Is the risk of a non-accredited investor worth it?
A company offering to sell equity to investors in order to raise funds must comply with securities laws. Generally, companies are required to register any sale of securities with the Securities and Exchange Commission, unless the sale fits into one of the registration exemptions. This posts examines the exemptions most relevant when selling securities to non-accredited investors as well as the associated risks.
The most common exemption used by startup companies is Rule 506, which permits, among other things, sale of an unlimited number of unregistered securities to an unlimited number of accredited investors. An individual accredited investor is someone who either has:
• net worth of more than $1 million (excluding residence); or
• an individual income exceeding $200,000, or a joint income with a spouse exceeding $300,000, in each of the last two years and a reasonable expectation of that income continuing.
A problem that some startups face in their early financings, however, is that the investors willing to purchase their securities are not accredited.
The Risks of Non-accredited Investors
While it is possible to sell securities to non-accredited investors, many experienced lawyers in this field counsel against it. The primary reasons for this strong preference for accredited investors are the increased amount of risk and decreased amount of flexibility that accompany investment by non-accredited investors, including:
Limited Flexibility Under Federal and State Exemptions: Depending on which securities law exemption the company relies on, there are either limits on the amount of money that may be accepted over time or regulations regarding the level of sophistication of the non-accredited investor. None of these limits or regulations is very clearly defined, so the company takes on some amount of risk in trying to comply with them. In addition, the relevant federal exemptions for non-accredited investors typically do not pre-empt state securities laws. So, startups raising capital from such investors will also need to comply with the relevant state exemptions.
Potential Chilling Effect on Future Investors: In addition, venture capitalists and future acquirers tend to proceed with caution when non-accredited investors or shareholders are involved. Indeed, some investors or acquirers may decline to invest or purchase a startup merely because that startup has sold securities to a non-accredited investor.
Investor Suitability: Finally, investment in a seed round is very risky because even if a company succeeds (which it is not likely to do) an investor may lose their most of their investment through dilution. It may be harder to create reasonable expectations of return on investment with non-accredited investors. Therefore, a non-accredited investor who had unreasonable expectations when purchasing the securities may be more likely to bring a claim against a company for a variety of reasons. That claim could be viable even if a company complies with all of the reporting and disclosure requirements of federal and state securities laws.
Specific Exemptions for Non-accredited Investors
If a company chooses to proceed with a non-accredited investor there are two provisions it is likely to rely on to avoid federal securities registration requirements: Rule 504 and Section 4(a) (2).
Rule 504: Rule 504 allows a company to raise a maximum of $1 million over 12 months from an unlimited number of non-accredited investors without any information disclosure requirements. This exception is problematic because the 12 month clock may be restarted if the SEC decides to integrate later sales of securities it deems related to the original offering. As a result, a company may have unexpected funding needs it cannot satisfy or the opportunity to receive a large sum of money which it cannot seize.
Section 4(a)(2): The second provision is Section 4(a)(2), which allows a company to raise an unlimited amount of money from an unlimited amount of “sophisticated” non-accredited investors but those investors must be presented with the type of information normally provided in a prospectus used in a public offering. This exemption does not make sense if a company plans to have more than three or four investors in its seed round and carries some risk because what constitutes a “sophisticated” non-accredited investor is not clearly defined. The advantage of Section 4(a)(2) is that there is no limit on the amount of money raised and the Company does not have to file a Form D with the SEC, which it does under Rule 504. The information requirement of Section 4(a)(2) does not exist under Rule 504, but it is wise to provide non-accredited investors with enough information to assess the risk of their investment even when a company relies on Rule 504. It is also important to note that the federal exemptions are not mutually exclusive. A startup raising capital from non-accredited investors can attempt to fit under both Rule 504 and Section 4(a)(2).
State Securities Laws: Regardless of whether a company relies on Rule 504 or Section 4(a)(2) as its exemption under federal securities law, it also must look into state securities laws. Each state may or may not have an exemption that fits the particular circumstances of the offering. As a result, it is necessary to research each state’s laws and it may not be possible to present an offering in certain states.
Benefits of Accredited Investors and Rule 506
Much of this decreased flexibility and increased risk can be avoided through the use of accredited investors. According to Rule 506, securities may be exempt from registration when sold to accredited investors and there are no limits on the number of investors or the amount of capital raised, and there are no information disclosure requirements. In addition, the definition of an accredited investor is provided clearly in the securities laws. Every state also exempts Rule 506 offerings under their own securities laws, so a company only has to make a filing similar to the one made with the SEC and pay a fine to engage in an offering in any given state. Finally, venture capitalists and potential acquirers are happy to work with a company that has prior accredited investors.
Despite the downsides to accepting funds from non-accredited investors, it is possible to use them and if there are no other investment opportunities available and if funding needs are dire that may be the best course of action for a company. In the event that a company elects to use non-accredited investors, it should consult with its lawyers early in the process to ensure that all requirements are satisfied throughout the offering such that the offering is properly exempt from registration under the securities laws.