The term “Accredited Investor” generally refers to a SEC definition that is laid out in Rule 501 of Regulation D (Reg D for short).
The term is important for startup companies because the SEC allows startups to be exempted from most of the registration requirements for a company that plans to offer or sell its equity (think IPO registration documents…). These regulations were first put in place with the Securities Act of 1933 and have been updated from time to time since then. This is primarily of importance to startups that expect to raise a significant amount of outside capital, and in particular ones that are considering raising capital from Angel Investors (while VCs also have to qualify, it is a safe bet that any you have heard of qualify with no problems). If this does not describe your startup, there may be other exemptions you can leverage. In any situation you should discuss this in detail with your legal advisor.
The following entities are considered Accredited Investors by the SEC
- Banks, insurance companies, as well as registered investment, business development and small business investment companies
- Employee benefit plans with assets in excess of $5 million (note: Employee Benefit plans are a major category of LP investor in venture funds)
- A director, executive officer or general partner of the company in question
- A business where all of the equity is owned by Accredited Investors
- A person who individually or jointly with their spouse has a net worth of at least $1 million
- A person who individually has income over $200,000 in each of the most recent two years, or joint income with their spouse of over $300,000, and has a “reasonable expectation” of the same income level in the current year
- A trust with assets in excess of $5 million that was not formed solely for the purpose of acquiring the securities in question
If you are a startup raising money from any investors (this is usually only an issue when individual investors are involved), it is your responsibility to ensure that each of your investors qualifies as an Accredited Investor. This is typically done by providing a questionnaire to each investor that among other things asks them to confirm they are Accredited. We would highly recommend that you take this process seriously and not “fudge” it to let in someone who does not fit the definition. The obvious reason of not wanting to get in trouble with the SEC aside, if an investor in your company turns out to not be Accredited, and then becomes a disgruntled shareholder, they can make your life miserable. It is not worth the hassle or risk, no matter who the person is (family, friend, only investing a small amount, etc.). This is true even if they falsely confirm they are Accredited when they fill out the questionnaire.
Rule 505 and 506 actually allow you to bring in up to 35 investors who are not accredited under certain circumstances (for Rule 505 it is the total amount you can raise in a 12 month period and for Rule 506 all non-accredited investors still must be “sophisticated” investors). However, with both of these exemptions you are required to make additional disclosures to the non-accredited investors that effectively amount to those used in registered offerings, which pretty much blows the entire point of getting the exemptions in the first place as the cost of preparing these documents in a manner that will give you all the legal protections desired is prohibitive for a startup.
Note – There are other exemptions in place that remove the “Accredited Investor” requirement in certain circumstances, but they are generally not as well defined and as a result startups are usually advised to allow Accredited Investors only. Exemptions like the “Private Offering Exemption” sound like they would be useful, but for the purposes of angel-backed companies that plan to raise millions of dollars over time, you will likely want to stick with Accredited Investors only.