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If you are looking for a short, individual accredited investor certification that takes into account the Dodd-Frank changes and the SEC guidance of just a couple of days ago, please see my example below. The changes prompted by the new law and the recent SEC guidance are emphasized in bold.

The Dodd-Frank bill does not change the requirement that the issuer has to reasonably believe that an investor is accredited.  As to what constitutes a reasonable belief, see SEC Release 33-6455, March 3, 1983:

"What constitutes 'reasonable belief' will depend on the facts of each particular case. For this reason, the staff generally will not be in a position to express views or otherwise endorse any one method for ascertaining whether an investor is accredited."

This short form certification is designed for use with other documents. Depending on the size of the offering, how well the principals of the issuer know the individual investors, and the number and type of investors, this short form certification may or may not be sufficient. Issuers should always utilize counsel when engaging in a securities offering.

INDIVIDUAL ACCREDITED INVESTOR CERTIFICATION

I hereby certify that I am familiar with the definition of the term “accredited investor” as defined in Rule 501 of Regulation D issued pursuant to the Securities Act of 1933, as amended, and that I meet the criteria to qualify as an accredited investor, in the category or categories indicated by my initials below.

1. [        ] I am a director, executive officer, or general partner of the issuer of the securities being offered or sold, or a director, executive officer, or general partner of a general partner of that issuer.
2. [        ] I am a natural person whose individual net worth, or joint net worth with that of my spouse, is at least $1,000,000, excluding the value of my primary residence, but including indebtedness secured by such residence in excess of the value of such residence.
3. [        ] I am a natural person who had individual income in excess of $200,000 in each of the two most recent years or joint income with my spouse in excess of $300,000 in each of those years and I have a reasonable expectation of reaching the same income level in the current year.

Dated:                                                 

Signature

Print name

Address:                                              

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Thanks to Broc Romanek for flagging this news this morning.

The SEC has issued a Compliance and Disclosure Interpretation ("CDI") relating to the new definition of accredited investor under the Dodd-Frank Act. I have quoted it in full below. You can find it here.

The key takeaway is--"Indebtedness secured by the residence in excess of the value of the home should be considered a liability and deducted from the investor’s net worth."

Section 179. Rule 215 – Accredited Investor

Question 179.01

Question: Under Section 413(a) of the Dodd-Frank Act, the net worth standard for an accredited investor, as set forth in Securities Act Rules 215 and 501(a)(5), is adjusted to delete from the calculation of net worth the “value of the primary residence” of the investor. How should the “value of the primary residence” be determined for purposes of calculating an investor’s net worth?

Answer: Section 413(a) of the Dodd-Frank Act does not define the term “value,” nor does it address the treatment of mortgage and other indebtedness secured by the residence for purposes of the net worth calculation. As required by Section 413(a) of the Dodd-Frank Act, the Commission will issue amendments to its rules to conform them to the adjustment to the accredited investor net worth standard made by the Act. However, Section 413(a) provides that the adjustment is effective upon enactment of the Act. When determining net worth for purposes of Securities Act Rules 215 and 501(a)(5), the value of the person’s primary residence must be excluded. Pending implementation of the changes to the Commission’s rules required by the Act, the related amount of indebtedness secured by the primary residence up to its fair market value may also be excluded. Indebtedness secured by the residence in excess of the value of the home should be considered a liability and deducted from the investor’s net worth. [July 23, 2010]

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Now that the new definition of accredited investor is in effect, questions are coming up on how to implement the new definition (aside from just using the new definition going forward). Two questions that we have become aware of are set forth below.

Question:  How does the change in the definition of accredited investor affect ongoing offerings? What if a company is in the middle of an offering and has had a closing and in that closing accepted funds from an investor who was accredited under the old definition but is not accredited under the new definition? Does the company have to return the investor's money?

