Startups and other companies seeking investment through private securities offerings will quickly have to master the concept of the “accredited investor.” The underlying idea is that accredited investors have either specialized knowledge or a level of wealth that gives them greater protection in making more speculative investments. By selling only to accredited investors, startups and other companies can make use of the more flexible private placement exemptions, and may be able to avoid some of the more burdensome and expensive disclosure obligations. In addition, accredited investors may be able to provide more value to a startup, through advice, connections, and access to other valuable resources.
On the flip side, anyone that isn’t an accredited investor is an unaccredited investor. These are the widows and orphans, the great unwashed, people like, well, you and me. SEC rules require a much higher level of disclosure when a company seeks investment from an unaccredited investor.
There are three basic categories of accredited investor: one, institutional investors, two, insiders, and three, Very Rich People. The first category, institutional investors, includes:
- Banks, savings & loans, registered broker-dealers, insurance companies, investment companies registered under the 1940 Investment Company Act, and certain employee benefit plans;
- Private business development companies as defined in Section 202(a)(22) of the Investment Advisors Act of 1940;
- Any organization described in section 501(c)(3) of the Internal Revenue Code, corporation, Massachusetts or similar business trust, or partnership, not formed for the specific purpose of acquiring the securities offered, with total assets in excess of $5,000,000;
- Any trust, with total assets in excess of $5,000,000, not formed for the specific purpose of acquiring the securities offered, whose purchase is directed by a “sophisticated person” as described in the regulations; and
- Any entity in which all of the equity owners are accredited investors.
Venture capital firms and angel investment firms will typically be included in one of those institutional investor categories. These institutional investors are considered to have the financial resources and expertise to evaluate the prospects and financial condition of companies in which they invest, so that they can evaluate and absorb the risk.
The second category of accredited investors is insiders. These are directors, officers, or general partners of the company that is seeking investment. The idea here is that because they are insiders, they know the financial condition of the company, and are intimately familiar with its business plan and prospects.
The third and final category of accredited investors is Very Rich People. Very Rich People includes:
- Any person with an individual net worth, or joint net worth with that person’s spouse, of more than $1,000,000. However, when determining someone’s net worth, you do not include that person’s primary residence as an asset. There are additional rules as to what liabilities are counted in determining net worth.
- Any person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year.
The notion underlying Very Rich People is that because they are Very Rich, they can afford to lose a lot of money by investing in more risky companies. The problem with the current standard, however, is that it was set more than 30 years ago, in 1982. It’s like the classic scene in Austin Powers when Dr. Evil discovers that $1 million just isn’t that much money anymore:
The SEC is currently exploring an update to the wealth and income levels for individuals that are accredited investors. Adjusted for inflation, the income level would be $500,000/year and the net worth level would be $2.5 million in assets, in 2014 dollars. It’s too soon to tell whether the SEC will update the standards, or perhaps augment them with additional standards regarding education or occupational credentials.
So what are the key takeaways for startups and other companies that may be trying to attract investors? First, make a decision right away as to whether you are only going to talk to accredited investors. This isn’t a decision you can make after you’ve been meeting with potential investors for several weeks or months. In general, restricting your pool of potential investors to accredited investors will be a better strategy — you will have reduced disclosure obligations, and the investors you do attract will be better able to provide benefits to the company that goes beyond mere investment dollars. Second, have a way to confirm that your potential investors are indeed accredited. You may need to have them complete a questionnaire, or you may need to review tax returns or other personal financial statements from individual investors. This may seem awkward, but they are asking to see your company’s financials, too. They are evaluating you, and you are evaluating them. If they aren’t willing to actually share their tax returns or financials with you, ask for a letter from their attorney or accountant, stating that the attorney or accountant has reviewed the relevant materials and determined that the investor meets the standards of an “accredited investor.” Third, and finally, this is a complex area of law, with lots of traps for the unsophisticated. Before beginning to seek outside investments, it is wise to meet with a lawyer to discuss the various requirements, and to lay out a strategy for doing things the right way.
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