Capital Markets Insights

Best practices for investor verification

One of the biggest challenges firms are facing when raising capital with accredited investors is determining their investor status quickly, reliably, and confidentially.

Recent federal laws require companies raising money through private placement capital raises where they generally solicit to verify that their investors are “accredited investors”. A simple questionnaire isn’t enough – companies must take further “reasonable steps” to prove their investors are “accredited investors” with potentially serious consequences for failing to do so.

This is why we joined forces with Jor Law, a co-founder of VerifyInvestor.com and Principal at Homeier Law PC and one of the leading authorities on the topic of investor verification, to discuss:

  • What is an accredited investor and why you should care
  • How to successfully navigate the 506(c) and accreditation legislation
  • Best practices in finding the accredited investors
  • Staying compliant with global regulations

 

Full transcript:

Katipult: Hello and welcome to today’s webinar starring Jor Law from verify Investor. I am Brian from Katipult working in business development, helping our clients to choose the right solution. A lot of our clients ask about their investors, why should they deal with them, what's the purpose and for this topic we have Jor Law, a Co-Founder of Verify Investor who is an expert in this area. Welcome.

Jor: Pleasure to be here.

Katipult: So, let’s dive into the topic here. What is an accredited investor and why should people talk to accredited investor and not a non-accredited investor?

Jor: An accredited investor is what’s found throughout the world in various countries.

In the U.S. the accredited investor is typically a reference to someone that is a person or an entity that’s either rich, high income or sophisticated. So, someone who can afford to take on the risk of investment and/or make the investment decision.

This is important because, what the laws are trying to do is separate two classes of people. People who are not accredited receive more protection because they are less sophisticated, not as rich and the government has the interest to protect them from being scammed or making poor investment decisions.

On the other hand, you have this group that says ‘’You don’t need to babysit us quite as much, we can take care of ourselves. Let us do more and make more choices’’, and the government has kind of acknowledged that.

So, why would you go for one or the other? Well, obviously, the non-accredited population is significantly larger than the accredited population. On the other hand, the accredited investors tend to invest much more than non-accredited investors.

So, when thinking about whether to target accredited investors or not, you have to think about who your ideal investor is, would a non-accredited investor even invest, and then go out for the type of investor that they are.

So, as an anecdote, if you walked out into the street and you randomly grabbed a hundred people and you asked them what’s your favorite company in the world, many people would say Apple or Nike or something like that.

Your next question would be ‘’Did you know you could buy stock in this company?’’ and most people would say yes. Many people know they can own a company just by buying it like that.

Then the next question you ask is ‘’Do you own any?’’. In general, the answer is going to be a “no”.

And that’s your typical non-accredited investor. They could be so passionate about the company and yet not invest in it, and you have to think about whether your product, service, equity or securities that you are selling, if you are going to try get someone like that and commit him to buy, how many of those will there be and so on.

Certainly, there have been extremely successful gains that have targeted non-accredited investors but there is no question that accredited investors have fundamentally, in the past at least, surpassed non-accredited investors in terms of funding dollars.

Katipult: What regulations do actually cover these accreditation processes? You can of course talk about the US, but if you have some idea of going global as well, you can set it up like United States versus the global framework.

Jor: Starting off with the U.S., if you are issuing out securities then the law is out there to protect the investor, to make sure they know what they are buying and that they have adequate information at their disclosure and protections to make an educated investment decision.

The idea is that the fundamental basis of securities law typically is, if you are raising money – you must register your securities, because the active registration means that you’ve now gone to a central place and provided information about your offering, so people can go and find out more information.

But, registration is expensive and takes a lot of time, so what happens is that most look for an exemption that says ‘’Well, if you do it this way, then maybe you don’t need to register’’.

So when you look at crowd funding, there are only a few exemptions that are really used. One of them is called ‘’Regulation S exemption’’, which basically says ‘’If you are not selling inside the U.S., you are not conditioning the U.S. market, so our laws are not going to go out of our way to protect the oversees folks because that’s none of our business”. That is one possible exemption.

The other exemptions that are commonly used for crowdfunding are all contained within something called the JOBS act, and specifically in the JOBS act there is a Title II, Title III and Title IV component and they each have their benefits.

