One of the more common questions I get from clients interested in raising capital is “what is an accredited investor?” The answer is spelled out in fairly plain english in Rule 501 of Regulation D:
- 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 [08/05/2010 – See this link for a recent change to this portion of the definition];
- 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 understanding what it means to be an accredited investor, it is also important to understand how accredited investor status relates to the most common exemptions from the registration requirements of federal securities law. In a nutshell:
- Rule 504 permits allows a business to sell up to $1 Million in securities during a 12 month period to an unlimited number of non-accredited investors. Additionally, Rule 504 does not require the issuer to provide any specific disclosure to the offerees, regardless of whether they are accredited (but keep in mind the anti-fraud requirements).
- Rule 505 allows a business to sell up to $5 million in securities during a 12 month period to an unlimited number of accredited investors, and up to 35 non-accredited investors. The big problem with selling to non-accredited investors is that the disclosure requirements are significantly more difficult to meet – very similar to the disclosures required in a public offering.
- Rule 506 allows a business to raise an unlimited amount of capital via the sale of securities to an unlimited number of accredited investors, and up to 35 non-accredited investors. In addition to the substantial disclosure requirements discussed above for Rule 505, any non-accredited investors must also meet a “sophistication” standard, either themselves or via a qualified purchaser’s representative. The status of an investor as “sophisticated” is a fairly high standard; investors who are merely knowledgeable about the particular industry are not necessarily sophisticated.
As you can see, raising capital from non-accredited investors puts a start-up in a much more tenuous position in terms of disclosure – which means substantially more legal and accounting fees. Non-accredited investors also tend to be more difficult to deal with in the long term. Consider carefully the decision to raise capital using non-accredited investors – and of course consult with a securities attorney.
One other thing to keep in mind is that the burden of establishing whether an investor is an accredited investor falls on the issuing company. At a minimum, the issuing company must reasonably believe that the investor falls into one of the 8 categories in the definition of “accredited investor.” This is typically accomplished using a carefully drafted investor questionnaire – make sure you use one and that you consult a securities attorney.