Clients often ask whether they should accept unaccredited investors in venture-type transactions. My general advice is, if practicable, not to take funds from unaccredited investors. There are several reasons.
In most capital-raising transactions, we conduct offerings under Rule 506 of Regulation D, promulgated by the SEC under the Securities Act of 1933. That allows for an unlimited number of accredited investors and 35 unaccredited investors to invest an unlimited amount in a “private offering”. If the rule is followed, state substantive securities laws (aka “blue sky laws”) are preempted. However, if unaccredited investors are included in the offering, the issuer must provide extensive disclosures (think mini IPO); whereas, if all investors are accredited, there are no specific disclosure requirements. In any case, all material information that a reasonable investor would want to know should be disclosed to the investors as the Securities Act’s anti-fraud rules still apply. So, the unaccredited investor makes Rule 506 impracticable due to the time and expense in creating such disclosures.
Rule 504 allows the issuer to raise up to $1M from investors, even if unaccredited, with no stated limit on the number of investors (though in both Rule 506 and 504 the offering cannot be a “public offering,” which generally means each investor must have some pre-existing relationship (directly or indirectly) with the issuer outside the offering). However, any sales of securities taking place 6 months before or after the 504 offering will likely be integrated into the 504 offering. So, if an issuer raises $1M today under Rule 504, the issuer cannot do another raise for more than 6 months. So, the issuer would have to wait at least 6 months before it could even begin to speak with investors if it wants to do a larger offering and rely on Rule 506. Rule 504 does not preempt state blue sky laws (whereas 506 does), so the issuer would need to comply with the substantive securities laws of each state in which there are purchasers, which can be cumbersome.
Any future acquirer who purchases the issuer for stock would need to find an exemption for issuing the stock to the issuer’s unaccredited stockholders. Or, the acquirer could require those stockholders be bought out prior to the transaction, as acquirers (or potential future investors for that matter) are often averse to having unaccredited investors other than employee equity holders in a portfolio company.