Some of them allow you to raise up to a million dollars or fifty million dollars. Some of them can target both accredited and non-accredited investors while others can target only an accredited investor. There are series of laws that we could go into more detail later if we need and that’s the U.S. law.

Now, internationally - I am only expert in U.S. laws - but internationally you get a variety of regulation. In some jurisdictions they have no rules whatsoever. They don’t have vibrant enough securities market to really regulate these things.

In other jurisdictions they might have their own securities regulations and some other countries, for example Canada, have regulations that are very similar to the U.S., so it’s always a good idea, when you are doing these crowdfunding campaigns, that if you know you are going to target a country, or have many efforts to sell within that country, then you should  consult  local experts as well.

Katipult: A lot of the US platforms that I talk to or those that want to create a platform, also have foreign investors. So, Verify Investor, do they actually verify foreign investors, and, if that’s the case, how does that differ from the verification of a US investor?

Jor: Verify Investor has automated products, its core product, as well as kind of custom solutions. We can create a custom solution for any sort of verification whatsoever.

However, for our main product which is accredited investor verification, that’s done in conjunction with the US securities laws, specifically rule 506 C that says ‘’If you are conducting and offering and you’re relying on rule 506 C then every investor in that rule 506 C offering, regardless of foreign or domestic, have to get verified as an accredited investor to the US law definition”.

So, we will verify anyone anywhere in the world, any country, any type of a credit investor category for rule 506 C compliance.

It is possible to structure deals whereby you don’t have to verify international people, but you need to talk to your lawyer about properly structuring, kind of like concurrent Reg D for the US people in the concurrent Reg S offering for the non US people.

To as what differs, basically it’s the same exact test, so if they are asked for US style documentation, for example US tax returns, and they don’t have them, then they would provide their countries’ equivalent if it exists. If it doesn’t exist they just provide the best type of evidence that they could come up with.

A reviewer, in our case licensed attorneys in the US,  then conducts an analysis to see if that is sufficient and/or add more information to an extent that, if the documents are in a foreign language, they would typically just translate  the relevant portions.

Katipult: You mentioned the rule 506 C, which is something I hear a lot of about. I talked to a lot of people who want to set up a 506 C platform. It seems like they are pretty bothersome regulations, because you need third party accreditation.

So, what would be the benefit of going through the trouble of actually verifying their status as my credit investor?

Jor: Crowdfunding really is funding from the crowd of people that you don’t know.

Traditionally, the US didn’t allow crowdfunding.  They had a concept that you had to do deals through your private network. That was a form of protection. They figured that if you went through your private network then less people would be contacted and there would be less of a need to protect people. The people you would be contacting would be the people who you all know anyway.

As part of crowdfunding, what they did allow is, they basically said ‘’You can generally solicit’’. And, if you generally solicit and advertise your offering, you don’t do something like a Title III, which requires you to file a form at the SEC and only allows you to raise a million dollars, or Title IV which allows you to raise up to fifty million dollars but you really effectively have SEC review your deal.

If you are doing a deal that SEC is effectively not reviewing, so it’s fast, simple and relatively cheap, then they want to know that the people that you are selling to are actually accredited investors and that is kind of a pain and a hassle because you actually have to go and tell someone ‘’You’ve got to prove to me that they are rich, that they are sophisticated before they can invest’’.

Now why is that worth telling? It’s worth the trouble because accredited investors probably come together and fund something like a trillion dollars a year. Non-accredited investors don’t come together and fund that sort of money.

If you are doing a very large capital raise, if you want investors that are more sophisticated, you might end up going after the accredited investor anyway. So if you do that, and you want the ability to generally solicit without having to deal with the title three or title four, then really verification in Title II in the 506 C is the only way to go.

And, as painful as it is, people are going through it, deals are getting done, billions of dollars are getting raised. It’s as painful as for someone that’s applying for a loan for mortgage. You have to go through a painful application process, but if you want that loan, or if you really want to make that investment, it’s something that you are willing to go through.

Katipult: Let’s talk about best practices for accreditation. Let’s take it from two different sides. One is for the platform owner, what should they actually make sure of about the investors, and the other is from the investors point of view, what should they have ready to go through the accreditation on Verify Investor?

Jor: From the issuer’s side, all you really care about is safety of your investor and getting them accredited as simply as possible, so this obstacle in your fundraising is completed as quick and painless as possible.

