Recently the Securities and Exchange Commission (“SEC”) adopted final amendments to expand the definition of an accredited investor, something that has not happened in nearly 40 years. This is a big deal for cannabis companies (and all other companies) that are in fundraising mode because many of these companies rely on Rules 506(b) and 506(c) of Regulation D under the SEC’s rules. Offering securities to accredited investors is generally the safest way to engage in an offering.
According to the SEC, the revised rules will give individuals with the “knowledge and expertise” the ability to participate in “our multifaceted and vast private markets.” In plain language, it will let more book-smart people and insiders invest in private companies. In addition, it will give private marijuana and hemp companies access to seed capital that often comes with fewer strings than traditional bank and institutional investor financing arrangements.
As described in prior posts (see here and here), the SEC and state securities regulators want to protect investors from themselves and from shady companies. Accredited investors are the type of investors who can “take care of themselves.” They meet certain net worth or income requirements, showing that they either have the financial sophistication to know when they are putting their money at risk or enough of a financial cushion to bear the loss of their investment.
Another common accredited investor qualification is those investors who have inside knowledge of the offering company, investors who are already on the board of directors or managers and intimately acquainted with the company’s potential pitfalls. That is the type of insider knowledge that outsiders are not privy to.
Here are some highlights of the rule changes expanding the definition of accredited investors:
- Natural persons can qualify based on certain professional certifications, designations, or credentials or other credentials issued by an accredited educational institution, including those who hold Series 7, Series 65, and Series 82 licenses;
- Natural persons who are “knowledgeable employees” of a private investment fund;
- Any entity, including LLCs, Indian tribes, governmental bodies, funds, and entities organized under the laws of foreign countries with existing investments over $5M, as long as the investment vehicle was not formed for the specific purpose of investing in the offered securities;
- “Family offices” with at least $5M in assets under management and their “family clients” (both as defined under the Investment Advisers Act); and
- The income and assets of a “spouse equivalent” can be added to help spouse equivalents pool their investment assets to qualify as accredited investors.
This accredited investor expansion is important for many reasons. Here are seven of them:
- Companies can now raise funds earlier because they will be able to rely on the expanded federal exemption criteria instead of hunting through a patchwork of state exemptions.
- Companies can now raise funds on potentially better terms because they have a broader pool of potential investors from which to raise funds.
- Companies can now raise more funds in seed investment rounds because they have a broader pool of potential investors.
- Companies can now raise funds in a wider geographic range and will no longer need to focus on in-state investors.
- Companies can now raise funds without needing to research different state exemptions, depending on where their prospective investors live.
- Companies that weren’t aware of securities laws have a larger margin for fraud avoidance because states are likely to enact additional securities laws to encompass the expanded accredited investor definition. Many of these state securities laws exemptions contain self-executing safe harbor provisions.
- Offers limited to accredited investors means simpler private placement offerings because the issuer company can rely on one federal exemption instead of a patchwork of state and federal exemptions.
Although these rule changes have been in the works for several years, as the U.S. economy continues its slow recovery, the new definitions will give small and medium sized entities (SMEs) access to additional and different capital sources than those previously sought. The timing is excellent. It will also let newly minted accredited investors invest in non-traditional ways to manage their own finances separately from the public markets.
It is also interesting to note that the accredited investor qualification hurdle has gotten progressively lower since the 1982 adoption because the definition has not accounted for inflation. Using 1980 as the baseline, $1.00 then had the buying power of approximately $3.14 in 2020. All of this means good news for cannabis companies seeking investors. Even though these rules do not become effective until 60 days after publication in the Federal Register, it is time to start having conversations with prospective investors.
Written by Jonathan Bench: Jonathan is co-chair of Harris Bricken’s corporate practice group, where he focuses on international and domestic business transactions.