One common misconception I encounter among startups is the idea that companies raising capital can include non-accredited investors in Rule 506[1] offerings. While it is technically true that a Rule 506 offering may include up to 35 non-accredited investors, what is often missed is that it is not really practical to do so.
The main reason for this is set out in Rule 502(b), which requires that an issuer provide a large amount of information to potential investors who are not accredited investors. Generally, this information is roughly comparable to the type of information that would be provided in a small registered offering, including audited financials. Rule 502(b) goes on to strongly suggest that if an issuer provides such information to non-accredited investors but not to accredited investors, it could be deemed in violation of the anti-fraud provisions of securities laws. The practical effect of this requirement is that, if an issuer includes just one non-accredited investor in its offering, it will need to put together a very thorough offering document (even more thorough than most PPMs) and have the company’s financial statements audited. The combined legal and accounting cost could easily exceed $50,000, which usually wipes out any benefit of including non-accredited investors in the capital raise.
A second reason not to include non-accredited investors in a Rule 506 offering is that each non-accredited investor must, under Rule 506(b)(2)(ii), “either alone or with his purchaser representative(s) [have] such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment.” This section of the Rule also permits this condition to be met if the issuer reasonably believes that the non-accredited investor comes within this description. Many founders of startups assume this standard is easy to meet since they likely know plenty of people they consider “smart.” The problem is that who has and who doesn’t have sufficient knowledge and experience is often a gray area that can be second-guessed after the fact. What many don’t realize is that these ambiguities are often resolved against the issuer’s favor rather than in its favor. In any legal proceeding, the issuer is the one that bears the burden of proof that each condition to an exemption is met. In other words, when it comes to litigating whether the issuer met the exemption, the issuer is guilty until proven innocent.
Finally, it is worth noting that in any offering that takes advantage of the new provisions in Rule 506(c) that allow general solicitation, all investors must be accredited. So non-accredited investors are outright prohibited from Rule 506 offerings involving general solicitation.
The upshot of this is, if you didn’t get your financial statements audited, you can’t include non-accredited investors. If you didn’t pay a law firm a lot of money for an offering document that is the equivalent of a prospectus in a small registered offering, you can’t include non-accredited investors. And if you can’t gather sufficient documentation that your investor has sufficient investment experience, you can’t include that non-accredited investor. Most of the time, it is simply not worth including non-accredited investors in your capital raise.
[1] Rule 506 offerings are also often referred to as Regulation D or “Reg. D” offerings, though this is technically inaccurate since Regulation D also provides for two other types of offerings (Rule 504 and Rule 505 offerings). However, since Rule 506 is used far more often than the other two, people often use Regulation D to refer to Rule 506.
This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.