There are certain things you can do there.

First off, it is probably safer for you to use a third-party credit investor verification solution so you don’t have to collect all this information yourself. It has to have internal capabilities of defending why or how you did the verification, that they were done properly and not have to have the recourses to man investor support questions. Those are all good reasons for issuers to kind of outsource it.

The other thing is also educating the investors. If your investment pool doesn’t expect this because it’s kind of a new law still, just make sure that they know what to do.

If you are making them go through the verification explain to them that this is required by law, it’s not something anyone likes. You don’t like it, Verify Investor doesn’t even like it, and certainly the investors aren’t going to like it, but it is required by law.

Let them know that, if you are using a third party, which third party you are using, so they are not surprised if that third party is contacting them while working with them to go through it.

Also, pre-vet people. If people are going to go through this painful process of verifying themselves, well not painful, just burdensome, some people do in it minutes, some take longer, but if they are going to go through this process, perhaps you can do something on your side to pre-vet them a little bit.

Ask them if they are accredited. If they aren’t, don’t even bother putting them through the process.

These are all best practices.

From the investor side, really, it’s all about the safety and security. In order to prove that you are verified, you have to show some sensitive personal finance documentation. You are either showing your trust documents or your tax returns, bank accounts. The key thing to know is that you only need to show as much information as you need to in order to get verified.

Some of that information doesn’t require you to give up everything. For example, they shouldn’t need your social security number to determine what income you have, or to determine that you have over a million dollars of assets of net worth.

If you are sending in something and it has your address in it or your bank account number is in it, they theoretically don’t need to determine that you have a certain amount of income or certain amount of assets.

There are some exceptions, for example, if you are using a piece of property as proof of your net worth, that address of the property might be necessary so they can link the address of the property to the appraisal that you give them.

But, if you are smart about these things, you know that if the tax asks for a million dollars, that doesn’t prove ten million dollars, it just proves one million dollars.

Try to provide as little information as possible.

In general, they don’t need to know what type of evidence it is, or your name so they can match it and the value or the income of the assets. To do a credit investor check you don’t necessarily have to check identity.

For example, if someone and says he is Bill Gates accredited investor, I don’t know who is coming to me, it doesn’t have to be Bill Gates that comes to me. But I can still prove that Bill Gates is an accredited investor based on evidence that has been provided, without ever having to confirm that that person is indeed Bill Gates himself.

Katipult: So, now we have the best practices down, but what’s the best way to actually find accredited investors?

I talked to a lot of people who think that we provide everything. We do that essentially, but we are a platform technology, we do not provide the investors for example.

A lot of people ask if they can buy an investor, is that a valid way to go? In my experience, this all comes from people you know that know people that know people and that’s really the best network you have, but what are your thoughts on that?

Jor: In the past, to find an accredited investor you either had to buy lists, and the quality of those lists generally wasn’t that great, or you would just have to go through your private network. 

Now, with investment crowdfunding, the way it works is, as long as you are creative, you can create any list that you want.

If you came together and said I need to create a list of basketball aficionados, well, how would you create that list? You might go to forums where people are talking about basketball or something like that. You have to use the same sort of logic to find accredited investors and they are everywhere, there is a ton of them. Could it be that you go to American Express and ask them to solicit their investors or buy anonymous subscriber information if it’s targeting certain people.

One of our early users for example, was an offering that didn’t even have a social media account of any sort. They had a web page but it was just a landing page. You couldn’t even tell they were raising money, you could barely tell what type of business they were doing. When they were using Verify Investor we realized they were sending a lot of accredited investors and we were wondering where they are finding all these investors. One day I got on a call with the issuer and asked him, and he just said they advertised in sustainable living magazines because those were the people that like their product. That’s all they had to do.

Another deal that I personally invested in, they knew that they were creating assisted living facility in a community where there was shortage of and the community really wanted one. They just ran bus ads and just screened out people that were not qualified to invest. That’s how they found their investors.

Certainly, there is a way to go of finding these folks. The trick isn’t so much finding people who might be interested, the trick is how do you vet them out so that you are only attracting accredited investors and that you are not spending too much of your advertising or marketing on non-accredited investors who wouldn’t be able to qualify anyway.

