Can’t I Let Non-Accredited Investors In My Round?

non-accredited investorI was recently pressed by someone, “Can’t I let non-accredited investors in my Rule 506(b) round? The rule says that I can have up to 35 non-accredited investors.”

While it is true that Rule 506(b) says you can have up to 35 non-accredited investors, it goes on to say that if you allow even 1 non-accredited investor in your round you have to comply with very detailed and comprehensive disclosure obligations. In contrast, if you are raising money from only accredited investors, there are no specific disclosure obligations required.

Rule 502(b) states, “The issuer is not required to furnish the specified information to purchasers when it sells . . .to any accredited investor.” Whereas non-accredited investors require “disclosure documents that are generally the same as those used in registered offerings.” (See Rule 502 and a reference to the second quote, Rule 506)

[C]ompanies must give non-accredited investors disclosure documents that are generally the same as those used in registered offerings.

When you read, “disclosure documents that are generally the same as those used in registered offerings”–read, you are going to have to incur a lot of expense. More than you will typically desire to incur based on the amount of investment from non-accredited investors that you will receive. This is one of the reasons why startups in my experience almost always limit their fundraising to all accredited investor offerings.

Another reason, a new one, is that if you generally solicit your offering under Rule 506(c), you can’t accept funds from any non-accredited investors. The potential trouble is this–if you are conducting what you plan to be a Rule 506(b) offering, you might change your mind mid-stream and decide that you want to generally solicit and generally advertise your offering. If you had accepted any non-accredited investors in your round, you would not be able to do this. Thus, accepting any non-accredited investors will inhibit your flexibility going forward.

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  • http://twitter.com/equitrend Equitrend Capital

    Thanks for this post – perfect explanation.

    • http://startuplawblog.com/joewallin Joe Wallin

      Thanks for your comment!

  • http://wac6.com/ William Carleton

    Joe, I agree with you.

    It seems to me that if one is going to sell to a nonaccredited investor, one probably ought to go ahead and structure and conduct the offering so that it meets the requirements (and submits to the limits) of Rule 504 and steers clear of 506.

    True, going with 504 means your deal can raise no more than $1 million, and that you are going to have to deal with one or more states. But that’s the practical cost of dealing with nonaccredited investors.

    Let’s also suppose that the existing 506 survives as 506(b) (recall that as part of the JOBS Act, 506 offerings that involve general solicitation can only have accrediteds as purchasers – no room for non-accrediteds at all, not even theoretically). I think the parallel existence of 506(c) makes it even tougher, practically, to include non-accrediteds in a 506 deal. Then you have no backstop with 506(c) in case you blow the 506(b) prohibition on general solicitation.

  • lunarmobiscuit

    Thanks for the answers to this, as I get asked quite often about these rules by entrepreneurs. However…

    One then wonders how many companies have managed to raise money from non-accredited investors, despite these rules?

    1- One well known social enterprise (withholding their name in case the SEC feels like investigating) knowingly has raised money via Rule 506, complying with the 35 investor limit (per round) and in terms of disclosures, focusing on the terms “generally the same”, interpreting “generally” to be different from “exactly”. All that said, they are not out taking money from anyone, instead individually vetting each non-accredited investor to document that they are “sophisticated”.

    2- The “Slow Money” movement of patient capital investing is making its way around the country, and many in those groups are non-accredited, and these groups are making investments in private companies.

    3- Of the half million startups created per year, most take money from friends and family. Whether that funding is as loan or equity, legally these rules still apply. And nothing in these rules have an exemption for friends or family. You cover that fact in http://www.startuplawblog.com/2010/08/23/is-there-a-friends-and-family-securities-law-offering-exemption/

    A few lawyers have pointed out to me that the risk associated with the specifics in these laws come down only when companies fail. As long as everything is going well, investors don’t complain about the financial reporting, etc. But upon failure, some litigious investors seek a return however they can, putting not only the company at risk, but also the lawyers who filed the paperwork.

    That seems to be the key on why #3 above works in practice, as nearly all friends and family take their losses without umbrage. Similarly, the Slow Money investors know they are taking risks, and to-date are handling their losses with grace.

    Taking money from any unknown non-accredited investors opens up a risk via that relationship, along with opening a risk that the SEC will come calling. For most, those risks are far too high. But going back to the opening question, if only we had some more accurate reporting to the true nature of private investing, we might find this risk-adverse position is actually in the minority of transactions.

    • http://startuplawblog.com/joewallin Joe Wallin

      Michael, the trouble is, of course, if you don’t comply with the law you can be personally liable to investors, and potentially even criminally liable. Oliver Wendell Holmes perhaps said it best, when you deal with the government, you have to turn square corners.

