Reasons to Include Only Accredited Investors in Your Rule 506(b) Private Offering
This post explains why limiting your private placement to only "accredited" investors is the most efficient and cost-effective way to complete your capital raise. We also examine how including "non-accredited" investors complicates an offering and limits your options. The bottom line is to think twice before including investors who do not have the net worth or income to qualify as "accredited" investors.
Federal securities law includes Regulation D Rule 506(b)which is widely used to complete private placements in compliance with the securities laws. A Rule 506(b) offering is attractive to companies because (a) there is no limit on the size of the offering or the number of accredited investors, (b) the issuer has no regulatory duty to furnish specific information to accredited investors, and (c) the issuer is exempt from state law (i.e. blue sky) registration and qualification requirements. The theory behind Rule 506 is that accredited investors are able to look after their own interests and do not need all the protections that non-accredited investors receive.
Many companies that start down the road of doing a Rule 506(b) offering to accredited investors later ask whether it is possible to include any non-accredited investors. The short answer is that non-accredited investors can be included, but only if additional costly requirements are satisfied. Rule 506(b) allows up to 35 non-accredited investors. But each non-accredited investor must receive an extensive disclosure document with almost as much detail as is required for an initial public offering registered with the Securities and Exchange Commission. For example, depending on the size of the offering, issuers are required to provide the most recent balance sheet, income statements, statements of stockholders' equity, and similar audited financial statements for the preceding two years, as well as a description of the issuer's business and the securities in the offering. The issuer must also give non-accredited investors a brief written description of any material information about the offering that is given to accredited investors. In short, the information required to be provided under Rule 502(b)(2) is much more comprehensive that the information typically provided in a private placement memorandum to accredited investors.
In most cases, the amount of capital that can be raised from non-accredited investors (which cannot exceed 35 investors who are not, by definition, high-net worth individuals) is rarely enough to justify the expense of providing the information required under Rule 502(b)(2). In fact, the combined legal and accounting costs for Rule 502(b)(2) compliance could easily exceed $50,000.
Moreover, each non-accredited investor must, under Rule 506(b)(2)(ii), “either alone or with his purchaser representative(s) [have] such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment.” This condition can be met if the issuer reasonably believes that the non-accredited investor meets this standard. Rather than rely on a reasonable belief that non-accredited investors are "knowledgeable" and "capable" of evaluating the investment, it is generally recommended that the issuer - at its own expense - provide accredited investors with a purchaser representative to represent the entire class of non-accredited investors to ensure that the sophistication requirements is met. Providing such a representative is yet another cost to the issuer for including non-accredited investors.
Additionally, once an issuer includes non-accredited investors in its offering, it is limited in its ability to later change its offering exemption. For example, by including non-accredited investors, the issuer is prohibited from later changing its exemption from Rule 506(b), which prohibits general solicitation, to Rule 506(c), which permits general solicitation so long as all investors are accredited. As such, an issuer will have less flexibility in its ability to raise capital should circumstances change in the course of fundraising.
Finally, there are also practical considerations for excluding non-accredited investors. Again, non-accredited investors are not high net worth individuals. In most cases, a $25,000 investment by a non-accredited investor will be one of the most significant financing decisions in his or her life, and such person is generally not able to bare the risk of loss without suffering some degree of financing distress. As a result, these investors may be more likely to demand information about the status of their investment, more critical of management if the enterprise is underperforming, and more litigious in the event the enterprise fails. By contrast, high net worth and sophisticated investors understand the risks associated with their investment, have multiple similar investments outstanding at any given time, and can bear the risk of loss of any one investment without financing distress.