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