A question I receive frequently from entrepreneurs raising capital for the first time is whether they can raise money from people who do not meet the SEC definition of “accredited investors.” The easy answers are “you shouldn’t” or “technically you can but it’s not worth it because of the hoops you have to jump through,” but a few of you are curious about why those are the answers. The purpose of this post is to provide a high-level answer to this question for an entrepreneur who is not an expert in securities law but is trying to figure out whether to include a friend, relative or other potential investor in an upcoming financing round even though the person is not an “accredited investor”.
Let’s start with some general background. The general rule in the United States is that if you sell shares of stock in your company, you either need to register the offering with the Securities and Exchange Commission, which is a very significant undertaking in terms of time and resources, or your sale of stock must fall within a specified exemption from registration.
Since public registration of securities is not practical for most early-stage companies, startups generally rely on an exemption from registration. Each state has its own distinct rules about what kinds of stock issuances can occur without registration, and it can be hard to keep track of all the separate requirements, but the SEC has provided a way to override the state requirements so long as your stock sale meets certain criteria, including restricting the offering to “accredited investors” or, if you do want to include purchasers who do not qualify as “accredited investors,” complying with some relatively detailed additional information requirements. These requirements include, in the words of the SEC, creating “disclosure documents that are generally the same as those used in registered offerings,” which are incredibly detailed and thorough, and prohibitively expensive for most startups to prepare.
Generally speaking, an individual is an accredited investor if he or she is any of the following (note that these categories reflect certain updates that went into effect in 2020):
- a person who has individual net worth, or joint net worth with the person’s spouse or spousal equivalent, that exceeds $1 million at the time of the purchase, excluding the value of his or her primary residence;
- a person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse or spousal equivalent exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year; or
- a director, executive officer or general partner of the company selling the securities, an individual with certain professional certifications, designations or credentials or other credentials issued by an accredited educational institution, and certain clients of family offices. For investments in private funds, certain “knowledgeable employees” of that fund are considered accredited investors. In certain circumstances, an entity, like a business or charitable organization, may be an accredited investor, as well, but typically that entity would either need to have $5,000,000 or more in assets or be composed solely of other accredited investors.
The disclosure requirements ease considerably if your financing is for less than $5,000,000. In that case, there is a separate SEC rule that says you can include non-accredited investors without requiring full, registered offering-style disclosure. The big drawback of relying on that rule is that it does not override state requirements, so your offering would still have to comply with the state securities laws, often referred to as “blue sky laws,” of each state where you are selling shares (the state of residence of the investors, not the company). In addition to an applicable exemption not being available in some states, this will require your legal counsel to research and meet the blue sky requirements of each applicable state. Remember, too, that the $5,000,000 limit applies to all sales within a 12 month period, so check with your counsel to make sure that you are considering all of the issuances that would apply.
There are also exceptions to accredited investor requirements for investments done under Regulation Crowdfunding, but offerings under those regulations are subject to other requirements. You can read more about offerings under Regulation Crowdfunding here.
One important point to note is that all securities offerings are still subject to the general anti-fraud provisions of the Exchange Act of 1934, which means that all documents or other information actually provided to the prospective investor must be accurate and not misleading, and may not omit any information that would render them misleading in any material respect.
Because of the limitations described above, many companies find that raising money from non-accredited investors would often result in incremental professional fees as high or higher than the amount of money they would raise from these investors. As a result, the vast majority of early-stage companies we work with exclude all non-accredited investors from their fundraising.