Katipult: Even though this is a very technical world we live in, everything doesn’t have to happen on social media and on the internet for that matter, there are still the good old ways of advertising in magazines and on busses and just being creative in that area.

Jor: And there are some great tools now, for example Facebook has the idea of like audience. If you go and you develop list of accredited investors, let’s say only 500 people, but you need more. You may be able to upload that list into Facebook and ask for a like audience and they will show you people that are similar to those people. Now your list is maybe magnitudes larger.

There are tools like that, but it all starts with screening out and trying to come up with high quality kind of targeted demographics of people who would be interested in your product and then try to screen out folks who might be unaccredited and work from there.

Katipult: Let’s talk about Katipult and Verify Investor. I was going to say the relationship between the two of us, as companies, but also you and I have spoken quite a bit.

So essentially, you have a technology, we have a technology and we integrated for the purpose of being compliant using our technology and your technology. I think our relationship has been really good and to my knowledge quite a few choosing this technology, so the feedback we got is really good and I am really interested in hearing your view on that.

Jor: Verify Investor platform has been dominant in the credit verification platform industry for a while, so we are integrated broadly. All the other providers similar to counterpart are going to kill me for saying this but honestly, our innovation with Katipult has seemed to go quite smoothly.

The issuers that use the Katipult system have in large part just been happy. There haven’t been issues that we spotted and the process has been pretty smooth.

So, when people come to us and they ask ‘’We are with Katipult, what do you think of them?’’, we usually breathe a sigh of relief, because not every platform technology or white label technology has these smooth integrations.

We see the support team of Verify Investor, we have an extremely knowledgeable support team, that seems to always be open. So, when other portals have issues, their investors actually email us sometimes and we start seeing which portals have issues.

I can honestly say that we get very few or almost none issues with the Katipult integrations. And without knowing the details of what you guys did to make it work I do know that we are always looking to have you when you guys are the portal that’s using us because we know we have to support those investors a lot less.

Katipult: That is really good to hear.

We have done a number of integrations, we are a global company so we have integrations from all over the world and it’s just about having a strong team behind this and they are the biggest reason that all of this can be so well done.

So, if you use Katipult and Verify Investor, then you would basically be compliant but it really depends on what regulations you are working under, Title 4 or 506 C, you would need escrow account. In that case you wouldn’t need a payment method, you could just wire the payments and then you would basically be compliant using Verify Investor and Katipult.

Jor: None of this is legal advice, as I happen to be also a corporate security attorney so through my law firm we represent a lot of issuers that are doing investment crowdfunding.

Whenever you are doing crowdfunding you always have the choice to do it yourselves, go on someone else’s platform or portal or do some sort of white label solution. There are various advantages and disadvantages to each.

When you go and you pick out other vendors it’s not so much that you are automatically compliant. All of this is still on you. You and your lawyers still have to decide how your offer should be done.

But for any other folks that have been successful in the space, what they’ve done is that they brought a lot of those compliance tools together for you and they automate it so that you don’t have to think about doing it by yourself. So, if you are using folks that have a good reputation within a space within the likelihood that you are going to be compliant or it’s easier to be compliant increases significantly higher.

For example, with verification, you could do it yourself if you wanted to and have a compliant method of doing so. It probably isn’t going to be as efficient and safe as using someone like Verify Investor. If you use Verify Investor then we would say ‘’Yeah, if you used us and there was no funny business going on the back end of your side, then yes, you would fulfill your accredited verification requirements’’.

And if we couldn’t say that there wouldn’t be any point of us being around for business but certainly that is a kind of analysis you have to make with each item. You have to realize that even with Katipult and Verify Investor there may be some other issues that are outside of our control that you have to watch out for.

Katipult: We got a question: ‘’So what is your technology, it seems all manual so far?’’

Jor: We have our lawyers review each verification, so that part of it is manual, and it has to be manual because of how the law works. There is a safe harbor if an attorney conducts a review and does it with certain standards. I can’t automate that part and still keep that safe harbor.

Almost all the rest is technology that helps to streamline the process so the reviewer spends less time educating the client and focuses only on conducting the review. So it only takes him a couple of minutes to actually do the review as opposed to a few hours if you were to call the same attorney at the law firm.

