Using Root Cause Analysis (RCA) to manage your team
I recently engaged in a discussion with another CFO about when to allow non-accredited investors in a seed round. I have been through this with a previous company, for 3 different rounds. My basic answer is really NEVER take non-accredited investors (with one exception — see below.) First, to make sure we are all talking about the same thing….
The SEC defines (in Section 501 of Regulation D), an accredited investor as having a substantial income (north of $200K) or assets (not including primary residence) of more than $1M. The thinking is that you’re okay to invest, since you’ve got liquidity.
If you start a seed round under Sec 506b, you are allowed a small number of non-accredited investors. But, the main downside of a 506b round is that you cannot advertise the investment offering (such as announcing it on your web site.) That is why I prefer a 506c round, because while it dis allows non-accredited investors, it allows for “general solicitation” of the offering.
With a 506c round, you are required to collect documentation of the investors’ accreditation status, e.g. tax returns for a couple years. You are not required to collect this data for a 506b — the investor just certifies that they meet the standards of the definition in Sec 501.
But, here’s the real rub. From the various lawyers (who should know) I’ve dealt with, even though you can (a) take non-accredited investors in a 506b, and (b) you aren’t required to collect their documentation, you should NOT do either! The reality in the courts is that it is just risky to your business. If things go south later on (and like it or not, sometimes you won’t meet the expectations of your investors), then the burden of proof is on the company (you!) that you fully informed your non-sophisticated (i.e. non-accredited) investors. And, companies often lose suits brought by such disgruntled investors. It is a prudent risk mitigation to only accept monies from accredited investors AND to make them prove it! Therefore, just go with a 506C round. (Plus, you have the advantage of being able to tell everyone about it through your awesome web presence!)
Of course, the main exception is if you choose to go with crowdfunding. This is a path that the SEC has defined specifically for collecting monies from non-accredited investors. (See the SEC’s Regulation Crowdfunding. Yes, it is really called that.) In this case, your risk is mitigated because (a) the individual investment amounts are limited, and (b) you are required to go through certified Crowdfunding providers, that take on the liability for you. But, unless you are going this route, I highly recommend a 506C round, and stick with ONLY accredited investors.
Just my opinion, of course. I ain’t no lawyer — just a lowly CEO/CFO/COO in hiding. (Insert appropriate legal disclaimers here.)