Answer: For offerings under Regulation D, accreditation is determined "at the time of the sale of the securities" under Rule 501. If a company has had a closing and accepted funds from an investor in that closing who to the company's reasonable belief was accredited at that time, we do not believe that the company should have to return the funds from that investor. But companies should be cautious that they have in fact closed on such funds. If, for example, an investor has completed documents but the subscription agreement has not been accepted by the company, or if there was an escrow or a milestone that had to be met before the closing could occur, the company may very well have to return the investor's funds.

Question: What happens if an investor has a negative value in their primary residence, meaning that an investor has more debt on their primary residence than value? How is that taken into account? We know that we exclude the "value" of the primary residence in determining net worth. But do we include negative value in a primary residence in determining net worth?

Answer: The SEC has indicated orally that negative net value in a primary residence should be taken into account in determining net worth. We expect that the SEC will issue guidance on this in the future.

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President Obama has signed the Dodd-Frank Wall Street Reform and Consumer Protection Act.

This means that the new definition of accredited investor is now in effect. The new definition applies to existing offerings. It is effective immediately.

Under the new definition, in determining whether an individual is an accredited investor under the net worth standard, the value of the primary residence of the investor must be excluded. See Section 413 of the Act, quoted below. 

For individual investors to qualify as accredited investors, they will now have to meet one of the three following categories.

1. A director, executive officer, or general partner of the issuer of the securities being offered or sold, or a director, executive officer, or general partner of a general partner of that issuer.
2. A natural person whose individual net worth, or joint net worth with spouse, is at least $1,000,000, excluding the value (if any) of such investor's primary residence.
3. A natural person who had individual income in excess of $200,000 in each of the two most recent years or joint income with spouse in excess of $300,000 in each of those years and a reasonable expectation of reaching the same income level in the current year.

SEC. 413. ADJUSTING THE ACCREDITED INVESTOR STANDARD.

(a) In General- The Commission shall adjust any net worth standard for an accredited investor, as set forth in the rules of the Commission under the Securities Act of 1933, so that the individual net worth of any natural person, or joint net worth with the spouse of that person, at the time of purchase, is more than $1,000,000 (as such amount is adjusted periodically by rule of the Commission), excluding the value of the primary residence of such natural person, except that during the 4-year period that begins on the date of enactment of this Act, any net worth standard shall be $1,000,000, excluding the value of the primary residence of such natural person.

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As soon as President Obama signs the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Act") (link to here), companies raising funds are going to have to adjust their definition of "accredited investor" to exclude from the net worth standard for individual investors the value of their primary residences in determining whether they qualify as accredited investors. See Section 413 of the Act, quoted below.

As far as Section 926 goes, which is quoted below, no immediate action is required. We have to wait until the SEC issues rules.

For individual investors to qualify as accredited investors, they will now have to meet one of the three following categories. 

1. A director, executive officer, or general partner of the issuer of the securities being offered or sold, or a director, executive officer, or general partner of a general partner of that issuer.
2. A natural person whose individual net worth, or joint net worth with spouse, is at least $1,000,000, excluding the value of such investor's primary residence.
3. A natural person who had individual income in excess of $200,000 in each of the two most recent years or joint income with spouse in excess of $300,000 in each of those years and a reasonable expectation of reaching the same income level in the current year.

For your convenience, I've attached a post Dodd-Frank Individual Investor Accredited Investor Certification.

How badly will this change in the law crimp the availability of capital for startups? It is unknown. Some people believe it could knock out a significant percentage of the angel investment community. I don't know. If you have data to share on this point, I would very much appreciate your sharing it.
 

SEC. 413. ADJUSTING THE ACCREDITED INVESTOR STANDARD.

(a) In General- The Commission shall adjust any net worth standard for an accredited investor, as set forth in the rules of the Commission under the Securities Act of 1933, so that the individual net worth of any natural person, or joint net worth with the spouse of that person, at the time of purchase, is more than $1,000,000 (as such amount is adjusted periodically by rule of the Commission), excluding the value of the primary residence of such natural person, except that during the 4-year period that begins on the date of enactment of this Act, any net worth standard shall be $1,000,000, excluding the value of the primary residence of such natural person.

