What is the Definition of an Accredited Investor?

Securities must be registered with the SEC before they can be offered for sale to the general public in the US. Certain securities are exempt from SEC regulation if the issuers intend to sell them to accredited investors. The issuer must verify that potential accredited investors meet SEC requirements even though these securities are not registered.

The process of registering securities is typically pricey. Companies can save a lot of money by avoiding the registration process.

Financial regulators like the SEC must verify such transactions and make sure investors are knowledgeable and financially secure enough to engage in such investments due to the high risk associated with unregistered private placements.

The Origins of Accredited Investors

Chances are you’ve heard the term "accredited investor" before. Perhaps it manifested itself as "Angel Investor" or another well-liked TV program. It might have come from one of your wealthy financial friends or from a wealth manager's advertisement. Or perhaps you found out about it by browsing websites with investment advice.

Regardless of where you heard the term, you're probably interested in better ways to invest your money. So, have you ever wondered where the term originated and why it's becoming more popular now? This story, it turns out, dates back to the beginning of the Great Depression.

The US economy was booming in the early 1920s. Investor confidence was high due to the newly established Federal Reserve, which was designed to limit the stock market's booms and busts. In an effort to boost their returns, investors became more and more speculative, financing their speculations with debt.

Large returns were promised by businesses without any solid data to back them up. As a result of the stock market crash, the United States experienced its worst economic depression in history.

Congress passed the 1933 Securities Act, which served two purposes in an effort to prevent a future market crash. The first requirement is that investors have access to financial and other important information about the securities in which they have invested.

The second is to make misrepresentations, fraud, and deception in security sales illegal. In other words, the purpose of this legislation was to protect the average investor.

In contrast, private placements were exempt from securities laws. It didn't take long for questions about what constituted a "public offering" to arise. In order to determine which group of people needed to be protected under the Securities Act, the Supreme Court was prompted to take action.

The court ultimately found that an investor needed sophisticated financial knowledge to evaluate the investment and the financial capacity to sustain a total loss in order to partake in a "private offering."

The Securities and Exchange Commission (SEC) adopted Rule 501 of Regulation D in an effort to further standardize investor eligibility to participate in private investments and to assist small businesses in raising capital. Rule 501 defined the term Accredited Investor in monetary terms and eliminated the "sophisticated investor" provision entirely.

What Is an Accredited Investor?

Certain types of investments are not available to everyone. Hedge funds and early-stage startups, for example, are exempt from a slew of rules and regulations designed to protect regular investors from the risks they face.

An accredited investor is a person or a business that is permitted to trade securities that are not registered with financial authorities. They are entitled to this privileged access if they meet certain financial and sophistication requirements.

The Securities and Exchange Commission (SEC) uses the term accredited investor in the United States under Regulation D to refer to investors who are financially sophisticated and have a reduced need for the protection provided by regulatory disclosure filings.

Common examples of accredited investors include high-net-worth individuals (HNWIs), banks, insurance providers, brokers, and trusts.

Accredited Investors: An Overview

Accredited investors are legally permitted to purchase securities that have not been registered with regulatory bodies such as the SEC. Many businesses decide to sell securities directly to this group of accredited investors.

Because this decision exempts companies from registering securities with the SEC, it can save them a significant amount of money.

This type of stock offering is known as a private placement. It has the potential to expose these accredited investors to significant risk. As a result, authorities must ensure that they are financially secure, experienced, and knowledgeable about their risky endeavors.

The regulatory authorities' role is limited to verifying or providing the necessary guidelines for establishing benchmarks to establish who is an accredited investor when companies decide to offer their shares to accredited investors.

Regulatory agencies assist in determining whether the applicant has the resources and expertise required to accept the risks associated with investing in unregistered securities.

Additionally, accredited investors enjoy preferential access to venture capital, hedge funds, angel investments, and transactions involving sophisticated and risky financial instruments.

Accredited Investor Requirements

Any market regulator has the duty to foster investments and defend investors at the same time. On the one hand, because they have the potential to become multi-baggers in the future, regulators have a vested interest in encouraging investments in risky ventures and entrepreneurial activities.

In August 2020, the Securities and Exchange Commission (SEC) broadened the definition of who qualifies as an accredited investor in terms of both people and institutions. Specifically, an accredited investor is defined as someone who meets the following criteria:

Financial Criteria:

● Over $1 million in net worth, excluding the primary residence (individually or with spouse or partner).

● Income of more than $200,000 (individually) or $300,000 (with spouse or partner) in the previous two years, and reasonable expectation of the same in the current year.

Professional Criteria:

● Investment professionals in good standing who hold a general securities representative (Series 7) license, an investment adviser representative license (Series 65), or a private securities offerings representative license (Series 82).

● The company's directors, executive officers, or general partners (GP) are selling the securities (or of a GP of that company).

● Any "family client" who satisfies the criteria of an accredited investor and who works for a "family office."