From the investors perspective there is a lot of tech build towards the automation flow as well as privacy and security. It’s much safer than you calling up lawyer, talking to him, emailing your documents and having them email information back to you. There is technology build around that.

In our case it’s hybrid, it is both the automation of tech and the human element. Katipult is significantly more tech than we are, but I don’t know the details of how their system works so I will defer to Bryan for that.

Katipult: Well, essentially, it’s automated as much as possible. There are some processes that you simply can’t automate.

So, when an investor comes to the platform, you grab some information, maybe a passport or photo ID, their income or whatever you want to collect there, then that is something we can custom build for you.

But the actual input in that form, that of course can’t be automated, that is a manual solution, but we are just getting away from back and forth emails, like ‘’you haven’t filled out the form correctly, send it back to you, explain what you need to fill in and send again’’. You have all that process on a platform, and you can call it automated in a way, because it tells you all that you need to do.

If you haven’t filled out something and you want to proceed to the next step, you are not allowed, but it tells you what you need to fill out. If you don’t have that information ready, well then, we need to find that information before you can actually move on. It will save hours and hours by just going through that onboarding form and of course provide a marketplace for the investors to find investment opportunities.

There are automated subscription agreements using signatures and of course various payment methods that can be used here, either integrations or manual, but in either case it is still going to be more efficient than sending information back and forth via emails. This can happen in one very short session if you have everything ready.

And then in your case with the Verify Investor integration into Katipult, then that would simply be that after you filled all the onboarding forms, you go through the transaction process and then you will be directed to the Verify Investor portal where they will go through your accreditations and submit that.

And when you actually approve those accreditations that might be manual work but you have a lawyer actually looking through it, but when you hit that button that confirms the accreditation all is sent to Katipult platform, and in that way it is automated. It is all this back and forth communication that is automated and that makes it a lot more efficient than if it had to be done in the old school manual way.

Jor: We basically use tech as much as possible to cut out the human element.

For example if you went to any random law firm and said ‘’Hey, help me process 2000 verifications this week’’, you couldn’t find a law firm that could do it. We can process thousands of verifications per week without problem mainly because of tech automation tools. Each review takes a little time and we have essentially an army of review attorneys.

Katipult: Outside of general solicitation such as advertising on the side of a bus, what other strategies of investor acquisition have you seen being successful in campaigning?

Jor: I think forming partnerships with folks that have the type of investor that you like have been very successful. People who have managed to form relationship with wealth management groups, have sometimes had those wealth managers feed their entire list of investors over.

That’s not very different from folks that have said ‘’Hey let me hit these various RAA offices and wealth managers and see what they can do”. It turns out that if you have a good deal, you hit one demographic, sometimes those deals are shared around, so once you find one group of accredited investors it often turns into multiple groups of accredited investors.

There is no secret sauce to this.

Every time you go and look at how you developed a group of accredited investors that are interested in your deal, you really have to think about who your most targeted audience is, and if you don’t find it through some sort of advertising in marketing then you’ve got to find it through some sort of partnership.

I would be very cautious of anyone selling lists. Reputable folks like us will not sell our lists, and people who are willing to sell their list, the quality of those lists is probably questionable.

Katipult: What have you guys seen as successful tricks for finding an accredited investors?

Jor: The general advertising seems to work. I haven’t seen any new thinking in this area here.

The most successful platforms are those that already have an investment network. Not that you can’t be successful out of it but then it requires some more legwork.

You need to get out there, so social media of course, but also doing trade shows or conferences, presenting what you have, your platform for example. I think that would be a really good tool to use.

You can’t just have your platform up and have some sort of online presence and then expect everyone to come to you. It is still a lot of work, as it is in any other business.

Yes, just study demographic trends, certain types of groups are more likely to have accredited investors but then you also have to see if they are a fit for you.

For example, high-end luxury car groups, you know the people who are on the Porsche forums are more likely to be accredited investors. Conferences that are attended by doctors and dentists are more likely to have accredited investors.

You target an area where the accredited investors are more likely to hang out and you ideally target them in sectors you are interested in. If you are going to a car conference to try to sell something that’s against cars for example, that is probably not the greatest place for you.

Certainly use logic in terms of finding out where are the rich and sophisticated people who are interested in my product, service or securities.