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by William Carleton, Joe Wallin and Marcus Williams

Is there a loophole in the "Angel Investor Amendment" just passed this week by the Senate? If so, was it intended, or does it reflect a last-minute mistake?

"Section 412(b)(2) [in SA 4056, the version of the amendment that actually passed,] mandates that the SEC undertake reviews of the definition every 4 years thereafter, but solely as regards the definition of the term in 17 CFR Sec. 230.215 (Rule 215 under the '33 Act for purposes of the definition of "accredited investor" in Section 2(a)(15)(ii) and, in turn, the Section 4(6) exemption), but not as regards the definition in Rule 501(a) of Reg. D. The version of Section 412 in SA 4037 made no such distinction between the rules."

Here's a summary of precisely what the amendment does, with respect to the Reg D accredited investor definition:

• mandates an immediate change in both accredited investor definitions, to exclude the value of one's principal residence from the net worth threshold of $1 million;
• contemplates (but does not require) that the SEC may review the definition as a whole (including, presumably, the annual income requirements); and
• requires that there be no adjustments to any accredited investor definition that raise the net worth threshold in excess $1 million, less the value of one's principal residence, for a period of four years.

We are staying tuned to see if the House-Senate conference committee revisits this distinction. 

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By Joe Wallin and William Carleton

On a voice vote today (7 pm Eastern time, just a few minutes ago), the United States Senate amended Senator Dodd's financial regulatory reform bill, fixing what had been previously proposed for startup companies and angel investors.

The amendment, SA 4056, was co-sponsored by Senator Dodd and many others, and we believe it largely incorporates what Senators Bond, Cantwell, Warner and Brown introduced Thursday last week as SA 4037.

Senator Murray joined Senator Cantwell as a co-sponsor of SA 4056, meaning that both Senators from Washington State stood up and acted to protect startups, angels, startup innovation, and the jobs the startup ecosystem creates. Congratulations to Marianne Hudson of the Angel Capital Association, and Dan Rosen of the Seattle Alliance of Angels!

We expect to confirm shortly that SA 4056 does the following:

• eliminates the industry killing 120 day wait period;
• eliminates the "go back in time" provision, which would have re-adjusted the accredited investor financial thresholds in a way that would have wiped out 2/3rds of existing angel investors qualifying as "accredited investors";
• excludes the value of an investor's primary residence in determining whether the investor would meet the net worth standard; and
• adds "bad boy" provisions to Rule 506 offerings.

We expect to find that SA 4056 may improve SA 4037 slightly, by protecting the current accredited investor income thresholds for four years, in addition to protecting the current net worth test for four years (other than the exclusion of home value).

As soon as we obtain a copy of the amendment as passed, we will post it. Thank you Senators Murray and Cantwell!

UPDATE 05-18-10. Here now is the text of SA 4056, from the Congressional Record:

The Senator from Connecticut [Mr. DODD], for Mr. Bond, for himself, Mr. Dodd, Mr. Warner, Mr. Brown of Massachusetts, Ms. Cantwell, Mr. Begich, Mrs. Murray, and Mr. Corker, proposes an amendment numbered 4056 to amendment No. 3739.

   Mr. DODD. Mr. President, I ask unanimous consent that the reading of the amendment be dispensed with.

   The PRESIDING OFFICER. Without objection, it is so ordered.

   The amendment is as follows:

    On page 387, strike line 13 and all that follows through page 388, line 3, and insert the following:

   SEC. 412. ADJUSTING THE ACCREDITED INVESTOR STANDARD.

    (a) In General.--The Commission shall adjust any net worth standard for an accredited investor, as set forth in the rules of the Commission under the Securities Act of 1933, so that the individual net worth of any natural person, or joint net worth with the spouse of that person, at the time of purchase, is more than $1,000,000 (as such amount is adjusted periodically by rule of the Commission), excluding the value of the primary residence of such natural person, except that during the 4-year period that begins on the date of enactment of this Act, any net worth standard shall be $1,000,000, excluding the value of the primary residence of such natural person.