● "Knowledgeable employees" of a private fund who will handle the investments.

How Entities Qualify for Accredited Status

Entities may qualify as accredited investors based on the structure of the entity or its assets.

● Investments: Entities with investments worth more than $5 million.

● Assets: Corporations, partnerships, LLCs, trusts, 501(c)(3) organizations, employee benefit plans, "family office" and any "family client" of that office with assets in excess of $5 million.

● Owners as Accredited: Entities in which all stockholders are accredited investors.

● Investment Adviser: SEC-registered broker-dealers and investment advisers (whether state-registered, SEC-registered or exempt reporting advisers).

● Financial Entities: A small business investment company, rural business investment company, bank, savings and loan association, insurance company, registered investment company, business development company, etc.

The stringent criteria for net worth, professional experience, and income are intended to protect investors who may not have sufficient cash reserves to withstand significant losses.

According to the SEC, inexperienced investors may get in over their heads. This is especially true given that these offerings frequently require significant minimum investments.

This is not to say that every early-stage startup or hedge fund will fail. However, because they are only required to provide the most basic information to their investors, unregistered investments are inherently riskier.

According to the SEC, the accredited investor exemption is intended “...to ensure that all participating investors are financially sophisticated and able to fend for themselves or sustain the risk of loss, thus rendering unnecessary the protections that come from a registered offering.”

How Net Worth Is Calculated

To qualify as an accredited investor under the net worth test, you must have a net worth of more than $1 million at the time of the sale of the securities, either alone or with a spouse or spousal equivalent.

When calculating joint net worth with a spouse or spousal equivalent, the property does not have to be held jointly, and securities do not have to be purchased jointly. To calculate your net worth, add all of your assets and subtract all of your liabilities. This calculation will give you your net worth.

Exclusion of Primary Residence from Net Worth Calculation

Any mortgage or other loan secured by the primary residence is also exempt from liability up to the home's fair market value. If the loan amount exceeds the fair market value of your primary residence (i.e., if your mortgage is underwater), the excess loan amount is considered a liability under the net worth test.

Furthermore, any increase in the loan amount (other than for the purchase of the primary residence) in the 60 days preceding your purchase of the securities will be counted as a liability (even if the loan amount does not exceed the value of the primary residence).

This is done in order to prevent home equity from being converted into cash or other assets, which would artificially inflate net worth.

Is There a Process to Becoming an Accredited Investor?

There is no certification provided to demonstrate that you are an accredited investor. Companies selling investments to accredited investors, on the other hand, must take steps to confirm your eligibility.

That means you'll have to release financial documents, such as W-2s, tax returns, and bank and brokerage statements, proving your current net worth is more than $1 million (excluding your primary residence) or that you had qualifying income in the previous two years.

Accredited Investor Qualifications

What's the big deal about becoming an accredited investor? In short, accredited investors have access to financial tools that most other investors do not, and if they know what they're doing, they can make a lot of money on those investments.

Remember that in investing, risk and reward frequently go hand in hand. If you're willing to put more money on the line, you might get more out of it. It's not guaranteed—no investment is—but the potential for huge rewards can pay off for the right investor.

Financial authorities, on the other hand, do not want ordinary investors to believe they can make a fortune only to lose it all. Their job is to ensure that investors understand what they're getting into, but with high-risk, loosely regulated investments, there's very little oversight protection. Authorities believe accredited investors know what they're doing.

Is Becoming an Accredited Investor Worth It?

Is it worthwhile to become an accredited investor? Your goals will determine what you want. You are not required to become an accredited investor, even if you meet the requirements.

You would only want to become an accredited investor if you wanted to take advantage of investment opportunities that are only open to those who qualify.

As a result, it's important to research the kinds of assets you might have access to if you do fulfill the requirements to become an accredited investor. It isn't worth becoming an accredited investor if you aren't comfortable with them or if they don't fit your personal investment style.

The Benefits of an Accredited Investor

As a business seeking capital, you've covered all of your bases by utilizing as many funding sources as possible to launch your small business. It is time to step up the ante and intensify the search for investors now that it has gained traction.

Whether you've considered them before or not, accredited investors may be able to help you achieve your objectives. Accredited investors have the knowledge to get you where you want to go, and you need all the help you can get as a small business.

Here are some of the major benefits that working with the right accredited investors can provide:

#1) They Have Substantial Assets

Accredited investors are people who have a sizable amount of assets, so dealing with them is safe. Otherwise, they wouldn't be eligible for accreditation.

Accredited investors provide you with access to those with capital to invest. They might have worked for hedge funds or other organizations that only permitted participants who could meet specific financial requirements.

Accredited investors, as a wealthy group, have the means to invest in your business.

#2) SEC Registration Exemption

Accredited investors are a subset of investors who can access investments that ordinary investors cannot. This is due to the fact that they meet the Securities and Exchange Commission's wealth and sophistication requirements.

