Jim Verdonik
Founder of Innovate Capital Law
Contact me at:
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.
Timing
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.
- Recommendations.
- 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:
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