When raising capital for your startup, it is important to ensure that you are raising funds from accredited investors.  In this post, we’ll explore what an accredited investor is, why the designation matters, and the risks in accepting financing from non-accredited investors.

What is an Accredited Investor?

One of the primary mandates of the U.S. Securities and Exchange Commission (SEC) is to protect the general public in the risk-laden realm of investing.  U.S. securities laws and regulations are complex – far beyond what a single blog post could cover – but one of the overarching rules is that, when selling shares in your company (an “offering”), you either need to register that offering with the SEC, or the offering must qualify under an exemption from such registration.  Registering an offering with the SEC is a lengthy and expensive ordeal, which is why savvy startups avoid it at all costs, instead carefully structuring their offerings to fall within a valid registration exemption.

We will delve into the different SEC registration exemptions in a future post but, for now, just know that critical to almost all of them is the concept of “accredited investors.”  In very simple terms, an accredited investor is an individual or entity that, by satisfying certain financial or professional criteria, demonstrates a high level of sophistication (to understand the risk and merits of an investment) and/or resources (to weather the financial consequences of a poor investment), such that the SEC need not worry about protecting them as much as it would the average person.

By limiting your investor pool to few (or no) unaccredited investors, you are more likely to qualify under the most advantageous of registration exemptions.  As such, by raising money from accredited investors alone, you reduce the time and expense in raising outside financing, and avoid the potential legal and financial ramifications of accepting non-accredited investors to your cap table.

Who Qualifies as an Accredited Investor?

An accredited investor will typically fit one of the following categories (though there are some other niche ways to qualify):

  • Individuals with a high net worth: Having a net worth of at least $1 million, excluding the value of their primary residence.
  • Individuals with high income: Earning at least $200,000 annually ($300,000 for joint income with a spouse or partner) in each of the past two years, with an expectation of the same or higher income in the current year.
  • Entities with substantial assets: Businesses, trusts, or other entities with at least $5 million in assets or entities where all owners are accredited investors.
  • Professional investors or knowledgeable insiders: Individuals with specific professional certifications (e.g., holders of Series 7, 65, or 82 licenses) or directors, executive officers, or general partners of the company selling securities.

Why Startups Should Sell Only to Accredited Investors

1. SEC Regulations and Exemptions
As mentioned above, registration exemptions require their own dedicated post, but at a high level, most startups raise capital under Regulation D of the Securities Act of 1933, specifically under Rule 506(b) or 506(c). Again, these exemptions allow companies to sell securities without the expensive and time-consuming process of registering such securities with the SEC. However, they impose strict limitations on the types of investors who can participate, revolving primarily around the accredited status of the investors involved:

  • Rule 506(b) allows up to 35 unaccredited investors but comes with additional disclosure requirements, making compliance more complex.
  • Rule 506(c) permits fundraising from accredited investors only but allows general solicitation (public advertising) of the offering.

By ensuring all investors are accredited, a startup significantly reduces its regulatory burden and avoids the potential pitfalls of selling securities to unqualified investors.

2. Avoiding Legal Liability and Costly Compliance Burdens
Selling securities to unaccredited investors can open a company to legal and regulatory risks, including:

  • Rescission Rights: Failure to comply with securities laws in carrying out an offering, including in terms of failing disclosure requirements or exceeding unaccredited investor limits, may result in the right of investors to demand their investment back, often with interest. Naturally, this can be devastating to a startup’s finances.
  • Increased Disclosure Obligations: Raising funds from unaccredited investors may require detailed financial disclosures and ongoing reporting, significantly increasing legal and compliance costs.  These increased costs can be burdensome and may become a source of significant financial drain on the company.
  • Regulatory Investigations: The SEC or state securities regulators may investigate and impose penalties if a company improperly sells securities to unaccredited investors.

3. Protecting the Company’s Future Fundraising and Reputation
Having unaccredited investors on the cap table can cause issues for future fundraising rounds, including:

  • Venture Capital Roadblocks: Institutional investors and venture capital firms typically prefer a “clean” cap table with only accredited investors. A complex or non-compliant investor base can deter future investment.
  • Complications in Exits and Acquisitions: When a company is acquired or goes public, prior securities law violations can create legal challenges, which may delay or jeopardize deals.

4. Ensuring Investors Understand the Risks
Accredited investors, by definition, have the financial resources and sophistication to gauge the viability of a prospective investment and absorb potential losses. Unaccredited investors may lack the experience or risk tolerance necessary for investing in high-risk startups, which could lead to legal disputes if things go wrong.

Best Practices for Ensuring Compliance

To ensure compliance and protect the company, founders should:

  1. 1. Ask investors to Certify Accreditation (for Rule 506(b) offerings): for offerings under Rule 506(b), the best practice is to ask all of your investors to fill out an accredited investor questionnaire (which you can get from your attorneys).
  2. 2. Verify Accreditation (in Rule 506(c) offerings): For Rule 506(c) offerings, you must confirm that investors are accredited. You can do this yourself, through your attorney, a third-party service, or by collecting documents like tax returns, brokerage statements, or a letter from an accountant or other qualified professional.
  3. 3. Use Proper Legal Agreements: Work with experienced legal counsel to draft investor agreements that include representations and warranties regarding accredited investor status of all investors.
  4. 4. Keep Detailed Records: Maintain records of investor accreditation, subscription agreements, and any relevant disclosures to demonstrate compliance in case of an audit or legal challenge.
  5. 5. Educate Your Team: Ensure that all executives and employees involved in fundraising understand the legal requirements and risks of working with unaccredited investors, as well as the other potential pitfalls in raising outside capital (like public solicitation).

Conclusion

Selling securities to unaccredited investors is a serious legal risk that can have long-term consequences for a startup. By raising capital only from accredited investors, founders can streamline compliance, reduce legal exposure, and enhance the company’s ability to attract institutional investors in the future.

By prioritizing legal and regulatory compliance from the start, founders can focus on what matters most: building and scaling their business. Bowery Legal can help your startup navigate these regulations successfully and ensure a smooth fundraising process.