1. What is an Accredited Investor?
2. Why is Understanding Accredited Investors Important?
3. Reasons Using an Accredited Investor Matters
4. Accredited Investors: You Have the Cash Now What?
5. Raising Money Using Securities Laws Exemptions
6. Frequently Asked Questions About Accredited Investors
7. Forms You May Need and Helpful Information

What is an Accredited Investor?

An accredited investor in the United States is a person or applicable entity that meets certain financial or sophistication criteria that should, in most cases, allow such an investor to absorb or anticipate a complete loss related to an investment. In other words, if you are accredited then U.S. law contemplates that you knew, or should have known, that an investment was a bad idea prior to making the investment.

Anyone can “invest” in the stock of a company not registered with the Securities and Exchange Commission, but a person or entity is generally deemed “accredited” if one or more of the following three criteria are met:

  1. Earnings qualification – must earn more than $200k per year or $300k per year with a spouse. Earnings must have met the minimum for each of the last two years and must be expected to remain the same going forward.

  2. Net worth qualification – the individual on their own or with their spouse must have a net worth of $1,000,000. The value of the investors primary residence cannot be used to meet the minimum.

  3. Insider qualification – those who are general partners, executive officers or a combination of both of the company issuing the stock.

Simply put, a person must be wealthy and/or have a strong understanding of the risks of investing to be considered “accredited”. You can learn more about calculating net worth from the SEC website; this is important if you are considering raising money for your business from private investors.

Private offerings are essentially deregulated offerings where limited information can be presented and the risk is generally thought to be significant; therefore, non-accredited investors are protected related to such investments in ways that accredited investors are not.

Why is Understanding Accredited Investors Important?

If you are planning to raise money for your business, a basic understanding of the term “accredited investor” is important. Angel investors, venture capital sources, people driving nice cars and who live in nice homes, and people with grey hair are nearly always thought of as accredited investors.

However, where anyone can be any of those things, it is often prudent to make sure that you actually have some basis for believing someone is accredited prior to allowing an investment, and documenting the same just in case you are required to explain such status in the future.

When you're giving up part of the equity in your company in return for cash, you're selling a share of your company, which is normally considered a “security”. Because of the risks of investing in unregulated private offerings, investors should have the ability to survive a loss and the knowledge to understand they are facing a possible loss. Properly soliciting accredited investors not only improves your chances of raising money, it can also save you money if things go poorly because accredited investors are far less likely to sue because they anticipated a loss.

However, unaccredited and/or unsophisticated investors often get excited about opportunities to invest and because they can’t bear the loss, if they do invest then they are the first to complain if the revenue projections are not perfect, and they are the first to sue if anything goes wrong. Accredited investors will often sue, but they rarely win if fraud isn’t present because they knew, or should have known, that the investment was risky so the law doesn’t provide much in the way of protection for them.

The following is a simple explanation that may help you understand better what an accredited investor might be:

If you want to borrow money (personally) you would decide which of your friends is most likely to loan you money because of what you know about him or her. This is the same basic concept as borrowing money for your business or selling equity. Most of the time the difference between an accredited investor and a non-accredited investor is their net worth and their annual income. The following is a simple way to look at things:

You have a friend who makes $50,000 a year at his job, rents an apartment and leases a modest car. Clearly you're unlikely to believe that this friend could loan you much money and you would not likely ask this person to invest a substantial amount in your business; they probably don't have much disposable income and therefore a loan or an investment would be very risky for them.

You have a second friend who owns an apartment complex with 100 units that was paid off five years ago. He collects $100,000 a month in rent. This person is probably an accredited investor because he meets the income guidelines and probably the net worth guidelines.

All that being said, if your business was going to provide a 55% annualized return on an investment then your friend with no money would be very excited to invest, whereas your friend with lots of money would probably laugh at you and wonder what kind of scam you were running. So, you would be highly tempted to take whatever money you could rather than figure out where your numbers or business model are wrong.