Katipult: Why don’t we talk a bit about how you see the future of crowdfunding legislation in regards to accredited investors.

Do you see any involvement in that space, is it going to be changed a lot or is it going to still be this very standard procedure to accredit the investors or to become an accredited investor, or are there new thought on how to do this?

Jor: I am not sure about this, I do hate verification. Obviously, Verify Investor makes more money on verification than any other company in the world, but currently I am not convinced that it actually protects investors. If anything, I think it actually harms investors more.

Ideally, we do away with this verification or we make it a bit more practical.

As for the future of the investment crowdfunding legislation, I think that if we can get over this fundamental hub now, which to me is the education hub, bring people into the new economy, then the regulations will loosen up.

I think that in the early day, long time ago when these laws were passed, information was not as freely attainable as it is today. There was a real need to make sure that people had the information they needed to make investment decisions. That was a decade ago.

Now it is actually pretty easy for you to go research a company, see if they are legitimate. Talk to other people, ask around on the internet. Order very inexpensive diligence and background reports on other people. You can even commission a drone to fly over the property if you want to.

You can do all sorts of things and many of these things are in public record so we are at a time when information if freely available and this need to protect the investor with this centralized concept of ‘’register with us in order to sell to everyone’’, that may ultimately shift because of information.

But the problem is, we don’t have an educational system, at least not in America, where people are trained to learn how to invest as a form of savings etc. You have a lot of people early on in deals where they might win some money, they might lose some money, but in downturn when everything and everyone loses money, including the rich, you get a bunch of people that will lose money. We got to get over that hump I think.

If we grab better education so that fundamentally more of the general population is comfortable with crowdfunding and seeing that as a legitimate asset allocation for their savings, as part of their portfolio, then I think you start seeing legislation really loosening up because this idea the accredited and the non-accredited is very similar to the haves and have-nots.

There is some bitterness because some people say ‘’Why are you telling me what I can do with my money. I can go to a casino and lose everything, I can participate in a state sponsored lottery where I am almost guaranteed to lose money, but you won’t let me invest and you only let the rich invest‘’.

There are some really good reasons why everybody should be able to invest but until there is better education and better systems built out, there is always going to be this need to protect the people from themselves.

Katipult: My next question is about ICOs and cryptocurrencies. How do you think Verify Investor will work with them?

Jor: ICOs have taken over. In the last 6 months the amount of deals that are going through our system for accreditation has definitely skyrocketed. Within the ICO industry I think we handled most of the ICOs that have chosen to go for the rule 506 C compliance.

In the future, given the rhetoric of the SEC which is basically, if you are going to deal with ICO, basically it is a security risk, so if they get their security raised then, now you essentially only have so many options available for exemptions.

If you have only so many options for exemptions then the most likely exemption is likely to be the rule 506 C, so at Verify Investor we have seen the traffic explode and we see it continuing to explode even if ICO slow down.

ICOs are getting a bad reputation these days and not doing as well, but this movement of having the blockchain technology could be the fundamental technology that tracks securities of all assets of all sorts through some sort of tokenized digital mechanism. That makes a lot of sense.

There is a lot of cost savings and better tracking systems that can be employed by using blockchain technology. Even if ICOs fade away I think it will be replaced simply by capital raises of securities that are associated with tokens.

Katipult: Are you able to explain the differences between the US and Canada with respect to the need to verify accredited status with third parties?

Jor: I am not qualified to answer that. I can say what the US laws are and some Canadian attorney should explain what the Canadian laws are.

However, to my knowledge, Canada doesn’t have a verification obligation. There are various levels of obligations, there is someone who is accredited and you just trust them. Then there is someone accredited and you have done some diligence, meaning you have gotten a questionnaire from them and they self certified it but they did give you information so you can make a determination.

Then there is this level of ‘’that’s not enough, you have to prove it, evidence has to be seen’’. If I file a 6 B in the US, all you need is diligence, and in 6 C you need verification. Now I don’t think Canada has any level that raises up to verification, but, again, that’s something to check with a Canadian attorney.

Katipult: Yes, I haven’t seen anything similar to your system in Canada.

If you are interested in learning more about Katipult platforms and the integration with VerifyInvestor that can save you significant amount of time with investor accreditation, KYC, and AML, contact us here.