If you are looking to raise capital, finding an “Accredited Investor”, or even being able to explain the rules to a possible investor, can seem as impossible as catching a glimpse of a Snow Leopard.
Yes, it can be difficult to find investors for your project, and it certainly seems that the SEC makes it more difficult than it should be, but there is a reason why…and more importantly, reasons why you need to know the rules and follow them.
The bedrock of most exemptions from SEC registration is a requirement that securities only be sold to “Accredited Investors.” This way people that aren’t sophisticated enough to understand investing aren’t taken advantage of.
Qualifying as an Accredited Investor
So, what kind of education or experience is necessary to obtain the status of Accredited Investor? None whatsoever. For most intents and purposes, the operative definition of Accredited Investor from Rule 501 of Regulation D is either:
1) A natural person who has individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase, or has assets under management of $1 million or above, excluding the value of the individual’s primary residence; or
2) A natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year.
So, being an Accredited Investor isn’t about being educated or experienced – it’s about being (relatively) rich. The rationale behind this rule is not that rich folks are less likely to be swindled or make dumb investments, it’s that they are less likely to invest everything they have in a particular investment, and be left destitute if/when the whole thing tanks.
How the SEC plays a role
So if you’re raising capital for your business, depending on the procedure you’re following, the SEC requires you to treat potential investors in certain ways. Sometimes you can avoid looking for Accredited Investors.
The most popular exemption to SEC registration is Rule 506 of Regulation D, which allows those offering securities to raise an unlimited amount of capital from an unlimited number of Accredited Investors. It also nominally allows investment from up to 35 non-accredited investors, but for many reasons, that exception to the Accredited Investor requirement is a mirage. For all intents and purposes, ALL INVESTORS in a Rule 506 Offering must qualify as Accredited Investors.
So, why is this important? Well, for those raising (or thinking about raising) capital, if you sell your securities to non-accredited investors in a Rule 506 Offering, you will have blown your federal registration exemption, and you will be guilty of selling an unregistered security – which can subject you to both civil and criminal liability.
Another option is Rule 504 of Regulation D, which allows you to raise money from ANYONE! That’s right…you don’t have to worry if they are “Accredited”. However, there are some catches.
First, you are limited to a 5 million dollar raise of capital in any 12 month period.
Second, even though you may get out of the Federal or SEC rules for Accredited Investors, you have to confirm what the rules are in EACH state you talk with investors.
The History of “Why”
Over the course of two days on October 28 and October 29, 1929, the stock market lost nearly one-quarter of its value. By the middle of 1933, the Dow Jones Industrial Average had declined 89% from its all-time high of September 3, 1929.
A combination of rampant stock market speculation, unscrupulous business practices, and good old-fashioned American greed led to millions of Americans losing billions of dollars, and plunged the United States (and the entire world), into a decade-long economic morass that came to be known as The Great Depression. The Dow wouldn’t get back to the level of September 3, 1929, until around Thanksgiving in 1954.
In response to the 1929 Crash and the Great Depression that followed, FDR and Congress passed two landmark pieces of securities regulation legislation – the Securities Act of 1933 (the “1933 Act”), and the Securities and Exchange Act of 1934 (the “1934 Act”). The 1934 Act created the Securities and Exchange Commission (the “SEC”) which has been going strong regulating U.S. securities markets and working hard to protect American investors (or to make life unduly difficult for people trying to raise capital – depending on who you ask) for more than 84 years now.
The 1933 and 1934 Acts provide that any offer to sell securities must either be registered with the SEC or meet certain qualifications to be exempt from the requirement to register. One of the best-known SEC regulations, Regulation D, is where you can find the rules on how to meet those qualifications.
‘So What’ if I’m an investor and don’t care?
Ok, so if I just want to invest (and I’m NOT an accredited investor) then I’m fine, right? It’s my risk I’m taking. Wrong. If you lied and told the party selling the securities that you were accredited when you weren’t, then you are probably guilty of fraud. A more nuanced problem comes to the surface when you participate in a securities offering, and it’s sort of “don’t ask, don’t tell” when it comes in Accredited Investor status. At the very least, this means you have invested with someone who has failed to “dot their I’s and cross their t’s.” You could end up with your investment becoming frozen for months or even years, while the SEC and state securities regulators investigate and figure out what to do.
At the end of the day, someone trying to sell you securities who is willing to cut corners on securities issues just raises a ton of red flags. Where else are they cutting corners? Are they incompetent, or just cheap? What are they promising to other investors? Why are they so desperate to raise capital?
Bottom line, knowing what to ask (and how things “should” work) is a huge advantage, regardless of which side of the transaction you are on. However, it’s a situation where you usually just don’t know what you don’t know.
This is why an experienced securities attorney is invaluable to walk you through the transaction to make sure everything is done correctly. Having one on your side can help keep your investment safe – and maybe even keep you out of prison.
[Written in collaboration with Jarom Bergeson, Attorney at KKOS Lawyers]
* To sign up for Mark’s weekly Free E-Newsletter and receive his Free E-Book “The Top 10 Best Tax Saving Secrets Everyone Should Know” visit www.markjkohler.com.
Mark J. Kohler is a CPA, Attorney, co-host of the Radio Show “Refresh Your Wealth” and author of the new book “The Business Owner’s Guide to Financial Freedom- What Wall Street isn’t Telling You” and, “The Tax and Legal Playbook- Game Changing Solutions For Your Small Business Questions”. He is also a partner at the law firm Kyler Kohler Ostermiller & Sorensen, LLP and the accounting firm K&E CPAs, LLP.