Not All Investors Are Created Equal In The Eyes of the SEC: Why You Should Consider Only Accredited Investors in Your Startup
It is exciting to have people willing to invest money into your company. But before you sell any equity to friends, family or others, consider whether they are "accredited investors." Federal and state securities laws and regulations are a legal trap for the unwary any time equity is offered or sold, whether it is in a large publicly-traded company or your brand new startup. It is much easier to comply with these laws if you sell equity only to accredited investors. Most state securities laws defer to the rules on accredited investors promoted by the federal Securities and Exchange Commission ("SEC").
Why sell equity only to accredited investors? Federal and state securities laws have a lot to say about how securities (and this includes the equity in your company!) can be offered and sold, and to whom. For example, under federal law, absent an exemption, a company that offers or sells its securities must register those securities with the SEC. Some popular exemptions from this registration requirement include selling securities pursuant to Rules 505 or 506 of the SEC's Regulation D. However, offerings made to non-accredited investors are subject to significantly more onerous requirements than offerings made to accredited investors. For example, non-accredited investors need to be provided with a significant amount of financial and other business information that accredited investors do not need.
What is an accredited investor?
An accredited investor is a person or entity that meets specified requirements established by federal and state securities regulators. Generally speaking, these requirements are intended to distinguish between investors who have sufficient financial and business acumen such that minimal regulatory oversight is warranted (i.e., accredited investors) and investors who lack that acumen such that more regulatory oversight is warranted for the investors' protection.
Under federal securities law, with respect to a natural person, an accredited investor is one who satisfies an income test or a net worth test.
Under federal securities law, with respect to a natural person, an accredited investor is one who satisfies (or who the company reasonable believes satisfies) an income test or a net worth test. To satisfy the income test, the person must have earned income in excess of $200,000 in each of the prior two years and reasonably expects the same for the current year. The income test may also be satisfied if the person's joint earned income with his or her spouse was in excess of $300,000 in each of the prior two years and the person reasonably expects the same for the current year. To satisfy the net worth test, the person must alone or jointly with his or her spouse have a net worth in excess of $1,000,000. There are certain assets and liabilities that are excluded from this net worth calculation, including the value of the person's primary residence and the value of any mortgage on the residence up to the fair market value.
Under federal securities law, an entity can also be an accredited investor. Depending on the nature of the entity, different standards may apply. As a catch-all, though, any entity in which all of the equity owners are accredited investors qualifies as an accredited investor.
There are other nuances regarding the definition of accredited investor under federal and state securities law. Federal and state securities law may also impose other conditions on the sale and offer of securities, whether to accredited investors or not, including limitations on the number of investors or amount of the offering and restrictions on the ability to resell issued securities. Consult with your attorney regarding the specifics of your situation.
To ensure that your investors are accredited investors, you should consider having them fill out investor questionnaires disclosing information on their income and net worth. Your investors should also complete subscription agreements for a number of useful legal reasons including, in relevant part to accredited investor status, representations and warranties regarding their qualifications as accredited investors.
While compliance with federal and state securities law may seem burdensome now, future rounds of investors will want evidence and assurance that you and your company are considering the risk posed by securities law.