In “Bringing the Individual Accredited Investor Definition into the 21st Century,” which was posted on December 18th of last year, it was suggested that there might be certain common venture capital transactional structures that provide protections that could justify eliminating the additional disclosures and limitations required when non-accredited investors participate in an offering under Regulation D. If any of these structures were utilized, all securities issued in the transaction would be exempt from the registration requirements of the Securities Act. This is not a concept foreign to the Securities Act. For example, Section 3(a)(9) provides an exemption for “any security exchanged by the issuer with its existing security holders exclusively where no commission or other remuneration is paid or given directly or indirectly for soliciting such exchange.” The following are three additional types of transactional structures that could arguably sufficiently protect non-accredited investors and thus justify exempting the securities issued pursuant thereto from the registration requirements of the Securities Act.
The Gatekeeper Exemption. This transactional structure would require that one or two “gatekeepers” lead the negotiations for the proposed investment and purchase the lion’s share of the securities offered. Gatekeepers would need to be qualified in some manner with the Securities and Exchange Commission and provide regular publicly-filed reports to the Commission. The gatekeepers would be permitted to exact some small fee in connection with each investment to provide reimbursement for these costs. Non-accredited investors would be permitted to invest, subject to some dollar limitation both per investment and per annum, and the participation of non-accredited investors in any investment would be limited to some percentage of the overall investment. This structure is kind of a twist on “regulation crowdfunding” as proposed under the JOBS Act, but it doesn’t create the expenses (without any guaranty of success) that makes that proposed exemption largely untenable to cash-starved start-up issuers.
The Friends and Family Exemption. Everyone in the start-up world knows that, once the credit cards are maxed out, the next sources of capital are the friends and family of the founders. However, a founder’s college roommate may not yet have sufficient net worth or income to be deemed an accredited investor. Nonetheless, she or he may have a couple thousand dollars to spare to help her or his buddy out. This type of investment occurs all the time in early stage financings for start-up companies but can violate the Securities Act. If an exemption is created that limits these type of investments to close blood and marriage relatives, as well as people with whom a founder can establish a certain type of long relationship, these people would know at least one founder sufficiently well and thus have the knowledge needed to make the investment intelligently. There is also the argument that was used to justify overturning Prohibition that the federal government should not be creating a nation of scofflaws. In any case, these types of investments should be limited in amount, both per company and per annum, for any non-accredited investor.
Side Investments. More and more companies are making venture-type investments in private companies. These investing companies have professionals who do the diligence and negotiate the transaction for their employer. Yet often these very professionals do not qualify as accredited investors and, thus, could not make the investment they are recommending to and structuring for their employer on their own. Clearly, this makes no sense. These non-accredited professionals should be able to invest along side their employer – again, with per investment and per annum limitations.
Prior to the adoption of Regulation D, the private placement exemptions under the Securities Act tried to protect the public by, for example, limiting the participants to sophisticated investors. Regulation D substituted a bright line test, deeming persons who had an income or net assets exceeding a certain level as not requiring the protections required by the Securities Act – these investors are wealthy enough to “fend for themselves.” The time has come for expanding this concept to transaction structures that provide sufficient protections for all investors, regardless of wealth.