Why startups must only take financing from accredited investors

Seed stage investing is getting very busy these days, and over the past few months I have started hearing about companies taking money in small amounts from a large number of friends and family investors. Easy money ? Maybe, but…

Whilst it is great to get that kind of support from your close circle, it often involves investors who are not accredited. The accreditation has nothing to do with the sophistication of the investor, nor having gone through a formal exam but a set of criteria clearly defined by the SEC (Rule 501(a) under the Securities Act of 1933) – which are related to a minimum level of yearly income or a minimum NAV (net asset value).

Not complying with this rule, which means – yes – turning money down, will come back and haunt you down the road when it is time to further finance or sell your company. Just as an example: unaccredited investors can rescind their investment at any time – that means they can ask for their money back. You should also get your personal investors to sign a statement regarding their accreditation.

I have been meaning to write this post since I have given this advice 4 or 5 times in the past two weeks (in the context: How/From whom do I raise my initial capital ?), and Brad Feld has beaten me to it: check out his post (and the second comment) for more detailed problems you will be facing if you don’t respect that advice rule.

PS: As I am at it – I apologize to the 50 or so startups that have recently sent me some information about their deal. I am completely swamped and therefore my response/feedback might take a few more days (or weeks ?) to come.

PPS: Should I really go to bed for just one hour ?

  • http://galaxy.blogs.com/venture_capital_thoughts_/ Simon

    Securities concerns aside, I would recommend never taking money from friends and family.
    Starting a company, even under the best of circumstances, is a risky proposition fraught with ups and downs and unseen dangers.
    The prospect of losing money invested by friends and family adds a whole new (and in my opinion, unnecessary) dimension of stress.
    If your idea is good, you should be able to get capital from third parties.
    While you may be able to raise money from friends and family, raising capital from third parties is usually a good reality check since it will force you to answer the tough questions.
    If things turn out well you can always reward your friends and family in other ways.

  • Lee Courtney

    Did the friends and family financing with first startup (1987) with no problems, but would strongly advise against. Aside from all the financial heavy lifting an early stage venture doesn’t need to fool with, F&F (in general) can’t offer the essential business acumen, domain knowledge, and/or networking connections. Thats why VC’s and associated networks are appealing (at least to me).
    If you’re being told ‘No thanks’ to funding requests there is a good message there – not worthwhile per the funders parameters OR something better done as a life-style business. Wish I had listened in 1987.

  • http://onstartups.com Dharmesh Shah

    I agree totally. Quick points on raising money from friends/famiy:
    1. They *must* be accredited, or you are just asking for troublbe.
    2. Often, the social proximity can often generate a degree of obligation that can lead to non-objective decision-making (because you don’t want to lose your uncle’s money).
    3. They (friends/family) often don’t understand the nuances of startup investment, so you often end up negotiating against yourself. This can lead to a “no win” proposition for the entrepreneur.

  • http://www.martinjwells.com Martin Wells

    If you really want to take money from family and friends, and those people trust you, then just make it a loan until you have the time/legal help to do things correctly.
    I don’t however think this should replace getting good legal advice.
    If you don’t have someone that is telling you this already then you need to open some more doors before moving further.

  • http://www.touchstonegadget.com Chris Saad

    Wow this is timely – We just got offered a substantial investment from a colleague. It hard not to let greed blind you :/

  • scott shane

    I am a professor at Case Western Reserve University who is writing a book about angel investing and am looking to interview unaccredited business angels. If you are an unaccredited angel or have received funding from one and would be willing to have a 20 minute phone conversation with me, please email me at [email protected]