The Rules on Who Can Invest in Your Startup May Be Changing!
The Securities and Exchange Commission (“SEC”) is taking a fresh look at the “accredited investor” definition with regard to Rule 506 (the securities registration exemption upon which most startups rely when raising angel and venture capital money). This could affect your ability to raise money for your startup.
For those who may be unfamiliar, any time a company sells stock or convertible promissory notes, even to “friends and family,” it is selling securities. The default rule is that any sale of securities must be registered with the SEC (a very long, expensive process). Recognizing that not all investors require the protections afforded with securities registration, the SEC has established a number of exceptions to the default rule. The most common exception to the default rule that is utilized by startups raising funds from angel investors and venture capitalists is the exception under the SEC’s Rule 506, which provides that a company may sell an unlimited amount of its unregistered securities to “accredited investors,” assuming other conditions to the rule are also satisfied.
Currently, the definition of “accredited investor” includes any individual who has income of at least $200,000 per year individually (or at least $300,000 of joint income per year with a spouse), or has a net worth of at least $1,000,000 (not including the value of such person’s primary residence). The definition of “accredited investor” also includes a list of specifically enumerated entities that may qualify as well.
This means that, assuming you’ve satisfied the other requirements of Rule 506, you can sell an unlimited number of your startup’s unregistered securities to individuals who meet the income or net worth thresholds and to entities included in the list enumerated by the SEC. The idea is that high net worth individuals and business entities have the financial resources and sophistication to be able to evaluate the merits of an investment in unregistered securities, and can “fend for themselves” without needing the investor protections the SEC provides through securities registration.
Why is the SEC Considering a Change?
There are a few reasons the SEC is taking a fresh look at the “accredited investor” definition and considering making a change. One reason is that the Dodd-Frank Act requires the SEC to review the “accredited investor” definition, as it applies to natural persons, every four years. The other reason is, since its adoption in 1982, the SEC has not made any significant changes to the “accredited investor” definition. As a result, general inflationary effects have significantly expanded the pool of “accredited investors.” In the SEC’s view, the current financial thresholds may be too low to ensure that those who qualify are financially stable and/or sophisticated enough to be able to “fend for themselves.” Further, various studies have been conducted over the years that have shown that wealth alone might not necessarily be the best indicator of one’s ability to “fend for itself.” The SEC is tasked with protecting investors, and it is looking for an “accredited investor” definition that accomplishes this goal.
What Kinds of Changes is the SEC Considering? In a recent report by the SEC staff, the staff made several recommendations for changing the “accredited investor” definition both as it relates to natural persons and as it relates to entities. Some of the recommendations that the SEC staff made for revising the definition as it relates to natural persons are:
- to leave the thresholds as they are, but subject them to investment limitations (e.g., investors may only invest up to 10% of prior year’s income or 10% of net worth);
- increase the financial thresholds to account for inflation (e.g., $500,000 of income for individuals and $750,000 of joint income; $2,500,000 for net worth);
- index all financial thresholds for inflation on a going-forward basis;
- permit individuals with a minimum number of investments in unregistered securities to qualify as accredited investors (this would mean if an investor had made a minimum number of investments in securities that weren’t registered under an exemption other than Rule 506, such investor could qualify);
- permit individuals with certain professional credentials to qualify as accredited investors (e.g., if they have passed the FINRA Series 7, Series 65 or Series 82 exams, they may qualify);
- permit individuals who have passed an accredited investor exam to qualify as “accredited investors” (this would be a newly created test that would be administered by the SEC or some other body and might include portions of FINRA’s Series 7 and Series 82 exams).
As it relates to entities, the SEC staff recommended that the SEC replace its current $5,000,000 of assets threshold for certain types of qualifying entities with a $5,000,000 of investments threshold and to include all “entities” rather than specifically enumerated entities (currently, entities such Indian tribes, quasi-governmental entities, limited liability companies and other newer or less common entity types are not specifically enumerated in the SEC’s definition of “accredited investor”).
What This Means for Startups and Investors If the SEC adopts the suggestions made by the SEC staff in the recent report, it could significantly alter who is eligible to invest in early stage startup companies. If the SEC adopts only the changes to the financial thresholds, without adopting any of the other proposed avenues for potential investors to become “accredited,” the pool of potential investors for startups will shrink dramatically.
One very thoughtful proposal that the SEC staff made in its report is to grandfather in existing investors under the current definition with respect to a company’s future securities offerings. Meaning, if a company has a current investor who qualified as an “accredited investor” at the time she made her investment in the company, but no longer qualifies under the new definition, she can be grandfathered in to be eligible to invest in future rounds of financing for that company.
Whether the SEC will adopt any of the suggestions from the recent staff report remains to be seen. Over the years, the SEC has considered, but not ultimately adopted, several revisions to the “accredited investor” definition. Further, the SEC usually works at a snail’s pace when it comes to rules revisions and adoption, so the revision process will likely be a long one, and any changes are likely to be several months or years away.
We will provide any updates on the SEC’s process of reviewing and revising the “accredited investor” definition here, as they become available. You can read the SEC’s full report here: https://www.sec.gov/corpfin/reportspubs/special-studies/review-definition-of-accredited-investor-12-18-2015.pdf.