By: Louis Kern

You came up with a groundbreaking idea, formed an entity, and perhaps added to your leadership team. The hard part is over—or so you thought. Approximately 44% of all small businesses founded in 2014 did not exist after four years.[i] A primary cause? Lack of funding. One 2019 study of 101 startups that failed found that 29% were unsuccessful because they ran out of cash.[ii]

While bootstrapping may be a viable option for some businesses, most need to obtain some sort of external financing. Raising money may seem daunting to even the most well-connected entrepreneur. Identifying potential sources can be difficult, and navigating the murky waters of state and federal securities laws can be confusing. This post describes one option of obtaining external funding—a private placement—and summarizes a recent change regarding the persons eligible to invest through that vehicle.

  1. What is a Private Placement?

According to the U.S. Securities and Exchange Commission (SEC)[iii], a private placement is “a securities offering exempt from registration with the SEC.”[iv] Here’s what the SEC means—if you are trying to obtain money from someone other than yourself and you anticipate offering that person equity or debt in return, then you typically must notify the SEC. This process is referred to as “registration.”[v] Registering an offering requires your company to publicly disclose the terms of the deal and certain financial data, among other information.[vi] The SEC imposes the requirements as part of its mission to protect investors,[vii] but the process is generally complex, time consuming, and costly.

However, the SEC has recognized that certain investors do not necessarily need the full protection of its disclosure requirements when they invest in specific types of offerings. These “private placements” or “unregistered offerings” are therefore exempt from registration. Promulgated in 1982, Regulation D is a SEC regulation containing a number of those exemptions from registration that companies often utilize when raising money from others. Essentially, Regulation D is the SEC’s acknowledgement that the law negatively impacts the ability of small businesses to raise capital.[viii]

One of the most common Regulation D registration exemptions is Rule 506(b).[ix] The lion’s share of venture capital or angel investment is raised via this rule. Rule 506(b) allows your company to raise an unlimited amount of money by selling debt or equity to an unlimited number of “accredited investors” and no more than thirty-five “sophisticated” investors who are not accredited.[x] For persons who are no accredited investors, sophistication essentially means that they are able to evaluate the merits and risks of investing in your business based on their individual knowledge and experience in financial and business matters.[xi] There is no bright-line test for determining whether a non-accredited investor is sophisticated, and you should consult with your attorney if you are considering raising money from those investors.

  1. Who is an Accredited Investor?

If you can raise external funding from an unlimited number of accredited investors under Rule 506(b), the natural question is: who qualifies as an accredited investor? Before this summer, the answer was relatively simple — wealthy individuals and entities. Those included:

  • Directors, executive officers, and general partners of your company;
  • Natural persons who earned more than $200,000 (or $300,000 together with a spouse) in income each of the prior two years, and reasonably expect to earn the same amount in the current year;
  • Natural persons who have more than $1 million in net worth — excluding the value of their primary residence — either alone or together with a spouse;
  • Banks and certain other financial institutions;
  • Certain employee benefit plans;
  • Private business development companies;
  • Certain trusts having more than $5 million in total assets that were not formed for the specific purpose of investing in the offering;
  • Certain entities having more than $5,000,000 in total assets and which were not formed for the specific purpose of acquiring the securities; and
  • Entities in which all of the equity owners are accredited investors.[xii]

On August 26, 2020, the SEC “modernized” the accredited investor standard by adding certain other persons and entities to the definition.[xiii] In meaningfully updating the standard for the first time in over thirty years, the SEC stated that it wanted to more effectively identify investors that “have sufficient knowledge and expertise to participate in investment opportunities that do not have the rigorous disclosure and procedural requirements.”[xiv] The final rule now includes the following additional persons and entities under the definition of accredited investor:

