Who is an accredited investor and what is the significance of being an accredited investor? As a starting point, the definition of an accredited investor is contained in Regulation D, part of the private offering rules of the US Securities and Exchange Commission. Under that definition, an accredited investor is someone:
- With a net worth at time of purchase of more than one million dollars (may include spouse’s assets), excluding the value of their primary residence; or
- With an annual income over $200k in each of the last two years, or joint income over $300k in those years, and reasonable expectation of same income in the current year; or
- Who is a director or executive officer of the company issuing securities.
One of the biggest misconceptions among companies conducting a private offering is thinking that it is generally illegal to sell to unaccredited investors. This is true in one case: an offering under Rule 506(c) of Regulation D, which is an exemption added by the JOBS Act in 2012. It is one of the few private offering exemptions that permits general solicitations (e.g., newspaper ads, postings to general web sites, etc.). When the 506(c) exemption was added, the intention of lawmakers was to prevent fraud and abuse while allowing companies to engage in general solicitation. Investors for these offerings must be accredited investors, since they presumably have the sophistication to make such investments.
However, 506(c) offerings are the exception when it comes to accredited versus unaccredited investors. Under most private offering rules, sales to accredited investors are allowed. However, while those sales may be allowed it is often inadvisable – for several reasons. A key reason is that accredited investors typically have the sophistication to make a proper judgment about the suitability of the investment and have the financial resources to withstand loss of the investment funds. In contrast, unaccredited investors are typically less sophisticated and more likely to suffer substantial financial stress and harm if the investment is not successful. For those reasons, unless the investment is highly successful, there is a much greater risk of legal claims from disgruntled investors when accepting funds from unaccredited investors.
Another important point about unaccredited investors relates to Rule 506(b), which is an often-utilized private offering exemption. One of the reasons for the appeal of Rule 506(b) is that the company can raise an unlimitedamount of investment (not bad for a private offering!). Rule 506(b) permits sales of securities to an unlimited number of accredited investors and a maximum of thirty-five unaccredited investors. However, if selling to any unaccredited investor under Rule 506(b), the company must provide the investor with detailed disclosure information, which typically includes audited financial statements. These extensive disclosure requirements are often impractical for an early-stage company to provide. As a result, while sales to unaccredited investors are permitted under Rule 506(b), it is rarely (if ever) advisable or practical to do so.
Based on the various points mentioned above, in a wide number of private offerings, sales to unaccredited investors are technically permitted but generally not advisable. For these and other reasons, the typical offering is limited to accredited investors, but in many cases more for practical than purely legal restriction issues.
Another misconception that I encounter is the belief that if issuers sell only to accredited investors, they don’t need to be concerned with other aspects of federal securities compliance. This is a HUGE mistake. All offerings of securities, regardless of the exemption or the nature of the investors, are subject to the antifraud provisions of the securities laws. This means that if the investment is not successful and the investor loses his or her investment, the company and its principals will likely be the targets of lawsuits brought by those investors. The typical claims in this situations relate to misrepresentation of the company regarding certain facts or failure to disclose other key facts. For this reason, regardless of the type of offering and to whom it is marketed, it is vital for the company to work with legal counsel to ensure proper written disclosure is in place regarding such items as the experience of the management team, the competitive landscape, planned use of the investment funds, and other items of concern to investors, as appropriate.