How To Not Take Money From Unaccredited Investors
This write-up was originally sent to subscribers as a part of our Mission Control weekly insights, a series where we share wisdom and quick breakdowns on topics from our entrepreneur support network.
Founders are often tempted to take early money from people in their network who may not be accredited investors. While there are technical paths to do so, it is rarely ever a good idea outside of a Regulation Crowdfunding exemption.
What’s the Big Deal?
When a startup raises money by selling ownership in their business—equity or the promise of equity in the future—they are selling securities. The Securities and Exchange Commissions (”SEC”) has many regulations around who can buy and sell securities and what processes must take place in order to do so. The few options outside of a Reg CF exemption that allow for unaccredited investors to buy securities are so onerous and expensive that they aren’t cost effective when raising small amounts of money (like the amount of money a founder could typically raise from unaccredited investors in their network). The company can still take money from such individuals through a loan, but not in exchange for securities.
The Details
When a startup sells securities, by default, it is supposed to register them with the SEC. Registering securities is an incredibly time and money intensive process—effectively an IPO—that virtually no early stage company can afford or would want to. Obviously startups raise money through securities sales, often several times, so how do they not run afoul of the SEC? The SEC makes certain exemptions available for companies to sell securities without registering them, as long as certain criteria are met.
The most common exemption startups use to sell securities is called 506(b), which establishes a “safe harbor” wherein companies can raise unlimited amounts of money from an unlimited number of accredited investors.
The SEC defines an accredited investor as an individual with a net worth of over $1M not including their primary residence or an annual income of $200k in the last two years with a reasonable expectation of that continuing. There are some other criteria around licenses and certification but the monetary criteria are the most commonly used.
So, if you’re only raising from accredited investors you can establish safe harbor under the 506(b) exemption by filing a notice called Form D, and get on with your round. But what if unaccredited individuals want to invest? If you read the fine print on the 506(b) you’ll see there is the potential to sell securities to up to 35 unaccredited investors, however, by doing so the company now has to provide more disclosures and financial information to those investors and all other investors as well. While that might not sound bad, the level of disclosure required is the same as a Regulation A offering which is extensive. Providers that help founders facilitate a Reg A offering charge startups $350k+ to do so; that’s not the kind of costs a startup can or should bear to take small checks.
There are other SEC exemptions that seem like they might allow for unaccredited investors, but each one has a similar ‘gotcha’ as above. Here’s a quick breakdown:
- Regulation A—as above, massive disclosure and facilitation costs
- Rule 504—startups can raise up to $10M from any investors, however, they have to obey state by state laws and regulations (often called “blue sky” laws). As soon as you’re dealing with just a few states, compliance is costly and time consuming: legal research, investor communications, timing, and filing. You’ll spend $20k to raise $20k.
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What should you do?
So what does a startup that has interest from unaccredited investors do? Just leave the money on the table? There are two possible ways for two very different situations: a loan, or a Regulation Crowdfunding round.
In the case of a loan, that is best fit for small amounts in an early “Friends and Family” style funding. While those unaccredited individuals won’t be able to buy securities, they can help the company get off the ground with some initial capital. It’s a bummer they cannot participate in the upside if things go well, but the SEC’s laws are trying to protect people from taking too much risk. Startups are incredibly risky investments that are extremely illiquid; even accredited individuals are only recommended to have 5-10% of their net worth in high risk alternative assets, so if an investor is not accredited even a few thousand is a significant chunk of their finances.
It is worth noting you might find people who do seem to have that capital to risk but don’t know they are accredited. A lot of people don’t have an exact figure on their personal net worth and don’t think of things like stock or stock options in a past or current employer. It’s very possible someone who worked at a big company or late stage startup for several years has a bunch of vested, but potentially illiquid, options in the company. Those can still contribute to their net worth as well as people who own rental real estate, ownership in other businesses, etc.
The second way to raise from unaccredited investors is a Regulation Crowdfunding round. That is best fit for startups that already have a decent footprint of awareness and a ‘community’ around their venture. It is a way to sell securities to anyone, as long as you work through an SEC-registered intermediary: a crowdfunding platform like WeFunder, StartEngine, Republic, or a broker/dealer. They will help you make sure you obey all the rules for the offering and provide a place to send investors to invest. These platforms expect the startup to bring the majority of the investors from their own marketing and networking capabilities. These kinds of rounds are not intended as a way to take just a few checks from F&F as most platforms have a $50k minimum.
It’s a lot! Getting help to know if you can take money, how to do it properly, and why all of that matters is a hard part of the startup process. That’s why we built Mission Control and the Peachscore + Gust Data-Driven Accelerator. It gives you access to the collective knowledge of people who have navigated these processes with thousands of startups in a multitude of different contexts. We help you cut through the noise, understand what matters, and avoid making the avoidable mistakes that jeopardize your mission.
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This article is intended for informational purposes only, and doesn't constitute tax, accounting, or legal advice. Everyone's situation is different! For advice in light of your unique circumstances, consult a tax advisor, accountant, or lawyer.