In the 2000 Coen Brothers cult classic O Brother, Where Art Thou, Holly Hunter’s character, Penny, has a heated discussion with her ex-husband Everett (played by George Clooney) about her new beau, Vernon. When Everett questions why she would be with someone shall we say “less manly” than him, Penny claps back: “Vernon’s got a job. Vernon’s got prospects. He’s bona fide. What are you?”
So, why in the world do I bring this up (other than because I never pass up a chance to quote a Coen Brothers movie)? Because if you want to raise money, then you’d better be thinking about who is “Bona Fide”.
Now, of course, the SEC (Securities and Exchange Commission) doesn’t use the term “bona fide.” Instead, they use with the much more official term “accredited investor.”
Why does any of this matter?
The primary purpose of the SEC is to:
“…protect investors from dangerous or illegal financial practices or fraud, by requiring full and accurate financial disclosure by companies offering stocks, bonds, mutual funds, and other securities to the public.”
Now the SEC achieves this goal in a variety of ways, but really with a two prong approach. One, making sure that those seeking funds properly disclose everything with accuracy, transparency and uniform procedures. Second, they establish mechanisms and procedures to ensure the uneducated aren’t taken advantage of with slick sales pitches. Thus, they only allow promoters to approach and/or solicit “Accredited Investors” in most offerings.
Otherwise stated, if the person being ‘pitched the deal’ is determined to be smart enough to make an educated decision on the investment, the solicitor is given more latitude on how they raise money for their deal.
So, if you want to:
- Take money from “silent partners” to fund your real estate deals (or any other business venture) without spending hundreds of thousands of dollars in preparing and filing a full-blown SEC Registration Statement for those securities; OR
- Invest in these “private offerings” that typically offer bigger upside (but also bigger risk) than what is available on Wall Street.
Then you need to know what an “accredited investor” is!
Let’s Do It – Let’s Get Accredited!
Ok, sweet, so what sort of education do I need to become an accredited investor? Does the SEC have courses online? Can I get accredited at the local community college? In a word: nope. You become an accredited investor by graduating from one of two prestigious schools, either:
- The University of I HAVE a Lot of Money; or
- The University of I MAKE a Lot of Money.
Accredited investor status has nothing to do with investing education or experience. It is determined either by your net worth or your income. The SEC’s thinking is that if you have a fair amount of money or have demonstrated the ability to make a lot of money, then they are less concerned about you losing some of your money in a more loosely regulated private offering.
Now there are two tests that a person can meet to qualify as an Accredited Investor. Meeting either one satisfies the test and thereby are allowed to either be approached for the investment OR make the investment if they come across one on their own accord.
- Net Worth Test – To qualify here, your net worth (either individually or jointly with your spouse) must exceed $1 million. However, you are not allowed to include the value of your personal residence in the calculation. So, if the value of your assets (not including your house) exceeds the amount of your liabilities by more than $1 million, then congratulations – by the power vested in me by absolutely no one – I now declare you an accredited investor.
- Income Test – To make the grade here, your individual annual income must have exceeded $200,000 (or your joint income with a spouse must have exceeded $300,000) in each of the previous two years, and you have to have a “reasonable expectation” to make that at least that much in the year in which you are making the investment. If you make this much, then you can expect to receive your accredited investor certification in the mail in the next 6-8 weeks (or not)!
You may be asking why this is so important and thinking this Rule 506 and Accredited Investor rule is for the birds! Well, think twice… according to a 2018 SEC report, 99.9% of the more than $1.8 trillion (yes, that’s trillion with a “t”) raised in Regulation D Offerings in 2017 was raised under Rule 506. So although there are other options for raising money, by far the majority of money raised was through this method or rule.
However, it’s arguable that times are changing. The newer rules we are now operating under (allowing for a capital raise of up to $5M under Rule 504) didn’t come into effect until late 2016. So most deals in the works and closed in 2017 were probably designed under the old rules. Statistics should show in 2018 and 2019 that a fair amount of money will be raised under the improved “Crowd Funding” Regulations and Rule 504
Can I avoid this entire “Accredited Investor” rule?
If you don’t want the pain of only approaching/soliciting “accredited investors” you can use Regulation D – Rule 504. In simple terms, this rule allows you to raise up to $5M (up from a cap of $1M as of October 2016) over a 12-month period from an unlimited number of accredited investors, and up to 35 non-accredited investors (and unlike Rule 506, no pesky additional disclosures are required).
However, the drawback is that no general solicitation is permitted, unless you jump through some pretty draconian hoops – so that idea you had for an ultra-cute viral Super Bowl ad with all those puppies is probably a no-go. In fact, a more practical example, is that you can’t post on your Facebook page that you are trying to raise money for your cool business idea or real estate project. By doing so you would have just violated SEC law and that is NOT something you want to be accused of.
Also, using Rule 504 doesn’t preempt state registration requirements. This means you have to make sure your offering complies with “Blue Sky” requirements of every state where your investors live. Some states are cheap (or even free) and easy. Some states will be expensive and difficult (or even impossible). For example, this means that although your project may be in Arizona, if you have investors from Florida, Texas and Oregon, you have to comply with ALL four (4) State’s securities laws to raise your money. Essentially, these are more expensive with legal fees because you have to do your state-level homework before you get too far down this path.
Two sides of the table
Ironically, there are really two perspectives when complying with this rule/definition and understanding the rules. There are those raising money and those looking to invest. Depending on what side of the table you are on, will certainly depend on how liberal or strict you are in defining the term accredited investor. Make sure you know where you sit.
- For those looking to raise money: If you’re even thinking about raising capital, then knowing this definition is absolutely vital. If you don’t, you could end up wasting a lot of time and resources developing contacts and relationships from people who can’t invest their money with you anyway. Even worse, you may end up taking money from a non-accredited investor, which could potentially put you in hot water with the SEC and/or state securities regulators.
- For potential investors: As an investor, knowing the accredited investor definition is maybe only slightly less important. They have a name for intentionally misrepresenting your accredited investor status – it’s called fraud. Even if you don’t have the intention of miss leading anyone, getting the definition wrong could cause big problems for the company in which you invested. Dealing with securities investigations (whether federal or state) is a time-consuming and expensive proposition – one which could cause that company serious economic harm and a possible civil suit against you. Remember, ignorance is rarely an acceptable defense.
Bottom line, this is not an area of the law you want to take the Do It Yourself (DIY) approach. There are so many technical issues, and the mistakes can literally land you in jail. These rules are really set up to protect the promoter AND the investor…both sides benefit from following the rules. It’s not worth risking your money and/or your freedom to cut corners in the area of security law. Get a consultation with a securities lawyer before stepping into this minefield and they will be able to show you the map to get you safely to the other side.