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.