The term “accredited investor” is frequently heard in the field of financial investing. But many investors lack an in-depth understanding of the implications of accredited investor status or how it is acquired, especially investors accustomed to purchasing only assets sold in offerings that are registered with the SEC.
What is an Accredited Investor?
From a practical perspective, an accredited investor is a person to whom companies can sell securities[i] (e.g., stocks or bonds) in an offering that is not registered with the Securities Exchange Commission (SEC). Regulations passed under the Securities Act of 1933 include several definitions specifying how different types of persons can qualify as accredited investors.[ii] By implication, relevant regulations identify all such accredited investors as persons from whom companies may raise capital without first making detailed public disclosures. Essentially, accredited investors are deemed to have sufficient financial sophistication to forego the requirement of certain regulatory disclosures prior to investment.
Why is Accredited Investor Status Important?
Most investment in U.S. companies is raised through the sale of securities to accredited investors in “unregistered” offerings, which term describes offerings of securities that are not registered with the SEC. Registration is a laborious process that requires detailed public disclosures of a company’s business information and plans.
Despite their frequent use, unregistered offerings are unlawful unless they comply with the detailed guidelines of a “registration exemption.” The negative consequences of unlawful securities offerings can be very significant.[iii] Exemptions from registration allow for the lawful sale of securities in “exempt offerings.” The application of a registration exemption is contingent on compliance with detailed regulations and guidelines.[iv] Qualifying for an exempt offering can be difficult but is generally much easier when securities are sold only to accredited investors in “private offerings.” In 2019, according to the SEC, capital raised in exempt offerings accounted for about 70% of all capital raised in the United States and the most frequently used exemptions were those applicable to private offerings.[v] Thus, the most used avenues to raise equity capital in the United States are probably the registration exemptions for private offerings.
Allowing companies selling securities (referred to herein and, in the Securities Act, as “issuers”) to avoid the onerous obligations associated with registered offerings helps to expedite capital formation by making available sources to which they may not as readily have access. Notwithstanding, some investors are more or less “off-limits” in certain types of unregistered offerings. Because these types of investments are usually illiquid and typically involve limited disclosures or legal complexity, they imply a significant risk of loss which unsophisticated investors are not likely to fully comprehend. Therefore, by regulatory design, accredited investor status is generally a threshold requirement to participate substantially in most exempt offerings.
The most frequently used regulatory exemptions for capital raising are those under Regulation D, which is composed of Rules 504, 506(b) and 506(c), with 506(b) being the most intensely used.[vi] Except for Rule 504 (which is used infrequently for other reasons), these exemptions either prohibit participation by non-accredited investors or condition their participation to such an extent that issuers usually lack incentives to accept investment from non-accredited investors. As a result, the pool of investors eligible to invest in most exempt offerings in the United States is largely determined by accredited investor status.[vii]
Restrictions applicable to unregistered offerings mean that non-accredited investors generally cannot access the same type of investment opportunities that are available to accredited investors. Other registration exemptions, however, allow non-accredited investors to participate in unregistered offerings, subject (generally) to limitations on investment amounts.
Types of Investments Sold in Unregistered Offerings
Private, public, and small to large companies engage in unregistered offerings. A typical example of an unregistered offering is the sale of preferred or common stock to raise initial capital, finance growth, or fund a new project or business unit. Additionally, many pooled investment funds, such as hedge funds, real estate investments funds, and other private equity funds, typically sell equity interests in unregistered offerings.
Rule 506(b) allows for up to 35 non-accredited investors to invest in a private offering.[viii] However, their participation is conditioned on compliance with additional burdensome requirements. Because of the additional compliance burden and risk that may be implied by incidental non-compliance, most investments sold pursuant to Regulation D are not available to individuals or entities who don’t qualify as accredited investors. The SEC has estimated that less than five percent of offerings under 506(b) involve non-accredited investors.[ix]
How does a Person Become an Accredited Investor?
There is no process by which a person earns an accreditation or certification as an accredited investor. Rather, accredited investor status depends on whether a person meets any of the several definitions set forth in the relevant regulations passed under the Securities Act.[x] For individuals, the definitions principally reference thresholds for personal wealth and annual income, but there are a few other qualifiers with limited scope. Several definitions determine whether different types of entities qualify as an accredited investor. Generally, whether an entity so qualifies depends on the value of the assets it holds or whether its owners are accredited investors.
Financial Criteria for Individuals
Individuals qualify as accredited investors if they have: [xi]
- A net worth of over $1 million (individually or with spouse or partner), excluding the value of their primary residence and any mortgage on that residence; or
- An annual income of over $200,000 (if individually) or $300,000 (with spouse or partner) in each of the prior two years, with a reasonable expectation of achieving those levels in the current year.
For more information, regarding calculating accredited investor status under the net worth test, see this helpful Investor Bulletin published by the SEC’s Office of Investor Education and Advocacy.
