Unfortunately, the Securities and Exchange Commission (SEC) does not allow a startup to raise capital from just anyone. Startups should only fundraise from Accredited Investors.
First, it’s important to understand some basic concepts. The general SEC rule is that if you are raising money, you need to register with the SEC—an incredibly expensive process. But the good news is that there are exemptions to that rule for startups under Regulation D, known as Reg D. In order for the exemption to apply, the startup must meet certain criteria, including only allowing “accredited investors” to invest in the company.
So who are these accredited investors? The major categories of accredited investors include:
- certain institutional investors (e.g., banks and SEC-registered investment companies and broker-dealers),
- certain business entities with assets greater than $5 million,
- certain entities (including Native American tribes, governmental bodies, funds, and entities organized under the laws of foreign countries) that own investments in excess of $5 million,
- directors and officers of the seed stage startup, and
- individuals with annual incomes greater than $200K (individually) or $300K (household), or a joint net worth of greater than $1 million (excluding equity value of primary residence).
Securities law assumes accredited investors that meet the above criteria are sufficiently sophisticated, knowledgeable parties that do not require any additional disclosures. But they assume that people that do not meet the accredited investor standard might be easily tricked, so they require much more disclosure.
The quickest, cheapest ways to raise money for your startups under the Reg D exemption are Rule 506(b) and Rule 506(c). Under 506(c) non-accredited investors are barred from investing. Period.
Under Rule 506(b), you can also take investments from accredited and non-accredited investors, but there’s a huge catch. In a 506(b) offering, if you want to take funds from even one non-accredited investor, your disclosure obligations go through the roof (and your legal bills do as well). By taking just one non-accredited investor, you can easily triple your legal expenses. In practice, it’s not worth it.
Putting forth that amount of money and time just to raise a small amount of funds from a small amount of non-accredited investors is just not worth it.
In the Series Seed term sheet, the purchasers are listed as follows:
Purchasers: [Accredited investors approved by the Company] (the “purchasers”).
Thus, the startup will only take investments from accredited investors it approves.