      • lunarmobiscuit

        That concept I well understand. And while I in no way advocate anyone breaking the law, I have no qualms in running up to, but not across the gray line, when in a law such as this, there are terms like “generally like”, interpretable in multiple ways.

        Certainly, the simplest path is the commonly spoken of (and seemingly most common) path of sticking 100% with accredited investors. But after sixty years of venture capital, and a modern world with well over 500 Angel investment groups and daily news of startups and daily use of their products, it seems time to push these traditional paths. All while keeping within the law.

        For example, it seems reasonable to create a means to quality all investors as “sophisticated” (similar to but more deeply than we ask investors to accredit themselves), and to have them agree upon investing (a) to a set of well-defined financial reports, and (b) to agree to indemnify the company to that and other specified clauses of Rule 506. Such steps would then be in keeping with the law, and lower the risks associated with the reporting criteria.

        I’m still not sure that such efforts and any risk is worth the trouble for 35 investors, but for some companies, it might be.

        • http://startuplawblog.com/joewallin Joe Wallin

          The phrase generally like comes from the SEC summary page. The rules themselves are very detailed as to what is required.

          • lunarmobiscuit

            Ah ha! I think we found the crux of the issue, and it’s a knowledge gap, or two.

            First gap, most entrepreneurs don’t know the details of Rule 506, such as the specification for up to 35 non-accredited investors.

            Second, once they find out about that fact, they then don’t know to look within a separate document to find these ivied definition of “generally the same”, which otherwise appears vague.

            Given it’s the 21st Century, with the Web in existence over 20 years, I wonder why the SEC’s page on Rule 506, nor any other I found, doesn’t have a link from those words to the appropriate SEC summary.

            Hasn’t anyone created WikiLaw yet to make this easy on you lawyers?

          • http://startuplawblog.com/joewallin Joe Wallin

            yeah, you can find the rules here: http://www.ecfr.gov/cgi-bin/text-idx?c=ecfr&sid=20c66c74f60c4bb8392bcf9ad6fccea3&rgn=div5&view=text&node=17:2.0.1.1.12&idno=17#17:2.0.1.1.12.0.42.177

            See specifically Section 502(b):

            (b) Information requirements —(1) When information must be furnished. If the issuer sells securities under § 230.505 or § 230.506 to any purchaser that is not an accredited investor, the issuer shall furnish the information specified in paragraph (b)(2) of this section to such purchaser a reasonable time prior to sale. The issuer is not required to furnish the specified information to purchasers when it sells securities under § 230.504, or to any accredited investor.

            Note: When an issuer provides information to investors pursuant to paragraph (b)(1), it should consider providing such information to accredited investors as well, in view of the anti-fraud provisions of the federal securities laws.

            (2) Type of information to be furnished. (i) If the issuer is not subject to the reporting requirements of section 13 or 15(d) of the Exchange Act, at a reasonable time prior to the sale of securities the issuer shall furnish to the purchaser, to the extent material to an understanding of the issuer, its business and the securities being offered:

            (A) Non-financial statement information. If the issuer is eligible to use Regulation A (§ 230.251-263), the same kind of information as would be required in Part II of Form 1-A (§ 239.90 of this chapter). If the issuer is not eligible to use Regulation A, the same kind of information as required in Part I of a registration statement filed under the Securities Act on the form that the issuer would be entitled to use.

            (B) Financial statement information —( 1 ) Offerings up to $2,000,000. The information required in Article 8 of Regulation S-X (§ 210.8 of this chapter), except that only the issuer’s balance sheet, which shall be dated within 120 days of the start of the offering, must be audited.

            ( 2 ) Offerings up to $7,500,000. The financial statement information required in Form S-1 (§ 239.10 of this chapter) for smaller reporting companies. If an issuer, other than a limited partnership, cannot obtain audited financial statements without unreasonable effort or expense, then only the issuer’s balance sheet, which shall be dated within 120 days of the start of the offering, must be audited. If the issuer is a limited partnership and cannot obtain the required financial statements without unreasonable effort or expense, it may furnish financial statements that have been prepared on the basis of Federal income tax requirements and examined and reported on in accordance with generally accepted auditing standards by an independent public or certified accountant.

            ( 3 ) Offerings over $7,500,000. The financial statement as would be required in a registration statement filed under the Act on the form that the issuer would be entitled to use. If an issuer, other than a limited partnership, cannot obtain audited financial statements without unreasonable effort or expense, then only the issuer’s balance sheet, which shall be dated within 120 days of the start of the offering, must be audited. If the issuer is a limited partnership and cannot obtain the required financial statements without unreasonable effort or expense, it may furnish financial statements that have been prepared on the basis of Federal income tax requirements and examined and reported on in accordance with generally accepted auditing standards by an independent public or certified accountant.

