By: Jim Verdonik
I'm an attorney with Ward and Smith PA. I also write a column about business and law for American Business Journals, have authored multiple books and teach an eLearning course for entrepreneurs. You can reach me at JFV@WardandSmith.com. Or you can check out my eLearning course http://www.youtube.com/user/eLearnSuccess or you can purchase my books at http://www.amazon.com/Jim-Verdonik/e/B0040GUBRW
Most of the discussion about verification of "Accredited Investor" status in Rule 506 (c) offerings has been about verifying that individual investors are accredited.
But individual investors aren't the only sources of capital. Other investors often include:
- Small investment funds.
- Businesses that want to invest cash to invest to promote a customer or a supplier.
- Vendors who are willing to trade goods or services for stock.
How can issuers satisfy their obligation to take reasonable steps to verify the Accredited Investor status of these types of entities that want to invest in your Rule 506 (c) offering?
Some of these types of investors may contact you because of your general solicitation on a technology platform or through social media.
We think if the platforms that advertise offerings as ways to raise capital. But sales people will be looking at these platforms to find businesses that are growing and who may need the products and services they sell. Some of these sales people will be contacting issuers that make general solicitations and offer to take part of the payment for products and services in stock.
You may meet investment funds, corporate partners and vendors through in-person networking that has nothing to do with your general solicitation. But, because of the SEC's integration rules, it may be difficult to find another exemption from registration, if you are conducting a simultaneous Rule 506 (c) offering. So, you may be forced to take reasonable steps to verify the Accredited Investor status of many types of business entities that you meet in different ways.
As more offerings utilize Rule 506 (c):
- How do small investment funds, trusts and other business entities demonstrate to issuers that they are Accredited Investors?
- How do issuers satisfy the requirement to take "reasonable steps" to verify the Accredited Investor status of small investment funds and other business entities.
Let's start our analysis by looking at the two potential ways small investment funds and other business entities can be an Accredited Investor:
- Rule 501 (a) (3) indicates that any corporation or partnership "not formed for the specific purpose of acquiring the securities being offered or sold" is an Accredited Investor, if the entity has "total assets in excess of $5,000,000."
- Rule 501 (a) (8) indicates that "any entity in which all of the equity owners are accredited investors" is an Accredited Investor.
$5 Million + Total Assets Test
Let's discuss the $5 million + total assets test first.
Total assets for investment funds and other business entities are generally easier to determine than the net assets-test for individuals. You don't have to consider any liabilities of the investment fund or other business entity.
But unlike individuals, Rule 506 (c) doesn't provide a safe harbor for verifying that an entity meets the greater than $5 million total assets test. So, you have to rely on the more ambiguous "principles based" way to determine that you have taken reasonable steps to determine that different types of entities have more than $5 million of assets.
Some types of assets are easy to verify:
- If an investment fund has $6 million sitting in a bank account, then seeing the bank statement should be sufficient to verify the investment fund's Accredited Investor status.
- Likewise, an investment fund that invests in publicly traded securities can easily provide a brokerage account statement that shows the current market values of the securities in its account.
But many private issuers conducting a 506 (c) offering are likely to encounter small investment funds that focus primarily on investing in illiquid investments. There is no simple one size fits all way to establish the value of securities in privately held businesses.
- What multiple of revenue or EBITDA or profit or other metric do you apply to an industry?
- If there is a range of multiples for different companies in the industry (as is usually the case), what factors make this particular company more like businesses with the higher multiples or the lower multiples within the range?
- What discount do you apply for minority interest?
- What discount do you apply for illiquidity?
- What is the company saying about the value of its securities.
Because there is no single right or wrong answer to these questions, once the investment fund turns cash into securities of a privately owned business the value of the securities becomes unclear.
Entities that operate active businesses present other valuation issues. Most businesses don't have a lot of extra cash sitting around. Cash is constantly moving in and out of the business. Some businesses own tangible assets like real estate that has a readily ascertainable value. But the balance sheet of the businesses may carry real property at the property's depreciated cost. Used equipment that is highly specialized may have a very limited re-sale value. Often, most of the value of a business is in its intellectual property and customer relationships. Balance sheets rarely reflect the value of these intangible assets.
