A Guide To Raising Money From Accredited Investors
In the dynamic landscape of startup funding, understanding the intricacies of raising capital is crucial for founders looking to scale rapidly. Accredited investors play a pivotal role in this process, influencing the trajectory of ventures and shaping the future of the startup industry. This guide not only clarifies the concept of accredited investors, but also sheds light on the key stages of funding that startups encounter.
What is an Accredited Investor?
An accredited investor, according to the U.S. Securities and Exchange Commission (SEC), is an individual or entity eligible to participate in investment opportunities not available to the general public. This classification is determined by various criteria, including income, net worth, insider status, and professional knowledge. For startup founders, recognizing the significance of accredited investors is the first step towards navigating the complex funding landscape.
The SEC defines accredited investors under Rule 501 of Regulation D, using the following criteria:
- Individual Income: An individual who has had an annual income exceeding $200,000 (or $300,000 together with a spouse) in each of the prior two years and reasonably expects the same for the current year.
- Net Worth: An individual whose net worth, or joint net worth with a spouse, exceeds $1 million at the time of the purchase, excluding the value of their primary residence.
- Insiders: Executives, directors, general partners, and trustees of the company issuing the securities are also considered accredited investors.
- Professional Knowledge: In 2020, the SEC has expanded the definition to include individuals with certain professional certifications, designations, or credentials, or those who are "knowledgeable employees" of a private fund.
Why Focus on Accredited Investors?
Startups, particularly in the SAAS industry, often target accredited investors for several reasons. Compliance with securities laws, especially under Regulation D exemptions like 506(b) and 506(c), provides a streamlined and less burdensome path for fundraising. The sophistication of accredited investors aligns with the high-risk nature of early-stage ventures, where fewer disclosures are required.
Under Regulation D, companies can raise capital through private placements without the need for a public offering. However, these offerings are typically restricted to accredited investors due to the less stringent disclosure requirements compared to public offerings. This approach balances the need for companies to raise capital efficiently while protecting investors from undue risk.
The concept of an accredited investor is integral to the private securities market for several reasons:
- Risk Mitigation: Accredited investors are presumed to be more financially sophisticated and able to sustain the risk of loss, thereby requiring less regulatory protection.
- Market Efficiency: By limiting certain high-risk investments to accredited investors, the SEC aims to streamline the investment process for companies and reduce the regulatory burden.
- Investor Protection: This classification protects less experienced investors from potentially risky or complex investments.
Compliance with Securities Laws
Understanding the nuances of securities laws is paramount for startups. We explore the two main Regulation D exemptions, 506(b) and 506(c), shedding light on the differences and implications for fundraising. The guide also delves into the essential Form D filing at the federal level with the SEC and the "blue sky" filings required at the state level.
Regulation D Exemptions: 506(b) and 506(c)
Regulation D under the Securities Act of 1933 provides a series of exemptions that allow companies to raise capital without the need to register their securities with the SEC (which is a complicated and very involved endeavor which typically does not occur for a company until an initial public offering (IPO)).
Rule 506(b): Non-General Solicitation Offering
Under Rule 506(b), companies can offer securities to an unlimited number of accredited investors and up to 35 non-accredited investors. However, these non-accredited investors must be “sophisticated,” meaning they have sufficient knowledge and experience in financial and business matters to evaluate the merits and risks of the prospective investment.
Crucially, companies operating under 506(b) cannot use general solicitation or advertising to market their securities. This means that offers can only be made to investors in the company’s direct network and without blasting out the opportunity on social media, for example.
While there are no specific information requirements for accredited investors under 506(b), companies must provide non-accredited investors with disclosure documents that are generally similar to those used in registered offerings (which is a very involved process not typically undertaken by startups). If the company provides information to accredited investors, it must make this information available to non-accredited investors as well.
Accredited investors in a 506(b) offering typically self-certify their status, which the company can rely upon unless it has reason to believe the investor is not actually accredited.
Rule 506(c): General Solicitation Offering
In contrast to 506(b), Rule 506(c) permits companies to broadly solicit and advertise their offering, reaching a larger and more diverse group of potential investors. However, all purchasers in a 506(c) offering must be accredited investors.
A key difference in 506(c) offerings is the requirement for issuers to take reasonable steps to verify that all investors are indeed accredited. This can include reviewing tax returns, bank statements, credit reports, and other financial documents.
“Blue Sky Laws” and Federal Requirements
"Blue sky laws" are state securities laws that regulate the sale of securities to protect investors from fraud. While federal securities laws are uniform across the United States, blue sky laws can vary significantly from state to state. These laws require companies to register their securities or find an exemption before they can be offered or sold within a state.
However, if a startup relies on 506(b) or 506(c), then the company does not need to find a separate exemption at the state level because 506(b) and 506(c) “preempt” state law. However, some states do require notice filings to be made at the state level nonetheless. Notice filings are submissions made by companies to state securities regulators, typically when they are conducting a securities offering under a federal exemption that preempts state law. The purpose of these filings is to notify the state of the offering and to provide basic information about the company and the securities being offered.
California Specific Laws
For example, in California, the securities exemptions and corresponding notice filing requirements are outlined in the California Corporations Code. The state has its own unique regulatory environment and procedures, which can include different filing deadlines, fees, and documentation requirements compared to other states. For more information on California blue sky law requirements, read SPZ’s article on Common California Securities Exemptions for Startup Businesses.
Raising from Non-Accredited Investors
While an option, raising from non-accredited investors comes with additional complexities and potential risks, requiring more disclosures and potentially impacting future funding rounds. As an example, if a company raises from non-accredited investors in an early round where SAFEs or convertible notes are used, then later when those investment convert into preferred stock, the preferred stock round typically would be under 506(b) and there would be a conflict because the preferred stock round requires all investors in the round (including those converting from earlier investments) to be accredited.
In addition, non-accredited investors are typically less experienced and have fewer financial resources than accredited investors, which means they are afforded more protection under securities laws. Companies and startups may need to provide more detailed disclosures that include risk factors, a detailed business plan, and often audited financials.
Raising Capital from Crowdfunding
For startups seeking a broader investor base, raising capital from crowdfunding is sometimes explored. Often referred to as the CROWDFUND Act, Title III of the JOBS Act allows private companies to raise funds from non-accredited investors through registered online crowdfunding platforms, subject to certain rules and limitations. The act imposes limits on how much money an individual can invest in all crowdfunding offerings over a 12-month period, based on their net worth and annual income. Startups raising funds through crowdfunding must provide detailed information about the business, how the funds will be used, the price of the securities being offered, and the risks involved.
There are two major ways to crowdfund:
- Equity Crowdfunding: This allows individuals to invest in private startups and small businesses in exchange for equity. Notable platforms in this realm include Wefunder and MicroVentures.
- Reward-based Crowdfunding: Platforms like Kickstarter are popular for reward-based crowdfunding, where backers receive a product or service in return for their contribution. This type does not involve the exchange of equity or debt and thus typically does not involve securities laws.
Raising money from accredited investors is a pivotal step for startups eyeing rapid growth. With SPZ Legal by your side, the journey becomes smoother, allowing founders and leaders to focus on what they do best – building the next big thing.
Contact us today to find out how we can counsel you in working with accredited investors and making the right decisions for your startup.
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