Does everyone who purchases a convertible promissory note have to be an accredited investor? I am looking to fund my start-up with a friends and family round of financing. I plan on issuing convertible promissory notes to these initial investors. The convertible promissory notes I have seen all have a provision representing that the investor is an “accredited investor,” which I know refers to an individual with an income of more than $200,000 a year (or a joint income of at least $300,000), or a net worth exceeding $1 million not including the value of the person’s primary residence.
Each investor does not necessarily have to be an accredited investor, but life will be a lot easier if they are. Generally, a convertible promissory note, even for a small start-up, will be considered a security if the maturity is over nine months. (This is not absolute but is a good rule of thumb.) Securities must either be registered with the Securities and Exchange Commission (SEC) or offered pursuant to a registration exemption. Registration is what happens with initial public offerings (IPOs) and is time-consuming and expensive. You would not want to register notes offered in a friends and family round.
Regulation D of the Securities Act of 1933 contains several exemptions from registration, which can be found in Rules 504, 505, and 506. This would be an even longer answer if I detailed all of the benefits and restrictions of each rule, but briefly, Rule 504 allows companies to raise up to $1 million from investors in any 12-month period, and those investors do not have to be accredited. Rule 505 allows companies to raise up to $5 million from investors in any 12-month period, with an unlimited number of accredited investors and up to 35 persons that are not accredited investors. Rule 506 allows companies to raise an unlimited amount from investors in any 12-month period, with Rule 506(b) allowing an unlimited number of accredited investors and up to 35 persons that are not accredited investors if general solicitation is not used and Rule 506(c) not allowing any non-accredited investors if the company does use a general solicitation to sell its securities. Investors generally receive restricted securities in a Regulation D offering, that may only be resold if the company has registered the offering or if another exemption is used (such as the private placement exemption).
The Securities Act provides that companies relying on either Rule 505 or Rule 506(b) must provide information to non-accredited investors that is very similar to what is provided in a registration statement, and is much more comprehensive than the vast majority of start-ups are prepared to make, particularly early in their life cycle. The Securities Act specifically states that a company is not required to furnish such information to purchasers when it sells securities under Rule 504. However, Rule 504 offerings are subject to the state securities laws of all of the states in which the securities will be offered, and more often than not these “blue sky” laws require disclosures to investors that are similarly burdensome.
But, states do vary. In New York, the New York Investor Protection Bureau requires an “Issuer Statement.” The Issuer Statement (Form M-11) is four pages long and is similar to an application for employment, featuring questions about past work history and business affiliations of each officer, director, principal, partner, or managing member, as well as questions regarding the company and the proposed use of proceeds. Form M-11 may not be fun, but it is also not a registration statement. (Form U-2 is also necessary if the company raising the money is not incorporated in New York.)
New York is something of an anomaly, as most states do require something akin to a registration statement, though each state also has its own peculiar exemptions and safe harbors. For example, in the District of Columbia, there is an exemption available for transactions that are directed towards 25 or less DC residents within any 12-month period. It is worth engaging a securities attorney to research each state’s blue sky laws in which a company plans to offer securities, as there could very well be exemptions available.
Note that in the registration statement for an IPO a company will have to disclose prior sales of unregistered securities. The SEC will scrutinize these sales to ensure there were no violations of securities laws. Given the increased possibility for a securities law violation, some angel and institutional investors will not invest in a company that has non-accredited investors.
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