The Definition of “Accredited Investor” and Why It Matters
The definition of accredited investor is a topic we’ve touched on briefly in several posts throughout the years, but today’s post dives specifically into the definition of “accredited investor” as defined in Rule 501 of Regulation D of the Securities Act of 1933. We’ll also point out why it’s important for you to understand who is considered an accredited investor.
Definition under Rule 501
The SEC states that the definition of accredited investor is “intended to encompass those persons whose financial sophistication and ability to sustain the risk of loss of investment or ability to fend for themselves render the protections of the Securities Act’s registration process unnecessary.” The definition of accredited investor under Rule 501 includes several types of individuals and entities that qualify as “accredited.” For purposes of this discussion, we’re going to focus on two types of accredited investors: individuals with a high net worth or income and directors and officers of the issuer—“issuers” are the companies that are selling or issuing securities to shareholders.
Individuals with High Net Worth or Income
Rule 501 identifies dollar thresholds for individuals to qualify as an accredited investor—the definition also identifies several types of entities that qualify as accredited investors, though today’s post focuses on the thresholds for individuals. To qualify as an accredited investor based on your net worth, you must have a net worth of $1 million or more. To calculate net worth, you add up all of your assets and subtract all of your liabilities. You are not allowed to include the value of your primary residence as an asset in the calculation.
To qualify as an accredited investor based on your annual income, you must have had an annual income of $200,000 or greater (or $300,000 or greater combined income with your spouse) for the prior two years and have a reasonable expectation of the same or greater income in the current year.
The Dodd-Frank Act requires the SEC to review the accredited investor definition as it relates to individuals every four years to make sure the definition is not outdated. The SEC attempts to balance protecting investors while not overly restricting access to capital for businesses. The SEC’s most recent review recommended leaving in place the same income and net worth thresholds.
Directors and Officers
Rule 501 states that “any director, executive officer, or general partner” of the company selling securities is an accredited investor by default. These “insiders” are thought of as not needing the protections provided by registration, because their positions should provide them with access to information about the issuer and the securities offered (essentially all of the information that would be disclosed during the registration process).
Why This Matters
If you’re running a company or investing in private companies, it is especially important that you understand the definition of accredited investor and how it can impact your ability to raise money or invest. The most widely-used exemption from registration is under Rule 506(b). This exemption allows for fundraising from accredited investors with relatively few hurdles. However, as soon as you add any non-accredited investors to the fundraise, your disclosure requirements increase. These disclosure requirements can be significant. This is why almost all companies raising funds under Rule 506(b) limit the securities offering to only accredited investors.
From an investor’s standpoint, you’ll almost always be required to represent that you are an accredited investor under the definition in Rule 501.
Ensuring that you understand the definition of accredited investor and how that impacts your company’s fundraising efforts is an important step towards reducing your company’s liability as it navigates the process of compliantly selling securities to investors.
If you’d like to learn more about the securities laws discussed above and startup financing in general, please contact us today.