When founders are raising money to get their startup off the ground, the Securities and Exchange Commission (SEC) is not typically on their mind. But this agency has a profound impact on who startups can receive investments from.
If you sell shares of stock in a company, you either need to register the offering with the SEC, which is onerous and expensive for an early-stage startup, or the sale of stock must fall within a specified exemption from registration.
The most common startup exemption requires companies to raise capital from “accredited investors.”
What Is an Accredited Investor?
Generally, an “accredited investor” is any of the following:
- An individual with at least $1 million in net worth, excluding the equity in their primary residence, at the time of purchase.
- An individual with at least $200,000 in income in the last two years and the expectation of the same in the year the investment takes place, or $300,000 with their spouse.
- A director, executive officer or general partner of the startup selling the securities.
- An individual with certain professional certifications, designations or credentials issued by an accredited educational institution, and certain clients of family offices.
- Certain “knowledgeable employees” of a private investment fund.
- An entity such as a business, family trust or charitable organization with $5 million or more in assets, or composed solely of other accredited investors.
Who Is Considered a Non-Accredited Investor?
A non-accredited investor is essentially everyone else. Non-accredited investors are individuals with less than $1 million in assets outside of their primary residence and an annual income below $200,000, or $300,000 with their spouse.
Don’t be too quick to accept funds from friends and family. While your biggest fans may be eager to support and contribute to your growing company, entrepreneurs need to know how to raise funds within the boundaries of the securities laws before taking money from anyone, including family and friends.
What About the 506(b)?
As mentioned above, in order for a startup to avoid registration with the SEC, the financing needs to fit under an exemption. By far the most common exemption for startups is the 506(c), which requires all investors to be accredited investors. The company must take reasonable steps to verify that all purchasers are accredited investors.
However, under Rule 506(b), the company is permitted to include up to 35 non-accredited investors in the round. But there’s a cost. If you take money from even one non-accredited investor, then your disclosure requirements go through the roof. The company will have to complete essentially the same amount of disclosure that it would if it were going through an initial public offering.
What About Equity Crowdfunding?
In 2016, Title III of the JOBS Act opened access to non-accredited investors in a vital way for startups. The JOBS Act eliminated minimum income and net worth thresholds. This elimination opened up equity crowdfunding, allowing non-accredited investors to privately invest in companies while creating new opportunities and a larger pool of potential funding for startups.
Note that equity crowdfunding is different from traditional crowdfunding platforms. Whereas traditional crowdfunding platforms like Kickstarter offer perks for funding a product or project, equity crowdfunding offers stock in the company in exchange for an investment.
A capital raise through Regulation Crowdfunding must meet the following requirements, among others:
- The funding must be raised through a registered broker-dealer or online portal approved by the SEC;
- There’s an upper limit of raising $5 million in a 12-month period;
- Though non-accredited investors may invest, they are subject to investment limits based on the greater of annual income and net worth;
- The company must file a Form C, including two years of financial statements that are certified, reviewed or audited, as required, with the SEC
Conclusion
Though it’s technically possible to raise funds from a non-accredited investor, the legal and regulatory costs almost always outweigh the benefits.
