When raising capital, many private companies, or issuers, regularly rely on the exemption from registration provided in Rule 506(b) under Regulation D promulgated under the Securities Act of 1933, as amended (Securities Act). A private placement under Rule 506(b) is appealing to issuers because (1) the issuer can raise an unlimited amount of capital from an unlimited number of accredited investors and up to 35 non-accredited, but sophisticated, investors, and (2) the transaction qualifies for an exemption from registration or qualification under state securities laws (known as “blue-sky” laws), so long as the issuer refrains from a general solicitation and is not disqualified as a “bad actor” under Rule 506(d). Another reason for the popularity of a private placement under Rule 506(b) is that the disclosure requirements under Rule 502(b)(2) do not apply to accredited investors. As a result, as a preliminary matter before any documents are drafted or any discussions with investors can begin, a company must decide to include or exclude non-accredited investors.
If a company includes any non-accredited investors in a private placement, then the company must provide each non-accredited investor with much of the same information required in a registration statement. Depending on the size of the private placement, an issuer is required to provide two years of its financial statements, including balance sheet, income statements, statements of stockholder equity, and other financial information, which may need to be audited or certified by independent accountants. In addition, the issuer must provide non-accredited investors with a description of the securities being offered and the issuer’s business as well as any information provided to accredited investors. Preparing this level of disclosure, which is much greater than what is typically provided to accredited investors in private placements under Rule 506(b), uses up a lot of resources, including time, attention of management, and money. It is not uncommon for companies to spend over $50,000 in legal and accounting fees preparing the required disclosure.
Further, in addition to the cap of 35, only those non-accredited investors who are “sophisticated” can participate in a Rule 506(b) private placement. Rule 506(b)(2)(ii) requires that each non-accredited investor (alone or with a purchaser representative) possess “such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment.” An issuer can rely on its reasonable belief that a non-accredited investor meets the test for sophistication, and many issuers require non-accredited investors to complete a sophisticated investor questionnaire to support that belief. There is, however, no bright-line test as to what constitutes a “sophisticated” investor, and, if the matter were to be litigated, the issuer would have the burden to justify its reasonable belief in such non-accredited investor being sophisticated. Some issuers, rather than rely on a belief, elect to pay for a purchaser representative to represent all non-accredited investors, incurring such expense to remove some uncertainty.
By excluding non-accredited investors from a private placement, issuers do not have to provide all of the information required under Rule 502(b)(2) (though all of the anti-fraud provisions of the Securities Act still apply) and remove the uncertainty of sophistication. Generally speaking, “accredited investors” under Rule 501 of Regulation D include banks, insurance companies, trusts, brokers, officers and directors of an issuer and net worth individuals, with high net worth individuals being individuals who have (a) net worth of $1.0m or more (excluding their primary residence) or (b) income of $200,000 (or joint income of $300,000) in each of the last two years with a reasonable expectation of that same income in the coming year. In short, accredited investors are typically financially sophisticated investors. And the idea behind the reduced disclosure requirements for accredited investors is that these investors know what questions to ask and know how to protect themselves when it comes to an investment in restricted securities as well as being able to handle the financial reality of having an investment for an indefinite period of time.
As a practical matter, issuers should ascertain the status of an investor as an accredited or non-accredited investor at the onset of their discussions relating to the private placement. Most institutional accredited investors know their status, but some individuals may not. It is recommended that an issuer has on hand an accredited investor questionnaire that tracks the language of Rule 501 (and a sophisticated investor questionnaire for non-accredited investors) to facilitate the determination.
While issuers may be reluctant to exclude non-accredited investors from their potential investor pool at the onset, practically it may not impact the success of the private placement. How many people who do not meet the high net worth individual test have $10,000, $20,000 or more to invest in a private placement and hold indefinitely a restricted security? A company has to ask itself if the inclusion of non-accredited investors justifies the increased cost to comply with the specified disclosure requirements.
ABOUT JULIA TAYLOR
Julia V. Taylor’s practice focuses on mergers and acquisitions, debt and equity financing, corporate governance, as well as general corporate law. She helps clients with the formation and initial capitalization of business entities, including entity selection, founder agreements, employee confidentiality agreements, subscription agreements, incentive equity plans, shareholder agreements, and operating agreements. Ms. Taylor also serves as outside general counsel to clients, providing advice on a diverse range of issues that impact a company, such as employment, licensing, and intellectual property matters.
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