How to Raise Money from Non-Accredited Investors (and Why You Shouldn’t)
Super common scenario: your startup is running out of money (because whose isn’t). Taking money from your mother-in-law or favorite uncle in exchange for something like a convertible note—a kind of loan that converts into equity when a specific milestone has been reached—can seem like a great solution.
You get the cash you need to keep the lights on. They get a great valuation and potential return on their investment.
Until you get to that milestone, like a Series A fundraising round, and those shares convert.
And that’s when you remember that your mother-in-law is NOT an “Accredited Investor”.
You had originally planned on side-stepping all of those onerous, expensive, and time-consuming registration and disclosure requirements that are required by the SEC for most public offerings. But now that you’ve thrown a non-Accredited Investor into the mix (i.e. your well-meaning mother-in-law), you’re faced with a sticky dilemma.
Get your mother-in-law to waive her participation rights (THAT’s not going to go well…and not just because it’s your mother-in-law)?
OR, find yourself embroiled in the expensive headache of complying with all sorts of additional SEC compliance requirements?
This is just one of the real and frequent situations that startup founders can find themselves in when they decide to work with non-Accredited Investors and don’t take the time to thoroughly evaluate the potential consequences.
That’s why if you ask any startup attorney if you should take money from non-Accredited Investors, you’ll almost always get a resolute “no.”
Here, we’ll talk about:
What an Accredited Investor is
If you can raise money from individuals who aren’t
And some of the pitfalls of doing so.
Then, you can decide for yourself whether it’s worth the risk.
What is an Accredited Investor?
To better understand this issue, we’ll need to talk about things like how and why the SEC regulates investment offerings, what the courts have had to say about it, and how new, smaller businesses can use various “safe harbors” that have been established—such as 504, 506(b), and 506(c) exemptions—to avoid the incredibly detailed and onerous laws and regulations that the law requires if you want to register your company’s shares for sale to the public.
But first, it helps to have an understanding of what an “Accredited Investor” is and why that matters.
The definition of an Accredited Investor primarily boils down to this—is a specific investor financially savvy and do they have the ability to bear a big financial loss?
The logic here is that if someone is an Accredited Investor, then, unlike John Q Public, they are presumed to have the capacity to safely make riskier investment decisions without as many disclosure requirements and SEC oversight as is required for offerings to the rest of the public.
While the definition of an “Accredited Investor” covers a lot of different situations, a good quick, non-exhaustive summary of who the SEC considers to be an “Accredited Investor” includes:
Any individual who has an individual net worth, or joint net worth with the individual’s spouse, that exceeds $1 million (the value of a primary residence is excluded from this calculation).
An individual with income exceeding $200,000 (or joint income with a spouse exceeding $300,000) in each of the two most recent years, and a reasonable expectation that their income will be the same for the current year.
A director, executive officer, or general partner of the company selling the securities.
A legal entity with $5,000,000 or more in assets.
A legal entity that does not hold at least $5,000,000 in assets but is owned entirely by other Accredited Investors (so be careful here, even one non-Accredited Investor will prevent the legal entity from qualifying as an Accredited Investor).
Can my startup raise money from non-Accredited Investors and how?
In short, yes. But the “how” begs a more thorough explanation.
Among other things, one of the ways that the SEC protects investors is by ensuring that anyone marketing and selling securities—like stocks, bonds, and other financial instruments—to the general public has to register with the SEC and provide adequate disclosures to investors. Companies that do this can then sell their shares on the public stock exchanges and so are known as “public companies.”
This is an extremely time-consuming, onerous, and expensive process, even for huge companies, and almost always practically impossible for early-stage companies and startups. And every startup’s goal is usually to raise funds in the quickest, easiest, least risky, and lowest cost manner.
Recognizing this burden and its impacts on capital formation for some companies, the SEC crafted certain registration exemptions with (mostly) less onerous disclosure requirements, primarily for offerings that it considers “private,” rather than open to the general public.
As with most well-intended regulations, this carve-out created a lot of ambiguity. Because what exactly sets apart a public offering from a private one?
Over time, the courts considered various factors to distinguish a public from a private offering, including:
The issuing company’s relationship to the investing parties (are they close friends and family or complete strangers?),
How widely and by what means the offerings were communicated (broadly targeted advertising lends itself to the inference of a public offering, rather than opening up an investment opportunity to select friends and family),
The transferability of stock after the initial sale (more transferability creates a presumption that the stock was intended to be traded publicly),
How many securities were being offered and how much money was being raised (bigger numbers skew towards a public offering), and
The financial savvy of those investing and their ability to bear a financial loss.
The SEC ultimately codified its various rationales into specific safe harbor rules, including 504, 506(b), and 506(c). These safe harbors have been promulgated under Regulation D and often are referred to as simply “Reg D” offerings.
