To be “sophisticated,” the Investor must have, under Rule 506(b)(2)(ii), “either alone or with his purchaser representative(s) such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment.” The issuer must have a reasonable belief (based on a factual inquiry) that investors in its Rule 506(b) offering falls within this description.
Furthermore, this definition applies to ALL investors in a Rule 506(b) offering, not just non-accredited investors. Therefore, it is necessary for the issuer to conduct a factual inquiry – sufficient to satisfy the “reasonable belief” test – for both Accredited and non-Accredited investors prior to offering them an investment in a Rule 506(b) offering. The factual inquiry marks the beginning of the “substantive relationship” (more on this in the following paragraph).
In order to prove you didn’t advertise a Rule 506(b) offering (which is prohibited for a Rule 506(b) exempt offering), you must be able to demonstrate that you had a “substantive relationship” with each investor that pre-dated your offering (the proverbial “pre-existing, substantive relationship”). For proof, you need to have a “record-keeping system” that documents when you made the “factual inquiry” to determine the investor’s suitability and sophistication and that the factual inquiry pre-dated your offer to invest.
For more information about establishing a substantive relationship and some example suitability questions for your “factual inquiry,” see the article entitled “How do I Create a Substantive Relationship?”