Professional Criteria for Individuals
Certain individuals automatically qualify as accredited investors including:[xii]
- investment professionals and advisers licensed by the SEC;
- directors, executive officers, or general partners of the company selling the securities (or of a general partner of that company); and
- knowledgeable employees of private funds, with respect to investments in private funds.
Generally, the following entities qualify as accredited investors:[xiii]
- Entities owning investments in excess of $5 million;
- If they have assets in excess of $5 million, corporations, partnerships, LLCs, trusts, 501(c)(3) organizations, employee benefit plans, family offices and any “family client” thereof;
- Entities whose equity owners are accredited investors;
- Investment advisers (SEC- or state-registered or exempt reporting advisers) and SEC-registered broker-dealers; and
- Banks, savings and loan associations, insurance companies, registered investment companies, business development companies, small business investment companies or rural business investment companies.
How Do Companies Verify Accredited Investor Status?
Issuers commonly seek to verify accredited investor status in unregistered offerings. Depending on the circumstances, an issuer will generally seek to verify status by one of three methods: (a) investor self-certification, (b) confirmation by direct review of investor documents, or (c) use of a third-party accredited investor verification service.
Generally, the steps an issuer will take to verify accreditor investor status depend on the registration exemption(s) on which the relevant offering relies. For example, Rule 506(c) expressly requires issuers to take “reasonable steps” to verify investor status and specifies different types of conduct that can constitute such reasonable steps.
Failure to reasonably act to verify whether prospective investors qualify as accredited investors will result in the loss of the Rule 506(c) registration exemption. Therefore, failing to reasonably verify accredited investor status can result in the entire offering becoming unlawful—even when all of the investors in an opportunity are accredited investors in fact. Note, however, an investment by a non-accredited investor will not void the Rule 506(c) exemption as long as reasonable steps were taken to verify accredited investor status.[xiv] Several third-party companies furnish accredited investor verification services but, ultimately, the compliance burden falls on the issuer.
Rule 506(b), unlike Rule 506(c), does not contain an express mandate to take reasonable steps to verify accredited investor status. The difference is, ostensibly, because 506(c) allows for general solicitation or advertising, whereas Rule 506(b) only applies to “private placements.” Consequently, issuers often rely on self-certifications of accredited investor status when raising capital under 506(b). However, even in a “private placement” under 506(b), issuers may take a more rigorous approach—and they should do so if they have reason to believe that a prospective investor does not have accredited investor status.
Unregistered Offerings Available to Non-Accredited Investors
In recent years, the SEC and Congress have acted to allow issuers to raise capital by using an expanding array of registration exemptions, including several that allow investment by non-accredited investors.[xv] In addition to Rule 506(b), several registration exemptions allow issuers to raise funds from non-accredited investors, depending on the facts and circumstances. For example, non-accredited investors can invest in private offerings under the “Section 4(a)(2)” statutory registration exemption, which exemption is construed narrowly by the U.S. courts and the SEC.[xvi] More broadly applicable exemptions open to non-accredited investors include offerings under Regulation Crowdfunding, Regulation A, and the “intrastate” exemptions.
Continued Importance of Accredited Investor Status
To some extent, these types of registration exemptions have opened to non-accredited investors certain kinds of investment opportunities that were, generally, previously only available to accredited investors. Issuers acting under these exemptions usually may rely on investor representations of net wealth and income, etc., but given certain facts and circumstances, issuers should disregard representations of accredited investor status. Generally, the regulations applicable to these exemptions limit their scope in various ways. For instance, they may limit the amount of investment a non-accredited investor can contribute or involve separate requirements intended to protect unsophisticated investors.[xvii] Because of the relatively higher cost imposed by regulations appliable to raising capital from persons lacking such status, most issuers are likely to continue to prefer securities offer that exclude non-accredited investors. Accordingly, accredited investor status will likely continue indefinitely to determine the investor pool eligible to participate in most unregistered securities offerings.
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[v] Facilitating Capital Formation and Expanding Investment Opportunities by Improving Access to Capital in Private Markets, Proposed Rule, Rel. No. 33-10763 (Mar. 4, 2020) (“In 2019, registered offerings accounted for $1.2 trillion (30.8 percent) of new capital, compared to approximately $2.7 trillion (69.2 percent) that we estimate was raised through exempt offerings.”)
[ix] Supra, note 5.
[xv] For contrasting views of the benefits of this trend of liberalization, see “How Exemptions From Securities Laws Put Investors and the Economy at Risk,” Center for American Progress, March 22, 2023, and Your Money’s No Good Here: How Restrictions on Private Securities Offerings Harm Investors, CATO Institute, Center for Monetary and Financial Alternatives, February 9, 2018 | Number 833.
[xvi] Supra, note 8.