What is an Accredited Investor
An accredited investor is a person or a business entity who is allowed to deal in securities that may not be registered with financial authorities. They are entitled to such privileged access if they satisfy one (or more) requirements regarding income, net worth, asset size, governance status or professional experience. In the U.S., the term is used by the Securities and Exchange Commission (SEC) under Regulation D to refer to investors who are financially sophisticated and have a reduced need for the protection provided by regulatory disclosure filings. Accredited investors include natural high net worth individuals (HNWI), banks, insurance companies, brokers and trusts.
BREAKING DOWN Accredited Investor
The term originates from the English word ‘accredited’ which literally means someone who has been given special authority or sanction if they meet certain recognized standards. Accredited investors are most popular for purchasing securities which are not registered with the regulatory authorities like the SEC. Since the capital raising exercise involves a complex and costly process including regulatory filings, many companies offer securities to the accredited investors directly. The companies are exempted from registering securities with the SEC which saves a lot of cost for them, and are allowed to sell the shares to qualified accredited investors. Participants in such types of private placements are at the risk of losing their entire investment, and therefore authorities need to ensure that they are financially stable, experienced and knowledgeable about their risky ventures.
The role of the regulatory authorities in such transactions is limited to verifying or offering the necessary guidelines for setting benchmarks for an individual or entity to qualify as an accredited investor – that is, the applicant must possess the necessary financial means and knowledge to take the risks involved in investment in such unregistered securities. Other arenas to which the accredited investors have privileged access include venture capital, hedge funds, angel investments, and deals involving complex and higher-risk investments and instruments.
Requirements for Accredited Investors
The regulations for accredited investors vary from one jurisdiction to the other and are often defined by the local market regulator or a competent authority. In the United States, the definition of accredited investor is put forth by SEC in Rule 501 of Regulation D.
To be an accredited investor, a person must have an annual income exceeding $200,000, or $300,000 for joint income, for the last two years with expectation of earning the same or higher income in the current year. An individual must have earned income above the thresholds either alone or with a spouse over the last two years. The income test cannot be satisfied by showing one year of an individual's income and the next two years of joint income with a spouse. The exception to this rule is when a person is married within the period of conducting a test.
A person is also considered an accredited investor if he has a net worth exceeding $1 million, either individually or jointly with his spouse. The SEC also considers a person to be an accredited investor if he is a general partner, executive officer, director or a related combination thereof for the issuer of unregistered securities.
An entity is an accredited investor if it is a private business development company or an organization with assets exceeding $5 million. Also, if an entity consists of equity owners who are accredited investors, the entity itself is an accredited investor. However, an organization cannot be formed with a sole purpose of purchasing specific securities.
In 2016, the U.S. Congress modified the definition of an accredited investor to include registered brokers and investment advisors. Also, if a person can demonstrate sufficient education or job experience showing his professional knowledge of unregistered securities, he too can qualify to be considered an accredited investor.
Purpose of Accredited Investor Requirements
Any regulatory authority of a market needs to perform a fine act of balancing between promoting investments and safeguarding the investors.
On one hand, regulators need to promote investments in risky ventures and enterprenueral activities which may have the potential to emerge as multi-baggers in the future. Such initiatives are risky, may be focused on concept-only research and development activities without any marketable product, and may have a high chance of failure. If these ventures are successful, they offer a big return to their investors. However, they also have a high probability of failure which leads to the risk of investors losing all of their investments.
On the other hand, regulators need to protect the common, often less knowledgeable, individual investors who may neither have the financial cushion to absorb high losses nor the understanding of where they are putting their hard earned money. Therefore, a balanced approach is taken through the provision of accredited investors, who are financially strong as well as knowledgeable and experienced to fit the job of being allowed to invest in such unregistered securities and investments.
How to become an Accredited Investor?
There is no formal agency or a process to secure the coveted status of an accredited investor. No registration, form-filling or application is required, and no certificate is issued by any agency stating that one is now an accredited investor for this year. Instead, the onus is on the sellers of such securities to take a number of different steps in order to verify the status of entities or individuals who wish to be treated as accredited investors.
Individuals or parties desirous of applying for accredited investor can approach the issuer of the unregistered securities, who may ask the applicant to respond to a questionnaire to determine if the applicant qualifies as an accredited investor. The questionnaire may need to be accompanied by various attachments, like account information, financial statements, and balance sheet to verify the qualification. The list of attachments can extend to tax returns, W-2 forms, salary slips, and even letters from reviews by CPAs, tax attorneys, investment brokers or advisors. Additionally, the issuers may also evaluate an individual’s credit report for additional assessment.
Example of an Accredited Investor
Consider an individual who earned $150,000 of individual income for the last three years and reported a primary residence value of $1 million with mortgage of $200,000, a car worth $100,000 with outstanding loan of $50,000, 401(k) account with $500,000 and a savings account with $450,000. While this individual fails the income test, he is an accredited investor according to the test on net worth, which cannot include the value of primary residence and is calculated as assets minus liabilities. The person's net worth is exactly $1 million, which is calculated as his assets of $1,050,000 ($100,000 plus $500,000 plus $450,000) minus a car loan of $50,000. Since he meets the net worth requirement, he qualifies to be an accredited investor.
The Bottom Line
Money can be put to best use only with suitable knowledge. It may be tempting for the super-riches to earn the coveted title of an accredited investor and have the opportunity to invest in non-registered investments which are provided by companies like private equity funds, hedge funds and venture capital firms. While hundreds of business ventures are eagerly awaiting capital funding from such accredited investors, it’s the individuals with deep pockets who need to remain aware about the high risks involved in such ventures. Qualifying criteria set by agencies like SEC are designed to ensure that only the right candidate or entities take the high risk-high reward path.