Importantly, whether your company can take advantage of one of these safe harbors turns, in part, on whether you are going to have any investors who would not qualify as Accredited Investors.
What are the Reg D registration exemptions and which ones allow non-Accredited Investors?
Rule 504: Exemption for Limited Offerings Not Exceeding $10,000,000
Rule 504 allows an unlimited number of non-Accredited Investors but only for annual sales (within a 12-month period) up to $10,000,000.
Why It’s Not So Great: The biggest drawback here is that while exempted from full registered offering disclosures by the SEC, you must still comply with state securities laws and regulations (also known as “Blue Sky” laws”) for each state in which you sell shares. If your investors reside in multiple jurisdictions, you will have to spend substantial legal resources on researching and meeting the Blue Sky requirements of each state. General solicitations are also not permitted under Rule 504.
2. 506(b): Exemption for Up to 35 Non-Accredited Investors
Rule 506(b) permits up to 35 non-Accredited Investors. (Hooray! Problem solved!)
Why It’s Not So Great: Before you get excited, know that all of those non-Accredited Investors are entitled to a suped-up set of disclosure materials, or as the SEC says it, “disclosure documents that are generally the same as those used in registered offerings,” including audited financials. You must also make yourself available to field questions and inquiries from those non-Accredited Investors. And if you are providing suped-up disclosure materials and information to your non-Accredited Investors, you must make them available for any participating Accredited Investors as well.
This means more time, money, and investor scrutiny, which runs contrary to the intentions of most people wanting to use a safe harbor exemption.
Rule 506(b) also prohibits the use of general solicitation in an offering. Advertising is permitted only to investors with a pre-existing relationship with the company.
3. Rule 506(c): Exemption for Investment by Accredited Investors Only
This safe harbor even allows the use of general solicitation in an offering, provided that the issuer takes reasonable steps to verify purchasers’ Accredited Investor status and certain other conditions in Reg D are satisfied.
Why It’s Not So Great: The catch with 506(c) is that you can only market or sell to Accredited Investors—no non-Accredited Investors are allowed. Those investors must also be actively verified as being Accredited Investors (much more scrutiny than is required for other safe harbors), usually through the use of a third-party platform that provides detailed investor financial information.
What About Equity Crowdfunding?
Equity crowdfunding might be another option for you, but it also usually entails considerable hassles, which are far outside the scope of this piece to discuss as thoroughly as it deserves (stay tuned for more on this). In addition, Equity Crowdfunding usually means using a pre-existing crowdfunding platform, which usually comes at a considerable expense.
These Rules Apply to More Than Just Shares
Remember that all of these exemptions cover not just shares but anything the law deems to be a "security"—including any of the SAFEs or convertible notes commonly used in friends & family and angel investment rounds. As long as those can convert into shares, they'll be securities under the law and these rules will apply.
Here’s a visual breakdown summarizing the details for each safe harbor:
Should my startup raise money from non-Accredited Investors?
So yes, your startup can seek investments from non-Accredited Investors.
But SHOULD you?
As you can see, 504 and 506(b) do offer the option to sell to non-Accredited Investors, but with considerable costs and limitations.
Here are some other considerations to keep in mind.
Impact on future fundraising rounds
Understandably, most private investors want to protect against a loss of control from share dilution in subsequent offerings. Any properly drafted deal terms will reserve participation rights to current investors in future fundraising rounds.
But perhaps in future rounds, you want to utilize a different safe harbor provision (one that does not include Accredited Investors). Or your non-Accredited Investors transfer their shares to other non-Accredited Investors so, in the case of 506(b), the number of non-Accredited Investors exceeds 35 and you are no longer eligible for this safe harbor.
As you can see, it’s important to be thoughtful BOTH about how you draft your participation rights in any financing agreements, AND in thinking about how including non-Accredited Investors can impact future fundraising efforts. It’s a problem that can easily follow your company around for years with no easy solution.
2. Attractiveness to future investors
Just as importantly, your decision today to accept non-Accredited Investors can hugely impact your attractiveness to investors in a future major fundraising round. Non-Accredited Investors introduce a lot more compliance risk into future fundraising rounds, which may very well impact what terms the investment gets or whether the investment is made at all.
Conclusion
CAN you include non-Accredited Investors in early fundraising efforts? Yes. But a good rule of thumb is to avoid them if you want the quickest, most efficient, and least expensive fundraising experience that introduces the least amount of future compliance risk and legal complications.
If you DO decide that accepting non-Accredited Investors is right for you, do it carefully, making sure you comply with the requirements of the registration exemption your company wants to use, and that your deal documentation is written properly to avoid potential issues going forward.