We’ve all heard the phrase, it takes money to make money, but to rephrase it in terms that accredited investors would understand, we must make an appendage: it takes money to make money in unregistered offerings.
This is because accredited investors have access to investment offerings and opportunities that most people do not, even those who earn above-average incomes and have respectable net worths.
In this article, we discuss who is eligible to invest in unregistered securities and how the Securities and Exchange Commission (SEC) has moved the bar over the years for becoming an accredited investor.
Who is an Accredited Investor?
An accredited investor is a high-earning, high net worth, or knowledgeable individual who is eligible to invest in securities and offerings that have not been registered with the SEC.
Under federal law, companies or individuals may not offer or sell securities that have not been registered with or exempt from registering with the SEC. These unregistered securities, also known as private placements, are fair game for accredited investors, however.
Securities law is in place to protect the average retail investor from being defrauded. The SEC, who enforces this law, has decided that accredited investors are educated, sophisticated, and wealthy enough to understand the risks involved, or in the worst-case scenario, survive a total loss of capital.
How to Qualify as an Accredited Investor
The requirements of being an accredited investor are based on the following criteria:
- Net worth
As a single investor or couple, if your net worth is greater than $1 million — excluding the value of your primary residence — you qualify as an accredited investor.
Another qualification is income within the last two calendar years and the expectation to continue earning in the current year. As a single investor, an annual income of $200,000 or greater qualifies you. For couples, an annual income of $300,000 or more qualifies.
In 2020, securities law broadened the requirements by including some certifications and other education-based allowances when becoming an accredited investor. For example, those that have proven their financial astuteness with certifications like the Series 7 or have successfully registered as an investment adviser.
Entities are also eligible to become accredited investors if 100% of the company’s leadership are accredited themselves or the business has total assets in excess of $5 million.
What Accredited Means for Investors and Fundraisers
There is no such thing as a card-carrying accredited investor. Ultimately, it is the responsibility of the security issuer to determine whether their investors are accredited before selling them securities.
It’s not uncommon for issuers to inquire about financial history, assets, and even request documentation such as financial statements, W2s, or tax returns to verify an investor’s accreditation status.
Evolution of the “Accredited Investor”
The SEC first proposed the idea of investor accreditation in the midst of the Great Depression with the passing of the Securities Act of 1933. The two main objectives of the act were to (1) increase transparency and availability of information for investors to assess the financial viability of the securities they invest in and (2) prohibit fraud.
With a few exceptions, much is unchanged from the Securities Act’s definition of an accredited investor: an individual or household worth more than $1 million or an annual income of $200,000 for single investors or $300,000 jointly.
In 1982, an amendment passed to further limit the risk of a substantial financial loss in a concentrated and risky investment. The amendment specifies that a single investment worth more than $150,000 can not constitute more than 20% of the individual’s net worth. This means that if you only just qualify as an accredited investor with a net worth of $1 million, you cannot invest more than 15% of your net worth into any single investment.
In the wake of the housing bubble bursting and subsequent recession, the Dodd-Frank Act of 2011 was passed, significantly changing the accreditation requirements for investors. Dodd-Frank removed the value of one’s primary residence from calculating net worth, typically one of the most valuable assets individuals or couples own.
As we previously mentioned, the latest update to the accredited investor definition is based on education and knowledge. The amendments passed in 2020 allow those who have passed the exams for Series 7, Series 65, or Series 82, or knowledgeable employees to qualify as accredited investors.
Below is a timeline of the SEC’s establishment and modifications to the definition of an accredited investor:
Advantages of Being an Accredited Investor
Naval Ravikant has said, “Money is not going to solve all of your problems; but it’s going to solve all of your money problems.” Being designated as an accredited investor means that you are financially secure, with the resources to invest should an opportunity present itself.
1. Access to Deals
We previously mentioned that unregistered securities or private placements are available to accredited investors but usually not accessible to non-accredited investors. An example of a private placement is a new hedge fund manager setting out to raise millions from a few limited partners (LPs). Hedge funds are typically only accessible to high-net-worth individuals.
2. Diversification into Alternative Investments
Accredited investors are able to more widely diversify their portfolio into various instruments, asset classes, industries, and alternative investments. There is ample evidence that diversification is a good strategy for portfolio construction, usually provided by people that were heavily weighted in a single investment or asset class that subsequently declined and dragged the entire portfolio down with it.
Accredited investors are able to diversify into various types of investments such as fine art, collectibles, precious metals, stocks, bonds, venture capital, hedge funds, real estate, cryptocurrencies, and more.
Disadvantages of Being an Accredited Investor
The SEC did not establish the threshold for becoming an accredited investor without good cause. Throughout history there have been numerous precedents set of people losing everything on a risky investment. Let’s cover some of the disadvantages of being accredited.
When accredited investors make an investment in a private placement, the SEC does not require stringent financial disclosures as it does for registered securities. It is ultimately up to the investor to determine whether the venture, characters involved, and financial viability of the investment are sound.
As is the case with real estate, private equity, and other large investments, the deal is typically highly levered, meaning that it is backed by large amounts of debt. If the investment does not pay off in time to service the debt, the investors may be forced to invest more money or risk their initial investment.
While fraud is not exclusive to accredited investors, the cases of fraud at this level are usually very complex and can cost the investor millions of dollars or more. Bernie Madoff, a name that should ring a few bells, defrauded accredited investors around the globe to the tune of $50 billion with the facade of a successful derivatives strategy.
Becoming an Accredited Investor
Wealth is almost always built through sound investment and equity ownership. If you look at the wealthiest people in the world, you will see they all have one thing in common: they own equity in successful businesses.
Most of these same people did not start their lives as accredited investors, but they built value in business and made good investments that compounded their wealth. Today, the opportunities for raising capital for your business or investing in businesses are more accessible than ever before.
Whether you are an accredited investor, well on your way to meeting the requirements, or just starting, continue reading and researching potential investments so you are ready and able to invest should the opportunity arise.