Reasons Using an Accredited Investor Matters

If you are issuing stock in your company, there are generally two options to convert those shares into cash. One is raising money, by selling shares to the general public. The other is approaching private investors. Raising money from the public involves costly public offerings and reports to the Securities and Exchange Commission. The process is also time consuming.

Alternatively, you could elect to sell shares in your company only to specific people who meet certain guidelines under an exemption; known as Regulation D of the Securities Act of 1933. There are generally three rules that apply:

  1. Rule 504, or the “seed capital” exemption. This allows you to offer $1,000,000 of securities in a 12-month period.

  2. Rule 505 allows you to offer $5,000,000 in securities over a 12-month period. You may also sell securities to up to 35 non-accredited investors (although it is rarely recommended to do so).

  3. Rule 506 does not limit the amount of money you can raise and does not have a time period. However, you can still only sell to a maximum of 35 non-accredited investors.

It is important to note that the JOBS Act loosened some requirements; you can speak with an experienced securities attorney to find out how these changes may impact your business plan.

Accredited Investors: You Have the Cash Now What?

When you've sold shares in your company in return for cash the stock issued is restricted. That means the investor may not sell those shares for a period of time without registering such with the Securities and Exchange Commission. That being said, you are free to continue to grow your business with the money you have raised; state regulations may require you to file specific reports.

Raising Money Using Securities Laws Exemptions

As stated above, when you need cash to keep your business running and you don't want to go through the time and expense of offering your company’s stock for sale to the public, you can take advantage of an exemption. The following is a list of specifics related to possible exemptions:

Rule 504

Rule 505

Rule 506(b)

Rule 506(c)

J.O.B.S. Act Title II

Who Can Issue?

SEC-registered and private companies

SEC-registered and private companies

SEC-registered and private companies

SEC-registered and private companies

Who Can Invest?

No limit on number of investors

Unlimited accredited investors; maximum 35 non-accredited investors

Unlimited accredited investors; maximum 35 non-accredited investors

Accredited investors only

How Much Can I Raise?

$1,000,000 in a 12-month period

$5,000,000 in a 12-month period

No limit on amount raised

No limit on amount raised

Who Can I Ask?

Known investors only. You may not solicit the public nor through the internet

Known investors only. You may not solicit the public nor through the internet

Known investors only. You may not solicit the public nor through the Internet (may use third party services via the internet)

No limits on marketing

Frequently Asked Questions About Accredited Investors

  • How do I know if an investor is accredited?

    This is important because selling securities in your company to non-accredited investors can limit your ability to raise cash or otherwise subject you to significant liability. There are four common ways to establish that an investor is accredited:

    1. The Insider Method – you have (or request) proof the person is an "insider". This means they are a partner, director or executive officer of the company issuing the securities. This is often easy to prove with corporate documents.

    2. The Professional Letter Method – a licensed professional such as a CPA, attorney or registered broker-dealer provides verification. They must confirm they've taken steps to ensure the person meets the requirements within three months prior to making an investment.

    3. The Income Method – reviewing tax returns and/or pay stubs will establish whether the person has sufficient income to be considered an accredited investor.

    4. The Net Worth Method - the investor would be required to disclose all assets and liabilities. The information on liabilities is confirmed via credit reports, asset values are confirmed via various methods depending on the asset.

  • Do I have to file forms to offer equity to accredited investors?

    Yes. You must timely file a Form D with the Securities and Exchange Commission.

  • What happens if an investor wants to sell the shares I offer?

    The shares offered in these types of transactions are restricted. Generally, this means the investor must hold the stock for a specific period of time. They have a "legend" on the security face. Before an investor can sell (typically back to the company) the legend must be removed. This is known as Rule 144. You may have to purchase back the shares as there is generally no market for them.

Forms You May Need and Helpful Information

Form D

Non-accredited investors specified disclosure documents

Jumpstart Our Business Startups Act (or JOBS Act)

Rule 144: Restricted Securities Sales