When raising capital, startups and growing businesses must choose among various terms, structures, filings, and investor types. One decision—whether to include unaccredited investors—should be straightforward. For the reasons outlined below, companies should allow only accredited investors to participate in fundraising.
What Is an Accredited Investor?
An accredited investor can be an individual or an entity. An individual qualifies as accredited if they meet one of the following criteria:
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Have a net worth of at least $1,000,000 (excluding the value of their primary residence).
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Earn at least $200,000 per year for the last two years (or $300,000 combined income if married or with a spousal equivalent) and expect to make the same amount this year.
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Hold specific financial professional certifications (Series 7, 65, or 82 licenses).
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Work as a knowledgeable employee of a private fund (e.g., officers, directors, or employees involved in investment activities).
Entities qualify as accredited if all their equity holders are accredited investors or hold more than $5,000,000 in assets. Additionally, SEC-registered investment advisers, rural business investment companies (RBICs), and family offices with at least $5 million in assets now qualify as accredited investors.
Anyone who does not meet these standards falls into the category of unaccredited or non-accredited investors.
How Securities Sales Are Regulated
U.S. federal securities laws require companies to either register securities sales with the SEC or issue them under an exemption. Private offerings typically use Regulation D (Reg D) exemptions, which are divided into various rules:
Rule 504
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Provides an exemption for offering and selling up to $10,000,000 in securities within 12 months.
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Unlike other exemptions, it allows a private sale without specific disclosure requirements (though anti-fraud provisions still apply).
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Permits sales to an unlimited number of accredited and unaccredited investors.
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It does not provide federal preemption from state Blue Sky laws, requiring issuers to comply with state securities registration and qualification rules.
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Before October 26, 2016, Rule 504 capped sales at $1,000,000. The 2016 amendments also eliminated Rule 505.
Rule 506(b) and 506(c)
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Rule 506(b) permits sales to up to 35 non-accredited investors, but they must demonstrate sophistication in evaluating the investment's risks and merits.
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Rule 506(c) allows general solicitation and advertising but limits participation to accredited investors.
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Both rules preempt state securities laws, offering broad exemptions from state registration requirements. However, issuers must still comply with notice filings and pay fees in some states.
Why Companies Should Avoid Unaccredited Investors
While including unaccredited investors may seem appealing, it creates several challenges that could hinder your business's growth and legal compliance:
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Disclosure Requirements: Under Rule 506(b), companies must provide non-accredited investors with extensive disclosures, including audited financial statements, which increases costs and complexity.
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Preemptive Rights Risks: If a company grants investors the right to participate in future financing rounds, unaccredited investors could create compliance issues later.
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IPO Implications: The SEC scrutinizes prior securities issuances during an IPO. Past sales to unaccredited investors could require corrective actions, delaying or jeopardizing the IPO.
Can Foreign Investors Qualify as Accredited?
Foreign investors, including those in Canada, can qualify as accredited investors if they meet U.S. standards. However, companies must:
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Verify accreditation under U.S. rules, which differ from Canadian standards.
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Comply with foreign securities laws that may impose additional reporting requirements.
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Manage potential tax and compliance complications when accepting foreign capital.
This process differs from a Regulation S (Reg S) offering, which applies only to securities offerings conducted outside the United States.
Final Thoughts: Why Stick with Accredited Investors?
For most emerging companies, limiting participation to accredited investors remains the best approach. Accepting funds from non-accredited investors increases legal exposure, costs, and potential obstacles in future fundraising rounds. By restricting offerings to accredited investors, companies can minimize risks and maintain flexibility for future capital raises.
Before you move forward with any fundraising efforts, it's critical to consult with an attorney to ensure your business is compliant with all U.S. and international regulations. Taking these precautions now will help position your business for long-term success and keep your capital-raising efforts on track.
