Taking Non-Accredited Money – Survival.

Imagine you’re walking through a desert. You haven’t had water for days, it’s 100 degrees, and you know if you don’t get a drink soon your time here is done.  Then you come across a mucky pool of stagnant water that is almost certainly infested with some kind of bacteria. What do you do? Pass on it, for fear of getting sick? Sh** no. You get yourself a drink.  Rule #1: survive.  

This is the decision many startups face when questioning whether they should accept money from “non-accredited investors.”  It also highlights how ridiculous it is for startup lawyers to tell founders that non-accredited money is never worth taking.  They clearly haven’t stepped down from their mahogany pedestal and planted their feet on the same ground as their clients.  Being the product of low-income immigrants myself, and seeing how many successful startups rely on pre-angel funding (a lot), the “if you don’t have rich friends and family, don’t bother” mindset really rubs me the wrong way.

I’m not going to get into the background of what accredited v. non-accredited investors are, or why you shouldn’t take their money.  Most likely you’ve already heard it repeated in 5 different ways.  Professional investors don’t like them, there are onerous disclosure obligations, they can prevent you from raising larger amounts of money, etc. etc. Let’s just take it as a given. Taking non-accredited money is a bad idea. We all know it is. But you know what’s a worse idea? Shutting down when there’s life-giving capital on the table.

Texas is not California.

Unlike startups raised in the land of milk and honey (Silicon Valley), where many angels really will fund an idea, a true MVP, or something with no revenue, in Texas (including Austin) it generally takes a lot of work and some traction (with zeros) to get to a point where angels will even consider writing you a check.  And while it’s true that bootstrapping should definitely be considered, it simply isn’t feasible for a lot of business models; unless you’ve got some deep pockets.  For that reason, the “friends and family” round – $25K, $50K, $100K, whatever, just enough to build something angels actually find attractive – is often the difference between startups that scale, and those that never get off the ground. And statistically speaking, most people’s friends and family are non-accredited.

How do I safely take non-accredited money?

As a startup that knows professional venture capital will be essential to scaling, taking non-accredited money is not “safe” in an absolute sense.  No matter how you structure it, having non-accreds on your cap table/balance sheet will raise questions and diligence from future investors.  The real question should then be, given that whatever consequence is better than shutting down, how do I raise non-accredited money as safely as possible.  Here are some principles for taking non-accredited money, while minimizing the chances that it’ll prevent professional funding:

  • Get help.  Work with an experienced startup lawyer to ensure that you comply with relevant regulations as closely as possibleand within budget, for the financing.  A misstep from a legal standpoint could create an unfixable problem down the road.
  • Limit the group.  Take money only from people you consider true friends and family who can afford to lose all of the money they give you, and who understand that losing the money is a real possibility. This means people who care about you, want you to succeed, and absolutely do not view this money as a lottery ticket to becoming rich. This is not crowdfunding.
  • Lenders; Not Investors.  View the non-accredited friends and family as lenders, not investors.  Make it crystal clear to everyone that their money is a loan, not an investment.  It will not convert into stock, and hence if you hit it big, they will not get a piece of all the upside.  Post-IPO, you can offer free rides in your Bentley and shower them with benjamins. Just don’t offer them stock today. If the company succeeds, the money will be paid back. Offer them a very high interest rate, and work with your lawyer to structure a non-convertible promissory note.  Anyone who will write you a check for $5,000, knowing that it is extremely high risk, and that there’s no chance of a 100x upside, must truly be in it just to help you succeed.

Important sidenote: If you have people who are willing to back you in the above way, you are rich – in a way that many people aren’t. Other people leverage their affluence. Leverage yours.

  • Long Maturity; Subordinated.  Set the repayment terms of the non-convertible note so that the debt does not become “due” until the Company has raised a significant amount of money, maybe $2 million+, and that the debt will be subordinated to all future debt issued to professional angel (accredited) investors.
    • The goal here is to allay any fear from angel investors that their money will be used to repay your non-accreds, instead of funding growth.  The money is not payable until a true VC round, and their debt is always senior to the non-accred debt.

Does following the above principles mean that having non-accredited money in your company won’t blow up a possible financing? No, it doesn’t.  But, in my opinion, it will significantly de-risk things for you.  When VCs or angels ask about your non-accreds, you can make it clear to them that (i) everyone knows that they are being paid back, will never be equity holders, and are subordinated to all other investors, and (ii) they are a highly vetted group of true friends/family who will be cooperative with whatever helps the founders succeed. Once they are paid back, they are a non-issue.

To be clear, I am not promoting the funding of startups with non-accredited money in a broad sense.  I tell founders the exact same things other experienced startup lawyers do: it’s a bad idea, it creates more disclosure obligations, and some investors might not touch you.  If you can avoid it, do so. But being alive yet uncomfortable is always preferable to being dead.  And my observation is that, at least in Texas, a F&F round is often a prerequisite for progressing far enough to where angels find you investable. Drink the mucky water, and live to fight another day.

 

  • David Orlando

    Thank you for this.

  • Tom Watson

    How about warrants with the loans, priced at 10X or 100X founder pricing, and rising 2x per year in price if not exercised? Please describe the absolute necessity of keeping these people out of equity, from the “legally complicated to have these people not in equity” point of view.

    • http://www.twitter.com/gautampulla Gautam Pulla

      I have similar questions, though your request gets a bit complicated. I definitely would like to know this part in particular:

      “Please describe the absolute necessity of keeping these people out of equity, from the “legally complicated to have these people in equity” point of view”

      Basically, if you already resigned to taking on non-accredited money, is there anyway to get them the equity they so deserve?