As a result, accredited investors can freely invest in instruments such as private placements for startups like yours. As a result, they have the chance to take part in more dynamic investment opportunities and consistently earn higher rates of return.

Additionally, it implies that they could potentially become even wealthier in a shorter amount of time.

Banks and businesses with assets worth more than $5 million can be considered accredited investors. Individuals with a net worth of $1 million to charitable organizations with assets exceeding $5 million can also qualify as accredited investors.

As a small business, you are exempt from registering any securities with the SEC when you sell to accredited investors in accordance with Regulation D rules 505 and 506.

#3) Private Securities Offering

When conducting private stock offerings, accredited investors are ultimately your intended audience, allowing you to avoid SEC registration. You can finance your small business by soliciting accredited investors to purchase shares of your company's stock through a private stock offering.

You provide information about your business and the stocks you are selling to accredited investors through the private stock offering. This will provide your accredited investor with the information they need to make an informed decision about whether or not to invest.

This means they have a greater variety and diversification of asset classes in which to invest, resulting in less competition from other, more traditional, investors in some cases.

You will offer an Accredited Investor Questionnaire Form to prospective investors as part of your private stock offering. This will support confirming the investor's accreditation.

#4) A Wide Range of Accredited Investors

Despite being a select group, accredited investors can be any type of entity, including individuals and organizations. When it comes to soliciting investments, you have a large pool of accredited investors to choose from.

Individuals must have a net worth of $1 million or income of $200,000 in each of the two most recent years, as a general rule. Furthermore, they must be able to demonstrate that they have a reasonable expectation of earning the same income in the current year.

All equity owners in corporations must be accredited investors. Employee benefit plans and trusts with assets over $5 million are both examples of accredited investors.

The Types of Assets and Deals Accredited Investors Invest In

As previously stated, accredited investors are more likely to be offered investments with the potential for higher returns than non-accredited or retail investors. Naturally, higher potential returns also entail higher risk. Among these investments are:

Hedge Funds

In a hedge fund, money is invested by fund managers in a variety of different securities in an effort to "chase alpha," or produce profitable returns. A hedge fund's objective is to generate profits no matter the state of the market.

In order to increase performance, these funds typically trade in relatively liquid assets and employ fairly sophisticated trading and risk management strategies. Funds can choose to short-sell, use leverage, or invest in derivatives.

Investing in a hedge fund can be a difficult process. You can't simply dial a hedge fund number or invest through an online brokerage. You usually need to know someone at the fund, and the vetting process is rigorous.

Hedge fund management fees can be quite high. In addition to the expense ratio, fund managers typically receive 20% of the fund's returns, further reducing an investor's gains.

Accredited investors can also invest in funds of funds, which are intended to mimic the diversification of mutual funds. Typically, funds of funds invest in several other mutual funds or hedge funds.

The fees charged by a fund of funds are comparable to those charged by hedge funds, and their performance can be tracked and benchmarked using the Barclays Fund of Funds Index.

Venture Capital (VC)

It may sound exciting to join a startup at the beginning. Unfortunately, the majority of people are unable to invest in pre-IPO startups outside of employee stock options.

Accredited investors, on the other hand, have a number of options for investing in startups. They typically source private placement offerings through a venture capital (VC) firm or an online marketplace.

Accredited investors become investors in a venture capital fund, and the firm then invests money from the fund in a variety of startups. The liquidity of a venture capital fund is always limited, which means you won't be able to withdraw your money whenever you want.

Accredited investors should always be aware of the risks associated with the investment horizon of a venture capital fund.

Accredited investors can find investment opportunities through online marketplaces such as Yieldstreet, Peerstreet, and Cadence. The liquidity on these platforms varies, and thorough research is required before making any investments.

You can invest in start-ups even if you are not an accredited investor through relatively new crowdfunding platforms. Equity investors of any income level are welcome to support startup businesses through StartEngine, WeFunder, and NextSeed. Remember that these investments are far riskier and less liquid than stock in publicly traded companies.

Other investments:

Private Equity

This is money that has been raised and invested in a real estate asset purchase and sale fund. Once the target amount is reached, the fund will close to new investors and be liquidated within a predetermined time frame (say, 5-10 years), selling assets, and taking profits.

Equity Crowdfunding

As its name suggests, a "crowd (of people)" invests in an unlisted fund to acquire a multi-family property in exchange for fund shares; their share of ownership is proportional to the amount invested.

Private Placements

A private placement is the sale of stock in a real estate investment to prospective investors who have been hand-picked and may already be familiar with the placer.

Private placements are an alternative to other methods of raising capital for LLCs seeking to raise capital.

Conclusion

The accredited investor rules are designed to protect potential investors with limited financial knowledge from risky investments and losses for which they may be unprepared. People who begin with large financial assets, on the other hand, have a significant advantage over those who begin with smaller assets.