First time participants in the world of crowdfunding have a lot of new terms to learn and fast. Before raising capital, it is critical to understand the vocabulary that investors will use and common clauses that you may see in a term sheet. Failure to properly understand the language of capital raising could spell disaster for you and your company. In this post we will review one category of investor that you are sure to encounter throughout your crowdfunding journey: the accredited investor.
If you are going through many of the popular equity and debt crowdfunding sites you will certainly come across the term “accredited investors”. This is usually preceded by “investments only offered to”. So, who are these accredited investors and why are they the only ones allowed to participate in your offering?
An accredited investor is a person or entity that is allowed to invest in securities that are not registered with the Securities and Exchange Commission (SEC). While investing in any security carries risk, those that are not registered carry additional risk due to the lack of publicly available information. Companies may opt to issues securities under an existing regulation, such as Reg D, to avoid the timely and expensive process of a full-blown IPO and registration with the SEC. Those companies that do issue under an exemption are typically restrained to only selling securities to accredited investors.
To be an accredited investor, a person must meet the following requirements:
• Earned income exceeding $200,000 if single or $300,000 together with a spouse in each of the prior two years and an expectation to make the same amount in the current year OR
• Having a net worth over $1 million, excluding the value of the primary residence
Institutions such as banks, partnerships, and corporation may also be considered accredited investors. These entities may also be required to meet the following requirements:
• If a trust, then total assets must exceed $5 million, the trust cannot be formed to specifically purchase the securities, and the purchase must be guided by a sophisticated person OR
• Any other entity in which all the equity owners must be accredited investors
While the above requirements may seem to exclude many would-be investors, it is important to understand why the SEC creates rules. Their job, in a nutshell, is to protect investors. Investing in unregistered securities is risky and the accredited investor rules have been designed to protect those who may not be in a position to sustain the economic risk that comes with this asset class.
When raising funds from accredited investors it is not enough to simply take the investor’s word that they are accredited. The SEC requires that issuers take reasonable steps to verify the status of each investor. The issuer has a few choices when going about the verification.
1. Principles Based Verification
The issuer can make a determination as to the investor’s status by considering 1) the nature of the purchaser 2) the amount and type of information available about the purchaser 3) the nature in which the investor came to the offering, and 4) the terms of the offering (i.e. minimum investment amount).
While this verification method seems simple, it also exposes the issuer to the risk that they did not conduct reasonable efforts to verify the investor. Should the SEC make this claim the entire offering could be in jeopardy.
2. Non-Exclusive Safe Harbor Verification
For issuers who do not want to take a chance with principles-based verification, the non-exclusive safe harbor method provides certainty of legal compliance. The issuer verifies the investor in one of three ways: i) verifies the person’s income by reviewing US tax returns; ii) reviews a US credit report for bank accounts, brokerage statements, real estate assets, and liabilities; iii) verification through a licensed third party or professional.
To satisfy the verification check investors can prove they meet the income exemption by providing tax returns or a letter from their accountant confirming their annual income. A professional letter from a registered broker-dealer, CPA, or attorney may also be used. However, investors should expect that these professionals will need to conduct their own due diligence to verify that the person is in fact accredited. Finally, a person who is a director, executive officer, or general partner of the issuer is considered an insider and also accredited.
Understanding who is considered an accredited investor and the responsibilities of the issuer can help you avoid costly mistakes as you begin your crowdfunding campaign. If you have more questions our team of experienced investment bankers are ready to assist. Get in touch with us now to discuss your crowdfunding needs.