Investment fund balance sheets tend to be a better indicator of value than for businesses that operate an active business other than investing. Most operating businesses sell for valuations that are much higher than the value of their assets on the balance sheet. State corporate statutes related to insolvency recognize this and allow Boards of Directors to value assets higher than their balance sheet value. In doing such valuations, Boards of Directors often rely on experts to value assets like intellectual property or to value the business as a going concern, which includes the value of customer relationships. In other instances, the Board knows that businesses in their industry generally sell for a certain multiple of revenue, profit or EBITDA and the Board uses that measure to value the business.
A company raising capital isn't likely to have sufficient leverage to have a Board of Directors of a potential investor hire an expert to value assets or even do a valuation based on a multiple of revenue, profit or EBITDA. To raise capital, issuers will usually have to rely on less formal ways to take reasonable steps determine an investor has more than $5 million of assets.
Clearly, it would be burdensome to require all issuers who sell securities to a small investment fund or other business entity to dig down into these valuation criteria for all the securities owned by the investment fund or to try to value a privately owned business the investor operates. Where an entity cannot produce as balance sheet that shows more than $5 million in assets, issuers should be able to rely on other valuation criteria the investor represents reflects the true value of its assets.
Self-Certification of Assets' Value
The big issue is: Is it reasonable to rely on the investment fund's own valuation of the privately owned securities it holds or on an investor's own valuation of its business?
In tax and other situations where valuation is an issue, unless regulations specify a specific way to value assets, regulators look for consistency in valuations that are used for multiple purposes. Regulators generally become suspicious if you try to value the same assets in different ways to achieve different purposes.
For example, if the investment fund or other business entity provides financial statements to its investors or to tax authorities or other regulators, it would probably be reasonable to rely on values of assets listed in the entity's financial statements. The level of effort devoted to preparing financial statements may also affect an issuer's decision whether to rely on the financial statements. If the financial statements are audited or reviewed, you would have greater reason to rely on the investment fund's financial statements.
For an investor who operates an active business other than making investments, obtaining a representation that the business could be sold for more than $5 million could satisfy the requirement to take reasonable steps to verify Accredited Investor status.
Of course, any investigation of an investor to do can also help. For example:
- Do you know the investor's brand and customers?
- Have you seen the investor's physical plant?
- Has the investor done other investment deals before?
Documenting all such information you have about the investor can help you to determine that you have taken reasonable steps to verify Accredited Investor status, because you are not relying solely on the self-certification of the investor.
The next issue is timing.
How long can you rely on financial statements or other asset valuations? For individuals, the safe harbor's net worth test has a 90-day expiration period. If an investment fund or other business does not normally create quarterly or monthly balance sheets, requiring them to do so to verify Accredited Investor status would be unduly burdensome. It might be reasonable to rely on a statement from the investment fund or other business that it knows of no reason its assets values have decreased since the date of the last balance sheet that shows in excess of $5 million of total assets.
Not Formed for the Specific Purpose
You can rely on the $5+ million assets test only if the investment fund or other business entity was "not formed for the specific purpose of acquiring the securities being offered or sold."
This raises the issue of follow-on investments. What happens, if the investment fund was originally formed to invest in the business two years ago and now wants to make a second investment?
The definition of Accredited Investor doesn't address the issue of two separate offerings by the same issuer to the investment fund. But since Rule 506 applies on an offering by offering basis, it makes sense to interpret the Accredited Investor definition's requirement that the investor not be formed for the purpose acquiring the securities being offered or sold on an offering by offering basis.
If we apply requirement that the investor not be formed for the purpose acquiring the securities being offered or sold on an offering by offering basis, you could rely on the $5+ million assets definition of Accredited Investor in the second offering even if you couldn't rely on that test for the first offering, because the fund was organized for the specific purpose of investing in the first offering.
Of course, you would need to verify that the two offerings are not integrated under the SEC's traditional integration rules. Another issue arises if the investment fund allocates ownership of the securities purchased in the second offering only to its investors who put up new money for the second offering. Even if the legal entity is ten years old, each segregated pot of money might be a new entity for purposes of the Accredited Investor test.
Another issue that a second offering raises is how you value the issuer's own securities that the investment fund bought in the first investment round when you determine whether the investment fund has more than $5 million of assets for purposes of the second investment round:
- If the second round is a "down round," should you continue to value the first round at the original first round investment price?
