Are You Accredited?

Jason and I have mentioned accredited investors several times in various postings on this blog.  However, after I received the following question, I realized we had never talked about why non-accredited investors are an issue for a company.  The question I received follows:

Do you have any stories or insight into the dangers of non-accredited investors? I’m currently attempting to work out a messy deal where some of the original (and potentially very unhappy) investors come in all flavors – sophisticated and accredited, unsophisticated and accredited, sophisticated and unaccredited, and of course, unsophisticated and unaccredited.  I’d love to see a post on the subject in your blog, should you have the insight and interest.

For those of you that don’t know what an accredited investor is, the SEC provides a very clear definition.  In general, unaccredited investors can pose a number of problems.  You’ll have to ask your lawyer for the nitty gritty, but we’ll cover the three major points in this post. 

First, have you done a proper private placement?  One has to jump through many more hoops to sell securities to unaccredited investors.  Many times, what appears to have been done correctly, later turns out to have been done poorly or incorrectly.  This is particularly troubling because at any time, these unaccredited investors have the right to rescind their investment in the company.  This is a ticking time bomb that can explode, especially if the company is underperforming.  It’s a very dangerous thing to have investors around that can unravel a deal with 20/20 hindsight.  Let’s assume, however that your lawyers got it right, which leads us to the next issue.

What happens on an acquisition?  Regardless if the placement was done correctly to the unaccredited investors, an acquisition of the company could pose big problems.  Take the case where a private company acquires the company for stock.  Handling the unaccredited investors can be extremely difficult.  The unaccredited investors need a purchase representative to trade their stock for the acquiring company stock, or the stock needs to be registered or subject to fairness hearings.  Alternatively, the buyer will insist that they don’t want unaccredited investors holding stock in their company, in which case the seller needs to come up with cash to buy out the unaccredited investors. We’ve seen cases where the buyer completely refused to deal with the unaccredited investors and the accredited investors on the seller’s side had to invest new cash in the company to buy out the unaccredited investors.  Public company acquisitions can present similar problems if the stock being issued in the acquisition is not registered.  Basically, your garden variety mess.

Finally by nature, unaccredited investors are generally unsophisticated.  This might be the most concerning issue of having unaccredited investors into your company.  By nature, they are less experienced in these types of investments and have less money to invest than others.  What you normally get are more skittish investors whose emotions rise and fall with every piece of good or bad news from the company.  When things turn bad, “unsophisticated investors” – who often didn’t realize that they could lose 100% of their investor – become irrational or hostile, in an already difficult situation for the company (i.e. the company is failing.)

Now – just because an investor is accredited doesn’t mean he is sophisticated.  The basic message is always the same – know who your investors are and what their past behavior has been like, especially in difficult circumstances.  However, especially in early stage companies, try to insure that all of your investors are accredited and – if some aren’t – that your lawyer has done a proper private placement to eliminate any issues associated with the actual financing.

  • PRoales

    “First, have you done a proper private placement?”

    Is it correct to assume that the bulk of this is accomplished through the writing of a Private Placement Memorandum?

  • Eddie Walker

    Saying that doing an equity financing to nonaccredited investors means you need to jump through more hoops is vastly understating it. The accredited investor concept is used in connection with offerings under the SEC’s Reg D exemption. That provides that you can offer an unlimited number of accredited investors, but only 35 non-accredited to fit within the common Rule 506 exemption (which preepmts the need to comply with anythine more than a token filing requirement at the state level — don’t forget states have myriad securities laws as well). But the numbers limitation aside, the real kicker is that if you offer to nonaccredited investors you need to provide them disclosure of a massive amount of information information that, for the most part, amounts to what a registration statement for an IPO includes — including audited financials and MD&A on the financials. No startup company can afford that hassle, nor frankly should they try. It’s not worth the short term cost cost to a thinly capitalized company. Brad accurately points out later complications of having nonaccredited investors on your stock ledger as well — the money they invest means more to them and therefore they are more likely to sue or hijack a sale if things go poorly. The simple answer is dont take their money, EVER.

    To answer PRoales, a private placement memo, or PPM, would have to include the Reg D required information if the offerees are nonaccredited — which as I mentioned is pretty much impractical for a startup company to do. Most PPM’s don’t include that info. But PPM’s have another important function — they also serve an important risk-management and disclosure function, which is making sure that your prospective investors understand the terms, your business and, most importantly of all, the dozens of major risks that an investment in your company is subject to. A properly prepared PPM is therefore a pretty dismal document to read as it lists the many reasons the business could fail and the investor could lose her entire investment — but unless you’re doing a VC financing (in which PPM’s are rarely done), a PPM is a very helpful (and a good lawyer would say critical) risk management and disclosure device that can help reduce the likelihood of success of a later investor claim that you misled them about your business when you sold them their shares, while at the same time forcing you to focus on producing a good business plan and risk assessment — which can’t be a bad thing.

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  • Damon

    If a startup has given stock or options as compensation to a consultant or employee who is non-accredited, are there similar issues to worry about?

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  • If anyone is interested, I’ve started a project that will make this less of an issue for everyone that would like to be invested in or invest.

    Why is it that we have figured out just about everything else ‘collaborative’ but we have failed to figure out collaborative investing until now?

    -Bruce Boston

  • For some strange reason the
    government is under the impression that just because someone has money, it means that they must be able to understand and analyze investment choices!
    There should clearly be an updating of the current rules and regulations
    that more realistically reflects the true definition of a “sophisticated
    investor” and takes into account knowledge, intelligence and education.

    Jack Doueck
    Stillwater Asset Backed Lending Division

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