Each investor does not necessarily have to be an accredited investor (see definition below), but life will be a lot easier if they are. Generally, a convertible promissory note, even for a small start-up, will be considered a security if the maturity is over nine months. (This is not absolute but is a good rule of thumb.) Securities must either be registered with the Securities and Exchange Commission (SEC) or offered pursuant to a registration exemption. Registration is what happens with initial public offerings (IPOs) and is time-consuming and expensive. You would not want to register notes offered in a friends and family round. Regulation D of the Securities Act of 1933 contains several exemptions from registration, which can be found in Rules 504, 505, and 506. This would be a long guide indeed if I detailed all of the benefits and restrictions of each rule, but briefly, Rule 504 allows companies to raise up to $1 million from investors in any 12-month period, and those investors do not have to be accredited. Rule 505 allows companies to raise up to $5 million from investors in any 12-month period, with an unlimited number of accredited investors and up to 35 persons that are not accredited investors. Rule 506 allows companies to raise an unlimited amount from investors in any 12-month period, with Rule 506(b) allowing an unlimited number of accredited investors and up to 35 persons that are not accredited investors if general solicitation is not used and Rule 506(c) not allowing any non-accredited investors if the company does use a general solicitation to sell its securities. Investors generally receive restricted securities in a Regulation D offering, that may only be resold if the company has registered the offering or if another exemption is used (such as the private placement exemption). The Securities Act provides that companies relying on either Rule 505 or Rule 506(b) must provide information to non-accredited investors that is very similar to what is provided in a registration statement, and is much more comprehensive than the vast majority of start-ups are prepared to make, particularly early in their life cycle. The Securities Act specifically states that a company is not required to furnish such information to purchasers when it sells securities under Rule 504. However, Rule 504 offerings are subject to the state securities laws of all of the states in which the securities will be offered, and more often than not these "blue sky" laws require disclosures to investors that are similarly burdensome. But, states do vary. It is worth engaging a securities attorney to research each state's blue sky laws in which a company plans to offer securities, as there could very well be exemptions available. Note that in the registration statement for an IPO a company will have to disclose prior sales of unregistered securities. The SEC will scrutinize these sales to ensure there were no violations of securities laws. Given the increased possibility for a securities law violation, some angel and institutional investors will not invest in a company that has non-accredited investors.
Accredited Investor Definition
An accredited investor is an individual with who had an income in excess of $200,000 in each of the two most recent years or joint income with his/her spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year; a net worth exceeding $1 million not including the value of the person's primary residence; or is a director, executive officer, or general partner of the issuer of the securities being offered or sold, or any director, executive officer, or general partner of a general partner of that issuer.
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