the SEC. I don't think you can generalize what accredited investors as a whole prefer or want in an investment. But from a legal standpoint, I would recommend raising capital only from accredited investors.

  • Ryan Roberts
    Posted at 11:08h, 07 April Reply

    "Accredited" investors is a term defined by the SEC. I don't think you can generalize what accredited investors as a whole prefer or want in an investment. But from a legal standpoint, I would recommend raising capital only from accredited investors.

  • BA410.com » Blog Archive » Reading: Getting Financed
    Posted at 14:59h, 20 April Reply

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  • BA410.com » Blog Archive » Class 7: Getting Financed
    Posted at 14:59h, 20 April Reply

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  • North
    Posted at 19:36h, 01 August Reply

    What about friends and family? Aren't people with whom you have a "preexisting relationship" in the same category as qualified investors?

    Thanks, this site is a big help.

  • North
    Posted at 14:36h, 01 August Reply

    What about friends and family? Aren't people with whom you have a "preexisting relationship" in the same category as qualified investors?

    Thanks, this site is a big help.

  • Reading: Session 8 – Getting Financed — Start Your Business Course
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    [...] Life is Too Short to Deal with Non-Accredited Investors [...]

  • Wendy
    Posted at 22:23h, 17 March Reply

    Ryan -

    I think you are dead on for points 2. and 3.

    Regarding 1., although Rule 506 provides safe harbor for 4(2), can't one just claim an exemption under 4(2) and by-pass requirements for 506? Also, Senator Dodd's bill will kill accredited investor financing in the short-term if the SEC has 120 days to sit on everything.

    If a start-up simply doesn't have much financial information in the beginning, it would seem that using 4(2) and raising money from non-accredited investors wouldn't be that bad (taking into account your 2. and 3. above).

    Thoughts?

    Thanks, Wendy

  • Wendy
    Posted at 17:23h, 17 March Reply

    Ryan -

    I think you are dead on for points 2. and 3.

    Regarding 1., although Rule 506 provides safe harbor for 4(2), can't one just claim an exemption under 4(2) and by-pass requirements for 506? Also, Senator Dodd's bill will kill accredited investor financing in the short-term if the SEC has 120 days to sit on everything.

    If a start-up simply doesn't have much financial information in the beginning, it would seem that using 4(2) and raising money from non-accredited investors wouldn't be that bad (taking into account your 2. and 3. above).

    Thoughts?

    Thanks, Wendy

  • Ryan Roberts
    Posted at 22:51h, 17 March Reply

    Wendy – Senator Dodd's bill would ruin a bunch of things for startups and investors.

    Rule 506 (in it's current, pre-Dodd Bill state) has the benefit of pre-empting state securities law. Essentially, if you comply with Rule 506, the startup only has to make a notice filing with the state(s).

  • Ryan Roberts
    Posted at 17:51h, 17 March Reply

    Wendy – Senator Dodd's bill would ruin a bunch of things for startups and investors.

    Rule 506 (in it's current, pre-Dodd Bill state) has the benefit of pre-empting state securities law. Essentially, if you comply with Rule 506, the startup only has to make a notice filing with the state(s).

  • Wendy
    Posted at 03:35h, 23 March Reply

    Ryan -

    thanks so much for getting back to me. I guess I'm trying to reconcile a) Rule 506's general information requirements (specifically, 502(b)) and b) a start-up that has low or no information about itself yet and is essentially raising money. Any thoughts?

    Thanks!

  • Wendy
    Posted at 22:35h, 22 March Reply

    Ryan -

    thanks so much for getting back to me. I guess I'm trying to reconcile a) Rule 506's general information requirements (specifically, 502(b)) and b) a start-up that has low or no information about itself yet and is essentially raising money. Any thoughts?

    Thanks!

  • Matt
    Posted at 12:47h, 12 May Reply

    Ryan – I've heard there is a "business relationship" test that allows a company to raise capital from a non-accredited investor without providing all of the disclosure information only if the non-accredited investor has intimate knowledge of the business he or she is investing in. Do you know anything about this test? Thanks a lot.

  • Matt
    Posted at 07:47h, 12 May Reply

    Ryan – I've heard there is a "business relationship" test that allows a company to raise capital from a non-accredited investor without providing all of the disclosure information only if the non-accredited investor has intimate knowledge of the business he or she is investing in. Do you know anything about this test? Thanks a lot.

  • Ross
    Posted at 02:43h, 19 June Reply

    Can anyone come up with a legal structure under which unaccredited investors can pool funds together for the purpose of investing in early stage companies? What requirements would the “pool” need to meet to be able to take money from unaccredited investors and invest it in unregistered companies?

  • Ross
    Posted at 21:43h, 18 June Reply

    Can anyone come up with a legal structure under which unaccredited investors can pool funds together for the purpose of investing in early stage companies? What requirements would the “pool” need to meet to be able to take money from unaccredited investors and invest it in unregistered companies?

  • Phil
    Posted at 20:18h, 26 August Reply

    Does Qualifed 401 or IRA money exempt the Investor from the accredited Investor Rule? ie – If someone making say 100K per year wants to pull 150K out of their 300K Retirement Accounts to invest, do they have to meet Regulation D’s Rule 501 of the federal securities laws as an Accredited Investor to invest this money even thought their Net Worth is not $1,000,000 and/or they don't make over $200K annually?

    • Chris
      Posted at 22:41h, 20 November Reply

      Phil, did you ever recieve an aswer to this question? is it posted ro can you ahsre the answer?

    • Chris
      Posted at 22:41h, 20 November Reply

      Phil, did you ever recieve an aswer to this question? is it posted ro can you ahsre the answer?

  • Phil
    Posted at 15:18h, 26 August Reply

    Does Qualifed 401 or IRA money exempt the Investor from the accredited Investor Rule? ie – If someone making say 100K per year wants to pull 150K out of their 300K Retirement Accounts to invest, do they have to meet Regulation D’s Rule 501 of the federal securities laws as an Accredited Investor to invest this money even thought their Net Worth is not $1,000,000 and/or they don't make over $200K annually?

  • Quora
    Posted at 18:13h, 04 August Reply

    What are the best online resources (blogs, podcasts, articles, etc.) on startups and entrepreneurship?…

    Incorporation * Startup Company Laywer: What type of entity should I form? (http://www.startupcompanylawyer.com/2009/03/12/what-type-of-entity-should-i-form/) * Startup Company Lawyer: What state should I incorporate in? (http://www.startupcompanylawye

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  • Rustin
    Posted at 14:35h, 22 January Reply

    Phil -

    I know it’s rather too late. Answer I found was to add them as co-founders as convertible note, further coupled by vest founders shares, which is common stock.

    This should be a positive reflection as it does not present any conflicts against any preferred stock options or similar equity.

    Then again, I’m no lawyer and just how I approached this problem.

    Best of luck with your new adventure. Have fun with it!

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  • Zach
    Posted at 04:30h, 20 March Reply

    If I am not an accredited investor but my father is, could he make a company in which I have no equity position, but am paid a salary of $1 per year and am awarded bonuses if deals pan out well?

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  • Jessica Abril Fooks
    Posted at 05:10h, 12 September Reply

    Great Article! Thanks.

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