- If the second round is an "up round," can you mark up the value of the first round securities even though the investment fund's financial statements don't yet reflect this valuation increase?
- Is another investor who was not part of the first investment round setting the price for the "up round?" Or are the first round investors making their own determination that the business has increased in value?
- Have concrete value milestones been achieved after the first investment round?
- How do you take into account different preferences and other rights the two rounds may have when you value the first round?
Are All the Investor's Owners Accredited Investors?
Now, let's turn our attention to the other way an investment fund or other business entity can be an Accredited Investor.
Rule 501 (a) (8) indicates that "any entity in which all of the equity owners are accredited investors" is an Accredited Investor.
You can apply the tests in the other provisions of Section 501 (a) to determine which owners are Accredited Investors depending on whether the owners of the investor are natural persons or entities. Since we just talked about the greater than $5 million of assets test for business entities, let's discuss the two parts of Section 501 (a) that apply to natural persons.
There are two objective tests for determining whether natural persons are Accredited Investors. Rule 506 (c)'s safe harbor refers to both:
- The safe harbor income test of $200,000 of income lasts for one full year. Once you verify income for the preceding years, you don't have to check again until the current year ends.
- The safe harbor net assets test lasts only 90 days. After 90-days you fall outside the safe harbor unless you check updated documents.
The 90-day net assets test raises a question, on the 91st day you are outside Rule 506 (c) safe harbor. It often takes more than 90-days to close transactions. Would relying on the outdated net assets documents certification still be within the principles based approach to verification? Would relying on 91-day old financial information still constitute taking reasonable steps to verify Accredited Investor status?
The principles based approach to Accredited Investor verification depends on specific facts and circumstances relating to each offering and each investor. Whether relying on documents that are older than 90 days is a reasonable step would depend on a number of factors, including:
- How much longer after 90 days will you close the investment?
- How much above the $1 million net worth level was the investor? If the investor produced documents that showed a $10 million net worth, it's probably reasonable to rely on the documents after the safe harbor time period expires. It might not be reasonable, if the investor's net worth number was barely above $1 million.
- Whether the investor agreed to update you about net worth changes that occur before the closing.
- Whether you asked the investor for a written or verbal self-certification net worth update before the closing.
- Was there an intervening stock market crash or other event at would cause you to question whether the investor's net worth fell below the $1 million level?
- Was the investor's net worth diversified? Or did it primarily depend on one volatile asset?
Verification by a Manager or Officer of the Accredited Investor Status of All the Owners
Can you rely on the manager of an investment fund or officers of a business to tell you that all the owners are Accredited Investors?
Rule 506 (c)'s safe harbor lists specific people issuers can rely on to review the financial information of investors- licensed attorneys and accountants and registered broker-dealers and investment advisers. So, relying on a manager or officer of an investor would be outside Rule 506 (c)'s safe harbor. But under the principles based reasonable steps test, you can rely on other people to check investor documents. You just don't have the same level of protection against someone later challenging your decision to rely on them, if you don't fall within the safe harbor.
SEC Release (33-9415) indicates that these outside experts listed in Rule 506(c)'s safe harbor re not an exclusive list:
"While third-party confirmation by one of these parties will be deemed to satisfy the verification requirement in Rule 506(c), depending on the circumstances, an issuer may be entitled to rely on the verification of accredited investor status by a person or entity other than one of these parties, provided that any such third party takes reasonable steps to verify that purchasers are accredited investors and has determined that such purchasers are accredited investors, and the issuer has a reasonable basis to rely on such verification."
But the issuer can't fully delegate the issuer's responsibility to the manager or officer. The issuer still has to determine that the manager or officer has taken reasonable steps to verify that all the owners are Accredited Investors on the date of the investment. Accordingly, issuers should ask the manager or officer to describe the steps the manager or officer takes to verify that all the owners are Accredited Investors:
- When was the last time anyone asked the owners to verify relevant financial information?
- When was the last time anyone asked the owners to self-certify that they are Accredited Investors?
- Are the owners generally so wealthy that seeking financial documents seems unnecessary?
- Do the owners often invest large amounts in private placement transactions?
- How well does the officer or manager know the owners?
If the issuer determines that the steps the officer or manager took to verify that all the owners are Accredited Investors seem reasonable under the circumstances, then the issuer must determine whether it is reasonable to rely on the particular officer or manager who is making the representation.