  • Natural persons holding in good standing at least one professional certification, designation, or other credential from an SEC-qualifying accredited educational institution. For now, these include holders of FINRA Series 7, 65, and 82 licenses;
  • Natural persons who are “knowledgeable employees” of the company issuing the securities, if that company is a private-fund;
  • Limited liability companies (LLCs) having more than $5,000,000 in total assets and which were not formed for the specific purpose of acquiring the securities;
  • SEC and state-registered investment advisers, exempt reporting advisers, and rural business investment companies (RBICs);
  • Entities, including Indian tribes, governmental bodies, funds, and others organized under the laws of foreign countries, that own more than $5 million of “investments”—as defined in the Investment Company Act—and that was not formed for the specific purpose of investing in the securities; and
  • Family offices with more than $5 million in assets under management and their family clients, as each term is defined under the Investment Advisers Act.[xv]

“Today’s amendments are the product of years of effort by the Commission and its staff to consider and analyze approaches to revising the accredited investor definition.” — SEC Chairman Jay Clayton.

 

 

 

The SEC also clarified that natural persons may pool the income or net worth of a spouse or “spousal equivalent” for purposes of qualifying as an accredited investor.[xvi] A spousal equivalent is a cohabitant occupying a relationship generally equivalent to that of a spouse.[xvii]

III.       The Impact of the SEC’s Modifications

So, what does this mean? Put simply, more people are now considered accredited investors to whom you may offer securities in return for funding while not triggering SEC registration requirements. These include many persons who work for financial companies, unmarried wealthy individuals with long-term partners, LLCs with more than $5 million in total assets, and more. While the SEC recognizes that the impact of these changes on the total capital companies are able to raise is ambiguous,[xviii] the changes are undoubtedly a welcome improvement to the businesses that raised approximately $1.56 trillion through private placements under Regulation D in 2019.[xix]

 

NOTE: If you are considering raising money via a private placement, consult with your lawyers early in the process to ensure that all requirements are satisfied so that the offering is properly exempt from registration.

[i] Survival of Private Sector Establishments by Opening Year, U.S. Bureau of Labor Statistics, https://www.bls.gov/bdm/us_age_naics_00_table7.txt (Oct. 30, 2019).

[ii] The Top 20 Reasons Startups Fail, CB Insights, https://www.cbinsights.com/research/startup-failure-reasons-top/ (Nov. 6, 2019).

[iii] The SEC is a federal agency that oversees the financial industry to protect investors and maintain fair markets. See What We Do, U.S. Sec. Exch. Comm’n, https://www.sec.gov/Article/whatwedo.html (June 10, 2013).

[iv] Investor Bulletin: Private Placements Under Regulation D, U.S. Sec. Exch. Comm’n, https://www.investor.gov/introduction-investing/general-resources/news-alerts/alerts-bulletins/investor-bulletins-31 (Sept. 24, 2014).

[v] Registration Under the Securities Act of 1933, U.S. Sec. Exch. Comm’n, https://www.sec.gov/fast-answers/answersregis33htm.html (Sept. 2, 2011).

[vi] Id.

[vii] See id.

[viii] U.S. Sec. Exch. Comm’n, Report on the Review of the Definition of “Accredited Investor” (2015).

[ix] Constance E. Bagley & Craig E. Dauchy, The Entrepreneur’s Guide to Law and Strategy (5th Ed. 2018).

[x] 17 C.F.R. § 230.506(b)(2)(i) (2001).

[xi] 17 C.F.R. § 230.506(b)(2)(ii) (2001).

[xii] 17 C.F.R. § 230.501(a) (2019).

[xiii] Amending the “Accredited Investor” Definition, Securities Act Release Nos. 33-10824; 34-89669 (Aug. 26, 2020).

[xiv] Id.

[xv] Id. Note that the SEC may add certifications, designations, or credentials beyond FINRA Series 7, 65, and 82 licenses in the future. Any updates will be posted on the SEC’s website. Id.

[xvi] Id.

[xvii] Id.

[xviii] Id. For example, the SEC estimates that the upper bound of percentage of increase of the accredited investor pool due to the addition of newly qualifying individuals will be about 4%. Id. The SEC was unable to provide an estimation for the increase of the accredited investor pool due to the addition of newly qualifying entities. Id.

[xix] Id.