If you are a founder of a startup, you may have heard this before. You may not know what an accredited investor is, or you may not understand why it is incredibly important to only sell stock and notes to accredited investors. Here’s a quick primer on selling your startup’s securities.
Securities Laws
You’ve probably heard of the “Securities Laws.” Securities laws are the federal and state laws and regulations that govern the sale of securities, i.e., stocks, notes (including convertible notes), and other financial instruments. The securities laws are very complex, so I’m going to try and simplify what you need to know as regards accredited investors, however there are many other aspects of the securities laws you need to take into consideration.
Exemption or Registration
Under the federal Securities Act of 1933, a company that offers or sells its securities must either (i) register the securities with the SEC, or (ii) find a federal exemption from the registration requirements. In addition, the company must also comply with securities laws in each state where securities are offered or sold, which if you are selling under an exemption in most cases also requires a state exemption.
Avoid registration and disclosure requirements
You don’t want to register your securities; that is an expensive and liability-laden process. Not only do you have to pay lawyers and accountants to prepare the registrations statements and ongoing disclosures, but if something goes wrong your security holders can sue the company on the basis of your failure to disclose material risks.
The easiest approach is to sell securities under an exemption. There are a number of exemptions, and they all require close attention to the details in order to maintain the exemption. However, many of the exemptions require “disclosure” to your investors that is similar to the registration requirements, which you also want to avoid because you may also run into problems similar to registration.
Rule 506 – the most commonly used exemption for tech startups
An exemption called Rule 506 of Regulation D is the exemption used in virtually all sales of securities by tech startups. Why is it so common? Because Rule 506 permits you to sell an unlimited amount of securities to an unlimited number of investors without any disclosure requirements.
There’s a catch: In order to avoid the disclosure requirement, you can only sell stock to Accredited Investors.
Another added benefit is that if you comply with Rule 506, your offering is also compliant with California securities laws so long as you make a simple filing with the state (check your state securities laws to evaluate if there are similar exemptions under Rule 506)
What is an accredited investor?
The definition of an accredited investor is designed to ensure that securities are only offered or sold to people or entities with the means or sophistication to protect themselves in the absence of disclosure requirements.
The following individuals are accredited investors:
- a director, executive officer, or general partner of the company selling the securities;
- a natural person who has individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase, excluding the value of the primary residence of such person; or
- a natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year.
The following entities are accredited investors:
- a bank, insurance company, registered investment company, business development company, or small business investment company;
- an employee benefit plan, within the meaning of the Employee Retirement Income Security Act, if a bank, insurance company, or registered investment adviser makes the investment decisions, or if the plan has total assets in excess of $5 million;
- a charitable organization, corporation, or partnership with assets exceeding $5 million;
- a business in which all the equity owners are accredited investors; or
- a trust with assets in excess of $5 million, not formed to acquire the securities offered, whose purchases a sophisticated person makes.
What about crowdfunding? Can’t we sell to unaccredited investors under the new crowdfunding exemption?
As of the date of this article, the SEC has not yet released rules related to the crowdfunding exemption created by Congress in the JOBS Act. So it is not yet legal to use the crowdfunding exemption. Once the SEC has released rules, companies using the crowdfunding exemption may issue securities to unaccredited investors, but they will be subject to the disclosure requirements which, as mentioned, you probably want to avoid. I have previously written on why equity crowdfunding is not always a good idea precisely because of those disclosure requirements.
Conclusion: Why you should only sell to accredited investors
- It is the easiest way to get your securities offering exempted from both federal and California registration requirements;
- If you only sell to accredited investors under Rule 506, you will not be subject to disclosure requirements; and
- Perhaps most importantly, many VCs and other investors will only invest in companies where all of the securityholders are accredited investors, because it limits potential lawsuits that might be brought against the company in the future and avoids problems that crop up with unaccredited investors in an M&A exit.