RAISING STARTUP CAPITAL: BEWARE THE PITFALLS
Seeking
capital for a start-up business is daunting but full of traps. Before offering
to sell any equity to friends, family or others, determine if the y qualify as "accredited
investors." Federal and state securities laws, rules and regulations are a legal trap for the unwary if
non-recourse equity investment is offered or sold regardless of whether in a
large publicly-traded company or a “Mom and Pop” startup. Selling equity only
to accredited investors provides a safe harbor
from running afoul of these laws.. Most state securities laws defer to
the rules on accredited investors promoted by the Securities and Exchange
Commission ("SEC").
· Under SEC law, absent an exemption, a
company that offers or sells its securities must register those securities with
the SEC. Some popular exemptions from this registration requirement include
selling securities pursuant to Rules 505 or 506 of the SEC's Regulation D.
However, offerings made to non-accredited investors are subject to
significantly more burdensome requirements than offerings made to accredited
investors. Among other things, a non-accredited investors must be provided with
a significant amount of financial and other business information not required
to be disclosed to accredited investors.
An
accredited investor is a person or entity that meets specified requirements
established by federal and state securities regulators. Generally speaking,
these requirements are intended to distinguish between investors who have
sufficient financial and business acumen such that minimal regulatory oversight
is warranted and investors who lack that acumen such that more regulatory
oversight is warranted for the investors' protection.
Under
federal securities law, with respect to a natural person, an accredited
investor must have a annual income or net worth. To satisfy the income test,
the person must have earned income in excess of $200,000 in each of the prior
two years and reasonably expects the same for the current year. The income test
may also be satisfied if the person's joint earned income with his or her
spouse was in excess of $300,000 in each of the prior two years and the person
reasonably expects the same for the current year. To satisfy the net worth
test, the person must alone or jointly with his or her spouse have a net worth
in excess of $1,000,000. There are certain assets and liabilities that are
excluded from this net worth calculation, including the value of the person's
primary residence and the value of any mortgage on the residence up to the fair
market value.
Under
federal securities law, an entity can also be an accredited investor. Depending
on the nature of the entity, different standards may apply. As a catch-all,
though, any entity in which all of the equity owners are accredited investors
qualifies as an accredited investor entity.There are
other criteria involving the definition of accredited investor under federal
and state securities law, including conditions on the sale and offer of
securities, whether to accredited investors or not, including limitations on
the number of investors or amount of the offering and restrictions on the
ability to resell issued securities. Consider requiring potential investors to
fill out investor questionnaires
disclosing information regarding their income and net worth. Investors should
also complete subscription agreements disclosing their accredited investor
status, along with representations and warranties regarding their
qualifications as accredited investors.
Although
compliance with federal and state securities law may see onerous, future rounds
of investors will want evidence and assurance that you and your company complied
with securities law