When we determine that we can rely on people, we generally are making two determinations – whether the person is truthful and whether the person is competent to find the truth. Businesses do this every day. Issuers should be able to use the same standards for judging truthfulness and competency that they use in other situations, including:
- General business reputation.
- Personal observation.
- Background checks.
Under the principles based approach to determining whether the issuer has taken reasonable steps, how many of these tools are necessary will depend on the facts and circumstances. What would a reasonable person do given all the knowledge that person has?
Can You Use Rule 506 (c)'s Grandfather Provision?
Rule 506 (c) (2) (ii) (D) contains a grandfathering safe harbor that applies to verifying the Accredited Investor status of certain investors who were investors before Rule 506 (c) became effective:
"In regard to any person who purchased securities in an issuer's Rule 506(b) offering as an accredited investor prior to September 23, 2013 and continues to hold such securities, for the same issuer's Rule 506(c) offering, obtaining a certification by such person at the time of sale that he or she qualifies as an accredited investor."
Note that this grandfathering rule specifically applies to the owners of the issuer's securities. It does not say that investment funds can have their investors self-certify their Accredited Investor status for the purpose of determining whether the investment fund is an Accredited Investor. But wouldn't extending this grandfathering provision to investors in funds serve the same purpose that the grandfather provision serves? The grandfathering provision protects both issuers and investors:
- Grandfathering protects issuers, because issuers and their officers and directors may have either contractual, fiduciary or other obligations to allow their existing investors to participate in later investment rounds.
- Grandfathering protects existing investors, because the ability to participate in future investment rounds is the most effective anti-dilution protection investors have.
Since the owners of investment funds beneficially own the investment fund's portfolio securities, it seems reasonable to allow investment fund managers to ask the fund's existing investors to self-certify their current Accredited Investor status.
But how far should grandfathering be permitted?
The strongest case for grandfathering is where an investment fund was an owner of the issuer's securities on September 23, 2013 and the owners of the investment fund haven't changed since September 23, 2013. How should changes affect grandfathering? For example:
- If the investment fund's owners change after September 23, 2013, should the fund still be grandfathered? In this situation, the new investors in the investment fund have no interest to protect, because they made their investment decision after September 23, 2013. But both the issuer and the old investors have the same interests to protect. Should the change in ownership affect grandfathering?
- If the investment fund invests in a new issuer after September 23, 2013, should the investment fund still be grandfathered? On the one hand, people who invested before September 23, 2013 had a reasonable expectation that the investment fund would have access to deals. The fund may be excluded from many deals if the fund cannot satisfy issuers that the fund is an accredited investor. On the other hand, new issuers have no interest to protect (because they can't be sued for not letting the fund invest) and perpetually grandfathering the investment fund could create a major loophole in the reasonable steps verification obligation.
Of course, issuers aren't empowered to extend the grandfathering provision beyond what is stated in Rule 506, but under a principles based approach to taking reasonable steps to verify Accredited Investor status that depends on the facts and circumstances of each situation, issuers should be able to take into account the reasoning behind the grandfather provision to determine what is reasonable under the circumstances for each investment fund or other entity that was an investor on September 23, 2013.
Other Articles about Verifying Accredited Investor Status in Rule 506 (c) Offerings
This is one of a series of several articles about verifying Accredited Investor status in Rule 506 (c) offerings. The other articles deal with:
What is a reasonable basis for deciding you can use a technology platform operator to verify the Accredited Investor status of investors in Rule 506 (c) offerings?
How do you verify the Accredited Investor status of angel investors and angel groups in Rule 506 (c) offerings using the Angel Capital Association's Experienced Angel Group Program? The Angel Capital Association Program might apply to some types of small investment funds described above, if they are dedicated to investing in early-stage companies and satisfy other criteria.
We discuss the general requirement to take reasonable steps to verify Accredited Investor status and the details of Rule 506 (c)'s verification safe harbor provision in an earlier article:
If you would like to learn more about learning how to grow your business or other issues important to your success, you can reach me at JFV@WardandSmith.com. Or you can check out my eLearning course at http://www.youtube.com/user/eLearnSuccess or you can purchase my books at http://www.amazon.com/Jim-Verdonik/e/B0040GUBRW