Raising money from investors can help a startup grow, but securities laws limit who can participate in certain private offerings. One key issue is whether an investor qualifies as an accredited investor.
For startups using Regulation D, the process for confirming accredited status depends on the exemption being used. Rule 506(b) and Rule 506(c) have different requirements, and treating them the same can create legal problems.
What Is an Accredited Investor?
An accredited investor is a person or entity that meets specific requirements under Rule 501(a) of Regulation D. Individuals may qualify based on income, net worth, certain professional positions, or certain financial licenses. Entities may qualify based on their assets, ownership, structure, or type.
For individuals, common financial tests include annual income above $200,000, or $300,000 with a spouse or spousal equivalent, for the previous two years with a reasonable expectation of reaching the same level in the current year. An individual may also qualify through net worth above $1 million, excluding the value of the person’s primary residence.
Other qualification paths exist, so startups should confirm which category an investor is using before deciding how to verify that status.
Why Does Accredited Investor Status Matter to Startups?
Accredited investor status can determine whether a startup can rely on certain Regulation D exemptions when raising capital. The SEC places different obligations on companies depending on whether they conduct a Rule 506(b) or Rule 506(c) offering.
That means investor verification should be part of the fundraising process from the beginning. A startup should know which exemption it is using and what evidence it needs before accepting an investor’s money.
What Is the Difference Between Rule 506(b) and Rule 506(c)?
Rule 506(b) generally requires the company to reasonably believe an investor is accredited. The SEC says this depends on the facts and circumstances, including the company’s relationship with the investor and the information available about that person.
Rule 506(c) has a higher standard. The company must take reasonable steps to verify that its investors are accredited. Rule 506(c) also permits general solicitation and advertising, while Rule 506(b) does not.
This distinction matters. A simple investor questionnaire may be enough to support a reasonable belief in some Rule 506(b) situations, but it does not automatically satisfy Rule 506(c)’s verification requirement.
How Should a Startup Verify Accredited Investor Status?
Under Rule 506(c), the SEC provides several verification methods. For income-based qualification, a startup may review documents such as W-2s, 1099s, Schedule K-1s, or federal income tax returns.
For net worth qualification, the company can review certain financial documents, such as bank and brokerage statements, along with other required information. The investor must also provide a written representation concerning liabilities.
A startup can also obtain written confirmation from a registered broker-dealer, SEC-registered investment adviser, licensed attorney, or certified public accountant. That professional must confirm that reasonable steps were taken to verify the investor’s status and that the investor was found to be accredited.
The SEC describes these methods as non-exclusive. The company can consider the facts and circumstances of the particular investor and offering when deciding what verification steps are reasonable.
Can a Startup Use Different Verification Methods for Different Investors?
Yes. The verification process does not have to be identical for every investor in a Rule 506(c) offering.
The SEC considers factors such as the type of investor, the information available about the investor, and the nature of the offering. A startup can therefore use different reasonable methods based on the circumstances.
Recent SEC guidance also addressed situations involving a high minimum investment and written investor representations. The guidance described a high minimum investment as one factor that may support reasonable verification when combined with other conditions. It does not create a universal investment amount that automatically proves accredited status.
Why Is Investor Self-Certification Not Enough?
A checkbox or signed statement from an investor does not, by itself, satisfy the SEC’s verification standard when the company has no other information about the investor’s financial circumstances or sophistication. The SEC expressly states that self-certification alone is not enough for either the reasonable belief standard or the reasonable steps requirement.
Startups should therefore avoid treating an investor questionnaire as the entire verification process.
What Records Should Startups Keep?
A startup should keep clear records showing how it determined that each investor qualified. Depending on the offering and verification method, those records may include investor representations, financial documents, professional confirmations, and other information supporting the company’s decision.
Good records can help show that the company followed the applicable securities rules and had a reasonable basis for its decision.
What Risks Can Come From Improper Investor Verification?
Failure to follow the applicable accredited investor rules can create serious legal and financial problems. Potential consequences can include enforcement actions, problems with the offering exemption, and investor rescission claims.
These issues can become especially difficult when they are discovered after a fundraising round has closed. Getting the verification process right before accepting funds is far easier than trying to correct a compliance problem later.
How Should Startups Prepare Before Accepting Investor Funds?
Startups should determine the applicable securities exemption before beginning the fundraising process. The company should then establish a verification procedure that matches the exemption’s requirements and keep records supporting each investor’s status.
Legal counsel can help founders review the offering structure, investor documents, verification procedures, and related securities issues before the round begins. General Counsel Consulting Solutions provides ongoing legal support to businesses that need experienced counsel without maintaining a full-time legal department.
For startups raising capital, confirming accredited investor status is more than an administrative task. It is part of building a fundraising process that respects the rules and protects the company as it grows.
Need Help With Startup Legal Compliance?
Raising capital comes with legal requirements that founders cannot afford to overlook. General Counsel Consulting Solutions can help your startup review its fundraising plans, investor documents, and securities compliance before problems arise.
If you are preparing for a funding round or want to review your current process, contact General Counsel Consulting Solutions to discuss your legal needs.