By Charles Alovisetti and Michael Heyward, Vicente Sederberg LLC
*Updated to reflect new Rule 147A and Amendments to Rule 147
When raising capital from outside investors, companies are faced with several choices regarding terms, structure, filings to make or not make, and type of investor, among other decisions. One choice – whether or not to include unaccredited investors – should be easy to make. For the reasons outlined below, it is strongly advised that only accredited investors be allowed to participate in a fundraising process.
What is an accredited investor? An accredited investor can be an individual or an entity. An individual can be considered accredited if he or she meets one of the following criteria:
- net worth of at least $1,000,000 dollars (excluding the value of his or her primary residence); or
- income at least $200,000 each year for the last two years (or $300,000 combined income if married) and have the expectation to make the same amount this year.
For entities, different criteria can apply depending on the form of the entity, but generally speaking, an entity will be considered accredited if all of its equity holders are accredited or it has greater than $5,000,000 in assets. Persons or entities that do not meet the above standards are referred to as unaccredited or non-accredited investors. While this is not an insignificant amount of money, the threshold is not very high. Especially if the person in question is considering investing a substantial amount of money in an uncertain venture that, even in the best of circumstances, may not make any money for years to come.
To understand why this definition is important, you must understand how sales of securities are regulated in the United States. At a high level, federal securities law requires that any sale of securities must either be registered with the Securities Enforcement Commission (SEC) or issued pursuant to an exemption. A full description of each exemption available to companies is beyond the scope of this article. But most private offerings of securities make use of the safe harbor exemption from registration known as Regulation D (in the parlance of our times, Reg D). There are three exemptions under Reg D (note the descriptions below only address the accreditation and disclosure issues discussed in this article and ignore issues related to general solicitation and restricted securities):
Rule 504: Allows for an exemption for the offer and sale of up to $5,000,000 of securities in a single twelve-month period.* Unlike some other exemptions, this exemption allows for a private sale without any specific disclosure requirements (note that the anti-fraud provisions of the federal securities laws still apply). Sales can generally be made to an unlimited number of accredited or unaccredited investors.
*Prior to adoption of new rules on October 26, 2016, the aggregate amount of securities that could be sold pursuant to Rule 504 was $1,000,000. The new rules also eliminated Rule 505.
Rule 506(b) and (c): Has the same criteria and guidelines as Rule 505, with one additional requirement – in the case of a 506(b) offering, all non-accredited investors must be sophisticated (i.e., “must have sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment”). This is an amorphous standard and creates yet another potential issue for the company offering securities. While beyond the scope of this article, it is worth mentioning that a Rule 506(c) offering, which permits general solicitation and advertising (normally not allowed under a 506(b) offering), cannot include any non-accredited investors.
The most important takeaway from the descriptions of the exemptions above: if you wish to undergo an offering without limitations on the number of investors, size of amount raised, or without specific disclosure requirements, you must sell only to accredited investors. Any offering which includes unaccredited investors, whether done under 504 or 506, will impose at least one of these restrictions on the offering.
Beyond the above-mentioned restrictions, there are other reasons not to include unaccredited investors in an offering. For one, it is not unusual to give investors the right to invest in future financing rounds – often referred to as a preemptive right. This is fine, provided no investors are unaccredited, but would be an issue for a company that has existing unaccredited investors with the right to invest in future rounds. Suddenly, a future financing round may inadvertently involve unaccredited investors and this may require a company to spend time and money developing fulsome disclosure documents or risk violating securities law. Another concern, while not immediate, is that if the company wants to go public, the SEC may evaluate all prior issuances of stock by the company and require that it take remedial actions to cure any past violations of securities laws, which might delay or imperil the IPO.
While any emerging company would be wise to restrict its offering to accredited investors, cannabis companies should be especially vigilant. Securities regulators, both on a federal and on a state level, made it clear that they consider the cannabis industry to be an area of special concern. Not because of the ongoing federal illegality of cannabis, but because of the increased risk of fraud in such a new and dynamic industry. The last thing any cannabis company should want to do is take any action that could expose them to the ire of regulators.
What if your investors are Canadian? After all, almost $500,000,000 Canadian dollars were raised last year in the Canadian public markets, and many Canadian investors are eagerly eyeing U.S.-based assets. Setting aside any Canadian securities laws issues, which are beyond the scope of this article, a Canadian or Canadian entity can certainly qualify as an accredited investor and allow an issuer to rely on Reg D. But be sure to have any Canadian investors carefully review their accredited investor questionnaire (a document issuers should require investors to fill out certifying what criteria marks them as accredited) they provide in connection with the offering – while Canadians are familiar with their version of accreditation, the qualifications differ just enough from US qualifications to be a potential issue. Note that there can be additional complications involved with accepting foreign investment, both for the investors and the company raising capital beyond those related to securities law.
It is also worth mentioning that the underlying policy arguments for restricting offerings (in the absence of fulsome disclosures) to accredited investors become even stronger in the cannabis industry. The risk of failure, and the total loss of investment, is undoubtedly present in an industry and remains federally illegal and operates based on federal guidance that could be changed at any moment. And investing in a cannabis company requires an even higher level of sophistication than a typical deal because of the challenges involved. A company should not accept money from investors who cannot handle the risk of losing their entire investment – not only is this unfair to the prospective investor, but any burned investors who end up in a financially precarious situation increase the risk of damaging litigation. While it may be tempting to accept funds from non-accredited investors, all the above issues can be readily avoided if non-accredited investors are not permitted to participate in a company’s offering.
This information is educational only and shall not be construed as legal advice. Please consult your attorney prior to relying on any information in this article.
Charles Alovisetti is a senior associate and co-chair of the corporate department at Vicente Sederberg LLC. Prior to joining Vicente Sederberg, Mr. Alovisetti worked as an associate in the New York offices of Latham & Watkins and Goodwin where his practice focused on representing private equity sponsors and their portfolio companies, as well as public companies, in a range of corporate transactions, including mergers, stock and asset acquisitions and divestitures, growth equity investments, venture capital investments, and debt financings. In addition, Mr. Alovisetti has experience counseling portfolio and emerging growth companies with respect to general corporate and commercial matters and all aspects of compensation arrangements, including executive employment and consulting agreements, stock option plans, restricted stock plans, bonus plans, and other management incentive arrangements. Mr. Alovisetti has experience in both U.S. and cross-border transactions, and advised clients across a range of industries prior to focusing on the cannabis space. He holds a Bachelor of Arts, with honors, from McGill University and a law degree from Columbia Law School, where he was a Harlan Fiske Stone Scholar. Mr. Alovisetti is admitted to practice in both Colorado and New York and is a Level One Interpener. He can be reached at firstname.lastname@example.org. Follow him on Twitter @CAlovisetti.
Michael Heyward is a law student at the University of Denver Sturm College of Law and a law clerk at Vicente Sederberg LLC. He holds a Bachelor of Arts in History and Political Science, and a Master’s Degree in History from Florida Agricultural and Mechanical University.