What Is an Accredited Investor?
When you’re raising money as a startup, one of the first questions you should ask is also one of the most basic: Who can actually invest in your company? It’s not like you can stop random passersby outside your office and ask if they’d like to participate in your next funding round. No, the types of investors who participate in funding rounds generally must have a legal authorization to trade certain securities that aren’t registered with the U.S. Securities and Exchange Commission (SEC). In other words, they are accredited investors.
The SEC uses the term “accredited investor” to refer to individuals or entities that are allowed to trade certain security offerings that aren’t registered with financial authorities. Because registering securities and preparing investor disclosures can be prohibitively expensive for early-stage startups, many of these companies turn to accredited investors as a source of funding.
As a founder interested in raising capital, it’s crucial to understand the difference between an accredited investor and a non-accredited investor. The SEC doesn’t issue shiny certificates that say “Accredited Investor” on them, so it’s usually up to the company selling investments to verify the investor’s status. If you wrongfully sell unregistered securities to a non-accredited investor and those securities go belly-up, you may be partially accountable for that investor’s losses.
In this guide, we’ll walk through the SEC’s most recent accredited investor definition and spell out some of the finer points about accredited investor status. If your company has engaged with venture capital firms or angel investors, chances are you already know some accredited investors by name.
- What is an accredited investor?
- What are the requirements to be an accredited investor?
- What types of investments are available to accredited investors?
- Save on legal fees and model your fundraising with Pulley
What is an accredited investor?
An accredited investor can be either an individual person or a legal entity, such as a hedge fund or financial institution.
Only those who fulfill the criteria of the SEC’s accredited investor definition are eligible to participate in private capital markets. In other words, accredited investors can invest in unregistered securities and other private capital investments that aren’t available to members of the general public.
Why this special privildge? The SEC uses the term “accredited investor” under Regulation D of the Securities Act of 1933, which outlines certain exemptions that allow companies to offer and sell securities without first registering them with the SEC. The general idea is that unregistered securities come with a heightened level of investment risk, so the SEC wants to make sure that the people who invest in them know what they’re getting into and won’t be totally gutted by a wayward investment.
What are the requirements to be an accredited investor?
The SEC’s most recent definition of accredited investor is based on a number of criteria. For individuals, these criteria include thresholds for wealth and annual income as well as “other measures of financial sophistication.” Basically, you have to either show that you have a lot of money at your disposal or that you’re a financially sophisticated person with sufficient knowledge of what you’re dipping your toes into.
Entities have their own criteria for qualification, though the considerations aren’t all that different. Let’s take a look at the specific requirements for both individuals and entities.
Requirements for individuals to qualify as accredited investors
Individuals who want to qualify as accredited investors may need to reach one (not both) of the following thresholds for financial criteria:
- A net worth of over $1 million, excluding the value of the individual’s primary residence. This can also be a joint net worth between spouses or “spousal equivalents,” i.e. a partner and cohabitant whose relationship is generally equivalent to that of a spouse.
- Individual income over $200,000 or joint income (with spouse or spousal equivalent) over $300,000 in each of the prior two years. Income in the current year must also be expected to reach this threshold.
But there are other ways for individual investors to qualify, too. These “measures of financial sophistication” basically boil down to various professional certifications and qualifications. Individuals may be able to qualify if they are:
- Investment professionals in good standing
- Directors, executive officers, or general partners of the company selling the securities
- A family client of a family office that meets the qualification criteria
- Knowledgeable employees of a private fund (for investments in that fund). Note that “Knowledgeable employee” is not a description you can simply give yourself as a smart person who knows stuff. It’s a defined term in Rule 3c–5(a)(4) under the Investment Company Act of 1940. It includes, for example, directors and certain executive officers of the fund, as well as employees who participate in the fund’s investment activities.
Requirements for entities to qualify as accredited investors
The SEC also affords an opportunity for certain business entities to qualify as accredited investors. Depending upon various factors such as the entity’s structure and available assets, entities that meet the following criteria may qualify:
- Entities with investments that exceed $5 million in value
- Entities with total assets that exceed $5 million in value, if the entity is a corporation, partnership, LLC, trust, 501(c)(3) organization, employee benefit plan, or family office
- Entities in which all of the equity owners are themselves accredited investors
- Investment advisers and SEC-registered broker-dealers
- Certain financial entities, such as insurance companies and registered investment companies
What types of investments are available to accredited investors?
Accredited investors have access to a number of investment types that ordinary investors don’t. Again, this is largely due to the fact that the SEC wants to protect non-accredited investors from risky investments with a high likelihood of failure.
So, what types of investments fit into this category? Investments that generally require accredited investors include:
- Private equity financing. Private equity (sometimes called PE) is a type of financing in which private money is invested into private companies. One type of private equity you should know about as a founder is venture capital, which specializes in funding startups. Angel investing also plays a big role in early-stage startup funding and is considered a type of private equity.
- Hedge funds. These funds are typically managed by professionals who attempt to beat average market returns on behalf of their private investors. Because they tend to be more aggressive in their tactics, hedge funds are generally considered more risky than many other investment types.
- Equity crowdfunding. As its name implies, equity crowdfunding involves a company raising money from a “crowd” of investors online. For their money, these investors receive a share of equity in the company. Not all crowdfunding efforts require accreditation, but some might. For example, real estate crowdfunding platforms often require investors to be accredited.
Save on legal fees and model your fundraising with Pulley
As a founder, you should be proud of building a company that attracts people as a prospective investment. But you also need to do your due diligence to ensure that the investors you bring on board meet the qualifying criteria in terms of securities law. If you don’t, you may run afoul of the SEC and may even end up being on the hook for a portion of the losses those investors incur. Remember: The SEC doesn’t pass out accredited investor membership cards, so it’s on the issuer of the securities to verify the investor’s credentials.
Feeling overwhelmed yet? We get it, which is why we’ve built a better, more transparent way to model fundraising and help you keep track of your investors. Pulley gives founders and founding teams all the tools they need to model complex fundraising rounds and avoid costly cap table mistakes. Schedule a call with us today to learn how we can help you and your investors achieve a fairer, more flexible equity playing field.
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