    (b) Review and Adjustment.--

    (1) INITIAL REVIEW AND ADJUSTMENT.--

    (A) INITIAL REVIEW.--The Commission may undertake a review of the definition of the term ``accredited investor'', as such term applies to natural persons, to determine whether the requirements of the definition, excluding the requirement relating to the net worth standard described in subsection (a), should be adjusted or modified for the protection of investors, in the public interest, and in light of the economy.

    (B) ADJUSTMENT OR MODIFICATION.--Upon completion of a review under subparagraph (A), the Commission may, by notice and comment rulemaking, make such adjustments to the definition of the term ``accredited investor'', excluding adjusting or modifying the requirement relating to the net worth standard described in subsection (a), as such term applies to natural persons, as the Commission may deem appropriate for the protection of investors, in the public interest, and in light of the economy.

    (2) SUBSEQUENT REVIEWS AND ADJUSTMENT.--

    (A) SUBSEQUENT REVIEWS.--Not earlier than 4 years after the date of enactment of this Act, and not less frequently than once every 4 years thereafter, the Commission shall undertake a review of the definition, in its entirety, of the term ``accredited investor'', as defined in section 230.215 of title 17, Code of Federal Regulations, or any successor thereto, as such term applies to natural persons, to determine whether the requirements of the definition should be adjusted or modified for the protection of investors, in the public interest, and in light of the economy.

    (B) ADJUSTMENT OR MODIFICATION.--Upon completion of a review under subparagraph (A), the Commission may, by notice and comment rulemaking, make such adjustments to the definition of the term ``accredited investor'', as defined in section 230.215 of title 17, Code of Federal Regulations, or any successor thereto, as such term applies to natural persons, as the Commission may deem appropriate for the protection of investors, in the public interest, and in light of the economy.

    On page 388, line 14, strike ``1 year'' and insert ``3 years''.

    On page 998, strike line 12 and all that follows through page 1001, line 25, and insert the following:

   SEC. 926. DISQUALIFYING FELONS AND OTHER ``BAD ACTORS'' FROM REGULATION D OFFERINGS.

    Not later than 1 year after the date of enactment of this Act, the Commission shall issue rules for the disqualification of offerings and sales of securities made under section 230.506 of title 17, Code of Federal Regulations, that--

    (1) are substantially similar to the provisions of section 230.262 of title 17, Code of Federal Regulations, or any successor thereto; and

    (2) disqualify any offering or sale of securities by a person that--

    (A) is subject to a final order of a State securities commission (or an agency or officer of a State performing like functions), a State authority that supervises or examines banks, savings associations, or credit unions, a State insurance commission (or an agency or officer of a State performing like functions), an appropriate Federal banking agency, or the National Credit Union Administration, that--

    (i) bars the person from--

    (I) association with an entity regulated by such commission, authority, agency, or officer;

    (II) engaging in the business of securities, insurance, or banking; or

    (III) engaging in savings association or credit union activities; or

    (ii) constitutes a final order based on a violation of any law or regulation that prohibits fraudulent, manipulative, or deceptive conduct within the 10-year period ending on the date of the filing of the offer or sale; or

    (B) has been convicted of any felony or misdemeanor in connection with the purchase or sale of any security or involving the making of any false filing with the Commission.

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Senators Bond, Warner, Brown and Cantwell have proposed an amendment to Senator Dodd's financial regulatory reform bill to save Regulation D. The full text of the amendment is below. You can also find it at the following link. Thank you Senators.

In short:

• the amendment does away with the ridiculous and industry killing 120 day wait period;
• the amendment does away with the "go back in time" provision, which would have re-adjusted the accredited investor financial thresholds in a way that would have wiped out 2/3rds of existing angel investors qualifying as "accredited investors";
• the amendment would exclude the value of an investor's primary residence in determining whether the investor would meet the net worth standard; and
• the amendment adds "bad boy" provisions to Rule 506 offerings.

