In 2020, an estimated 13.6 million U.S. households are accredited investors [1]. These households control enormous wealth, estimated at over $73 trillion, which represents over 76% of all private wealth in the U.S. These investors participate in investment opportunities generally unavailable to non-accredited investors, such as investments in private companies and offerings by certain hedge funds, private equity funds, and venture capital funds, which allow them to grow their wealth. Both investors and issuers should fully understand the definition of an accredited investor as well as its qualifying criteria.

WHO IS AN ACCREDITED INVESTOR?

While the definition of “accredited investor” has broadened from time to time with SEC revisions, the term remains defined by Rule 501(a) of Regulation D adopted in 1982 as part of the Securities Act of 1933 as follows [2]:

An accredited investor, in the context of a natural person, includes anyone who:

  • Earned income that exceeded $200,000 (or $300,000 together with a spouse) in each of the prior two years, and reasonably expects the same for the current year, OR
  • Has a net worth over $1 million, either alone or together with a spouse (excluding the value of the person’s primary residence)

While this general definition has remained applicable, prospective investors and real estate deal syndicators need to keep themselves up to date with the SEC’s revisions in order to stay compliant with SEC rules and to take advantage of the broadening definition. Read on for details about the latest accredited investor revisions.

ACCREDITED INVESTOR DEFINITION BACKGROUND

Capital is the fuel that runs the economic engine of any country. Banks usually fund the majority, but seldom all, of the capital required of any acquisition. Then there are situations like startups, where banks don’t provide any funding at all, as they are unproven and considered risky, but the need for capital remains. In these cases, companies raise capital from investors, and this is where the government gets involved with regulations to protect investors.

The Securities Act of 1933 requires the issuer of securities to follow several regulations and very stringent reporting and registration requirements, which can potentially make capital raising prohibitive for small to medium size companies due to the costs and complexity involved in compliance. However, to promote capital formation and expand investment opportunities while maintaining appropriate investor protections, the Securities and Exchange Commission has issued “Exempt” status for certain offerings under Regulation D.

REGULATION D

Regulation D, adopted in 1982 [3], is a series of rules that sets forth exemptions and a safe harbor from the registration requirements of the Securities Act. There are primarily two rules that allow issuers of securities to offer unlimited amounts of securities to investors. One of them is Rule 506(b) of Regulation D, which allows an issuer to sell securities to unlimited accredited investors and up to 35 Sophisticated Investors only if the offering is NOT made through general solicitation and general advertising.

The second is Rule 506 (c), which provides exemption from registration requirements and allows an issuer to sell unlimited securities even while using general solicitation and advertising if the securities are being sold ONLY to accredited investors.

CAPITAL CREATION THROUGH REG D EXEMPTIONS

A significant amount of capital formation occurs every year through Reg D exempt Rule 506 offerings, and accredited investors are crucial for providing capital for this Reg D market. In 2018 alone, the estimated amount of capital raised (equity and debt) using unregistered Rule 506 offerings was $1.7 trillion compared to $1.4 trillion raised through registered offerings. Of the $1.7 trillion, $1.5 trillion was raised using pooled investment funds and $228 billion was raised by non-fund issuers.

These numbers show the magnitude of capital raised under Reg D offerings and underscore the importance of these exempted offerings in making capital accessible for companies and how they play an important role in job creation and economic growth

INVESTOR ACCREDITATION AND VERIFICATION PROCESS

The issuer of the Reg 506 (c) offerings has an obligation to perform due diligence to ensure that each investor qualifies for Accredited status before selling these unregistered/exempt securities. There are several ways to achieve this. The process often starts with a potential investor completing a questionnaire about the financials that qualify them for Accredited status – either by net worth or by income – and then providing relevant documents, such as tax returns and bank statements.

Issuers often engage a third-party verifier such as verifyinvestor.com so that this process can be outsourced, which can be very cost-effective. Another way to confirm an investor’s qualifications is to have them request a letter of accreditation from their CPA, attorney, RIA, or broker dealer who is knowledgeable about the investor’s financials. This can be a quick and painless process that also allows the investor to keep some privacy regarding their financials.

MODERNIZATION OF THE ACCREDITED INVESTOR DEFINITION

In August 2020, the SEC adopted several amendments to the accredited investor definition (to Rule 501 (a) of Reg D), which remains as the primary test to determine which natural persons can invest in unregistered/exempt Reg D private market offerings. Until now, the individual investors who didn’t pass income or net worth tests were denied the opportunity to invest in these private offerings. The newly adopted amendments for the first time accredit individual investors based on financial sophistication requirements. Several other amendments made to Rule 215 and Rule 114 A clarify and expand the list of entity types that can qualify as an accredited investor.

Here are a few highlights [4]. The amendments to the accredited investor definition in Rule 501(a):

  • include as accredited investors any trust, with total assets more than $5 million, not formed specifically to purchase the subject securities, whose purchase is directed by a sophisticated person, or
  • include as accredited investors any entity in which all the equity owners are accredited investors.
  • add a new category to the definition that permits natural persons to qualify as accredited investors based on certain professional certifications, designations or credentials or other credentials issued by an accredited educational institution, which the Commission may designate from time to time by order. In conjunction with the adoption of the amendments, the Commission designated by order holders in good standing of the Series 7, Series 65, and Series 82 licenses as qualifying natural persons.
  • include as accredited investors, with respect to investments in a private fund, natural persons who are “knowledgeable employees” of the fund;
  • clarify that 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;
  • add “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; and
  • add the term “spousal equivalent” to the accredited investor definition, so that spousal equivalents may pool their finances for the purpose of qualifying as accredited investors.

While the definition of “accredited investor” has broadened from time to time with SEC revisions, the basic definition remains to be “a person who has an annual income of $200,000 ($300,000 jointly) for the last two years and has a reasonable expectation of earning the same or higher in current year (or) a person who has a net worth of $1 million, excluding the value of their primary residence.”

Staying up to date with revisions to the definition can help prospective investors and syndicators stay compliant with SEC rules and take advantage of the broadening definition. And now that you know what it means, see 4 Real Estate Marketing strategies to attract accredited investors.