            (C) If the issuer is a foreign private issuer eligible to use Form 20-F (§ 249.220f of this chapter), the issuer shall disclose the same kind of information required to be included in a registration statement filed under the Act on the form that the issuer would be entitled to use. The financial statements need be certified only to the extent required by paragraph (b)(2)(i) (B) ( 1 ), ( 2 ) or ( 3 ) of this section, as appropriate.

            (ii) If the issuer is subject to the reporting requirements of section 13 or 15(d) of the Exchange Act, at a reasonable time prior to the sale of securities the issuer shall furnish to the purchaser the information specified in paragraph (b)(2)(ii)(A) or (B) of this section, and in either event the information specified in paragraph (b)(2)(ii)(C) of this section:

            (A) The issuer’s annual report to shareholders for the most recent fiscal year, if such annual report meets the requirements of Rules 14a-3 or 14c-3 under the Exchange Act (§ 240.14a-3 or § 240.14c-3 of this chapter), the definitive proxy statement filed in connection with that annual report, and if requested by the purchaser in writing, a copy of the issuer’s most recent Form 10-K (§ 249.310 of this chapter) under the Exchange Act.

            (B) The information contained in an annual report on Form 10-K (§ 249.310 of this chapter) under the Exchange Act or in a registration statement on Form S-1 (§ 239.11 of this chapter) or S-11 (§ 239.18 of this chapter) under the Act or on Form 10 (§ 249.210 of this chapter) under the Exchange Act, whichever filing is the most recent required to be filed.

            (C) The information contained in any reports or documents required to be filed by the issuer under sections 13(a), 14(a), 14(c), and 15(d) of the Exchange Act since the distribution or filing of the report or registration statement specified in paragraphs (b)(2)(ii) (A) or (B), and a brief description of the securities being offered, the use of the proceeds from the offering, and any material changes in the issuer’s affairs that are not disclosed in the documents furnished.

            (D) If the issuer is a foreign private issuer, the issuer may provide in lieu of the information specified in paragraph (b)(2)(ii) (A) or (B) of this section, the information contained in its most recent filing on Form 20-F or Form F-1 (§ 239.31 of the chapter).

            (iii) Exhibits required to be filed with the Commission as part of a registration statement or report, other than an annual report to shareholders or parts of that report incorporated by reference in a Form 10-K report, need not be furnished to each purchaser that is not an accredited investor if the contents of material exhibits are identified and such exhibits are made available to a purchaser, upon his or her written request, a reasonable time before his or her purchase.

            (iv) At a reasonable time prior to the sale of securities to any purchaser that is not an accredited investor in a transaction under § 230.505 or § 230.506, the issuer shall furnish to the purchaser a brief description in writing of any material written information concerning the offering that has been provided by the issuer to any accredited investor but not previously delivered to such unaccredited purchaser. The issuer shall furnish any portion or all of this information to the purchaser, upon his written request a reasonable time prior to his purchase.

            (v) The issuer shall also make available to each purchaser at a reasonable time prior to his purchase of securities in a transaction under § 230.505 or § 230.506 the opportunity to ask questions and receive answers concerning the terms and conditions of the offering and to obtain any additional information which the issuer possesses or can acquire without unreasonable effort or expense that is necessary to verify the accuracy of information furnished under paragraph (b)(2) (i) or (ii) of this section.

            (vi) For business combinations or exchange offers, in addition to information required by Form S-4 (17 CFR 239.25), the issuer shall provide to each purchaser at the time the plan is submitted to security holders, or, with an exchange, during the course of the transaction and prior to sale, written information about any terms or arrangements of the proposed transactions that are materially different from those for all other security holders. For purposes of this subsection, an issuer which is not subject to the reporting requirements of section 13 or 15(d) of the Exchange Act may satisfy the requirements of Part I.B. or C. of Form S-4 by compliance with paragraph (b)(2)(i) of this § 230.502.

            (vii) At a reasonable time prior to the sale of securities to any purchaser that is not an accredited investor in a transaction under § 230.505 or § 230.506, the issuer shall advise the purchaser of the limitations on resale in the manner contained in paragraph (d)(2) of this section. Such disclosure may be contained in other materials required to be provided by this paragraph.

  • http://blog.jparkhill.com Jay Parkhill

    I try to point people to the audited financial statement requirement. Entrepreneurs readily underestimate the pain of developing a good prospectus, but they can more easily imagine the time & expense of an audit.

    • http://startuplawblog.com/joewallin Joe Wallin

      Thanks Jay. Good point.

 
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