You can find the text of the amendment quoted below.

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Senator Dodd's bill has now been filed with the full Senate.

As stated in a tweet yesterday:

Senate Banking Cmte (@SenateBanker)
4/15/10 7:36 PM

The Wall Street Reform bill has been filed with the full Senate - S. 3217 http://bit.ly/bAP5sS 

Unfortunately, the bill keeps getting worse for startups.  The latest version of Section 926 is quoted below. 

If this version of the bill becomes law, it will essentially end the days of closing an all accredited investor offering and then filing a simple Form D with a filing fee post closing. Instead, companies will have to go through a process akin to registration, where they seek and obtain permission from state securities regulators before selling securities. This will be a significant burden for early stage companies trying to raise capital, and will slow down innovation in America, and hurt job growth. Let's hope the Senate amends these provisions before they become law.

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Critical to startups is access to angel capital. Angel capital almost always comes from "accredited investors" as defined in the federal securities laws. These are most often investors with more than $200,000 in income in the last 2 years (or $300,000 with spouse) with the expectation of the same this year, or investors with more than $1,000,000 in net worth (including joint net worth with spouse).

You can find the definition of accredited investor here.

Senator Dodd's financial regulatory reform bill would go back in time to when those thresholds were originally put in place and index them to inflation. Business Week estimates that this will reduce the angel investor pool by 77%.

Obviously, this would put a crimp in angel financing, and hurt the overall startup ecosystem. Barney Frank's bill, which passed the House, didn't have this provision. Let us hope, for the sake of the ecosystem, that Senator Dodd's proposal does not become the law. 

(The opinions expressed here are my own. For more information on this issue, see http://www.saveregd.com)

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 Senator Dodd's new financial regulatory reform bill is out.

• Copy of bill
• Copy of summary

 As written in TechFlash today, the bill is not a good and helpful development for startups. The concept of waiting 120 days for the SEC to clear an all accredited investor offering is truly an amazing things to ponder. 

For more information about Senator Dodd's proposal and how it would affect angel and venture financing transactions, see the following web site: Save Reg D.

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 Preferred Stock is stock which is "preferred" over common stock in any number of different ways.  For example:

• preferred stock may be entitled to dividends before common stock;
• preferred stock may have special voting rights (protective provisions; the right to block a subsequent financing or sale transaction);
• preferred stock may have the right to be paid first a certain fixed or formulaic amount of money before the common stock on a liquidation or merger of the company into another company;
• preferred stock may be redeemable at the option of the holder after a certain period of time; or
• preferred stock may have a purchase price protection mechanism built into it--such that if the company issues additional stock in the future at a price per share lower than the price per share of the preferred stock, the preferred stock's purchase price will in effect be reduced on the subsequent stock sale.

Preferred stock may have any one or more of these characteristics.  In addition, preferred stock holders may desire contractual rights in addition to the rights specified above--such as:

• a voting agreement with the other stockholders, ensuring the preferred stockholders representation on the company's board of directors;
• registration rights;
• the right to receive financial statements or other information on a regular basis;
• preemptive rights on future stock financings;
• rights of first refusal on sales of founder stock;
• co-sale rights on founder stock;
• drag along rights; and
• others.

Companies issue prefer stock for any number of reasons, but most typically, because their investors demand it.  For an example of a Series A Convertible Preferred Term Sheet, see the National Venture Capital Association's model legal forms page.

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Founders contemplating an angel financing often ask whether their company should issue common or preferred stock to angel investors. A fundamental difference between the two is that preferred stock has a liquidation preference, which upon a liquidation or sale of the company entitles the holder to a payment prior to distributions to the common stockholders. Thus, from the founders’ perspective it is typically desirable to issue common stock so the founders are on parity with the investors with respect to liquidating distributions. Issuing common stock also results in a simpler capital structure as the company will have only one class of stock outstanding (and thus will not be disqualified from making an S corporation election for having more than 1 class of stock outstanding).

