Updated December 2020 to include the SEC’s new update to the Accredited Investor Definition 2020. The new rules took effect on December 8th, 2020. You can read the SEC’s final rule changes to the Accredited Investor definition here: https://www.sec.gov/rules/final/2020/33-10824.pdf
An accredited investor is a designation created by the U.S. Securities and Exchange Commission (SEC). They are experienced investors or people who can meet certain criteria and afford to invest in a company, lose the investment, and not face financial ruin as a consequence.
EXISTING ACCREDITED INVESTOR RULES
Rule 501 of Regulation D defines the official criteria for an individual to be regarded as an accredited investor:
- A person who has earned at least $200,000 a year for the past two years and expects to earn the same this year; or a couple who has earned at least $300,000 a year for the past two years and expects to earn the same this year. OR
- A person whose net worth, excluding their primary residence, is more than $1 million.
The following entities are also considered accredited investors:
- A bank, insurance company, registered investment company, business development company, or small business development company.
- An employee benefit plan with assets over $5 million; or one that uses a professional investment advisor if assets are under $5 million.
- A charitable organization with assets over $5 million.
- A trust with assets over $5 million that is led by a knowledgeable investor and that wasn't created specifically to invest in the securities being purchased.
- A director or executive of the company offering the securities.
- A business in which all the owners are accredited investors.
NEW ACCREDITED INVESTOR RULES
As of 2020, the SEC has modernized the Accredited Investor Definition to also include:
- A person based on certain professional certifications, designations, or credentials.
- With respect to investments in a private fund, natural persons who are “knowledgeable employees” of the fund.
- Limited liability companies with $5 million in assets may be accredited investors and add SEC- and state-registered investment advisers, exempt reporting advisers, and rural business investment companies (RBICs) to the list of entities that may qualify.
- Any entity, including Indian tribes, governmental bodies, funds, and entities organized under the laws of foreign countries, that own “investments,” as defined in Rule 2a51-1(b) under the Investment Company Act, in excess of $5 million and that was not formed for the specific purpose of investing in the securities offered.
- “Family Offices” with at least $5 million in assets under management and their “family clients,” as each term is defined under the Investment Advisers Act.
- A “spousal equivalent” is now included in the accredited investor definition, so that spousal equivalent may pool their finances for the purpose of qualifying as accredited investors.
While the intent of the accredited investor definition is clear, many have criticized the criteria, noting that typical salaries of congressmen, professors, judges, and stockbrokers don't qualify them as accredited investors and that the criteria didn’t previously include advanced degrees, professional designations or securities licenses. This looks to be changing going forward.
WHY ARE ACCREDITED INVESTORS IMPORTANT TO A STARTUP COMPANY?
Long before they reach the maturity to have an IPO, most startup companies sell equity to outside investors. In fact, startups typically raise funds three or four times before they are acquired or go public. The SEC created Regulation D as a way for a private company to sell shares in the company to the public without having to complete the time-consuming and expensive registration process required for an IPO. In fact, companies that sell equity under Regulation D don't have to provide much information to the SEC or to the investors, and the SEC provides very little oversight. That's because a company can only sell to an accredited investor.
The SEC clearly believes that accredited investors don't need the commission's help to know what information to ask for and are qualified to make sound investment decisions, including not investing money they can't afford to lose. Historically, these accredited investors have been angel investors, institutional investors, and venture capitalists.
One consequence of the requirement to sell only to accredited investors is that only the wealthy have the opportunity to invest in a promising new startup. Even the founder's parents, for example, might not be allowed to invest in the company if they didn't qualify as accredited investors.
As part of the Jumpstart Our Business Startups (JOBS) Act signed into law by President Obama, the SEC added Regulation A+ which allows small private companies to raise a limited amount of money by selling equity to accredited and non-accredited investors. Compared to Regulation D, Reg A+ has many more requirements and the SEC provides much more oversight. However, since it limits the amount of money that a company can raise and limits the amount of money that a non-accredited investor can contribute, the requirements are much less onerous than what's required for an IPO. Reg A+ has earned the nickname of a "mini-IPO."
The JOBS Act also allows companies that sell to accredited investors defined under Regulation D to market and promote the sale, which was previously prohibited. It also holds the company accountable for verifying that each investor is, in fact, an accredited investor. The SEC also added additional rules specifically for crowdfunding.
This guide is provided for educational reference purposes only and it is always important to consult your legal advisor on your specific case.