Whether to issue common or preferred stock depends on a number of factors, such as:

• does the entity want to make or maintain S election status;
• the type of investor (friends & family investors will typically accept common stock, while organized angel groups will typically expect preferred stock. (Note, however, that all preferred stock is not the same – a topic for a future post.)

 The relative leverage of the parties can also play a role. If the founders have multiple term sheets from different investors or they can persuade investors that their company has a significant upside potential, they may be able to issue common stock. I recently observed a company decide to go with a term sheet with a lower pre-money valuation than other offers because the investors were willing to accept common stock. The founders felt that the benefit of not granting preferred stock rights, which included the right to block a sale of the company, was worth the slight compromise.

In conclusion, it is typically better for the founders if the company issues common stock to angel investors. Of course, issuing preferred stock in an angel financing is typically better than no angel financing.

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Venture capitalists and sophisticated angels typically insist on receiving preferred stock for their investments in emerging companies. As a result, companies pursuing such investments often ask “what rights come with preferred stock?” First, it is important to recognize that all preferred stock is not the same. Second, preferred stock terms requested by a venture firm may be a bit more onerous than those sought by angel investors.

Typical preferred stock rights and preferences can include:

• Liquidation preference
• Dividend preference
• The right to convert to common stock
• Anti-dilution protection if the company issues stock below the preferred share price
• Blocking rights on significant actions of the company (e.g., company sale, equity financings, increase in option pool, etc.). Sometimes these rights can extend to governance matters such as the right to approve the appointment of senior executives, to incur significant indebtedness, etc.
• Rights of first refusal with respect to transfers of stock by the founders and sometimes other shareholders
• A co-sale right to sell stock on a pro rata basis if the founders sell stock
• Right to appoint a member(s) to the company’s board of directors
• Rights to participate on a pro rata basis in future equity offerings of the company
• Rights to demand that the company engage in a public offering and/or register the investor’s shares for sale into the public market
• Information and inspection rights

The extent to which a company will be required to grant such rights will depend on the context of the financing, including the type of investors (e.g., venture capitalists or angels), the relative leverage of the parties and the rights granted by the company in prior financing rounds. With respect to the last point, a company should recognize that the rights it granted in its last financing round will serve as the starting point for its investors in the current round. These investors will typically get at least those rights or better.

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Q: What is participating preferred stock? What distinguishes it from non-participating preferred stock? Who prefers participating preferred stock, and who prefers non-participating preferred stock?

  A: Participating preferred stock is preferred stock that entitles the holder to a specified preferential payment upon liquidation and a share in any remaining liquidation proceeds on an as-converted to common stock basis. For example, if a company that issued $1 million dollars in participating preferred stock representing 10% of the company liquidated in a transaction for $10 million, the holders of the participating preferred stock would be entitled to receive a $1 million liquidation preference (or more, if specifically agreed upon), plus 10% of the remaining proceeds available for distribution, for a total of $1.9 million. If the same company sold instead for $15 million, the participating preferred stockholders would be entitled to $1 million plus 10% of $14 million dollars for a total of $2.4 million in total distributions.

 

In contrast, non-participating preferred stock is preferred stock that only entitles the holder to the preferential liquidation payment and not a share in any remaining liquidation proceeds. Using the example above, if a company that issued $1 million dollars in non-participating preferred stock representing 10% of the company liquidated in a transaction for $10 million, the holders of the non-participating preferred stock would be entitled only to their $1 million liquidation preference, and the remaining $9 million in proceeds would be distributed to the other stockholders. Note however that if the company was sold instead for $15 million, the holders of non-participating preferred stock would typically elect to convert their holdings to common stock in order to receive 10% of $15 million, or $1.5 million, an amount greater than their liquidation preference. 

 

Thus, from an investor’s perspective, participating preferred stock is preferable to non-participating preferred stock as it both allows for a preferred payment upon liquidation and participation in the upside if the Company is sold at a premium.

 

This article is not intended to be legal advice. You should always consult with an attorney before making an investment. 

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