To participate in most private equity offerings, investors must meet “accredited” status. Why? Who says so? And what does that even mean? Read on to discover what the requirements are, the purpose of the accredited investor rule, and how the verification process works.
What is the definition of an accredited investor?
The definition is simple and has become more inclusive over time. A person is accredited if they earn $200,000 a year as an individual or $300,000 with their spouse for the prior two years—with the expectation of earning the same amount in the current year. Alternatively, an accredited investor may have a net worth of $1 million outside of the primary residence. Finally, some financial professionals that have experience or certifications related to investing in unregistered securities are considered accredited.
In addition to individuals, entities can be accredited as well. An entity that consists of equity owners who are all accredited is considered accredited itself. Lastly, an entity that has assets in excess of $5 million is considered accredited.
What is the purpose of the accredited investor rule?
When companies want to raise significant capital in public markets through the issuance of stocks and bonds, there are many regulatory rules the company must comply with. These rules are set by the Securities and Exchange Commission (SEC). The objective of the SEC’s reviews and approval process is to ensure the public is investing in a legitimate business.
However, many smaller firms raise capital by selling a portion of the business, also known as equity, to investors. Since the out-of-pocket cost and burdensome process make an SEC review economically unviable for these firms, the SEC allows them to offer unregistered securities to accredited investors only. This rule was set to protect those who do not have the financial wherewithal to withstand a substantial loss of invested capital from making poor investments.
As these unregistered securities are not examined by the SEC, they are therefore deemed “riskier.” Essentially, this rule is in place to protect those who may not understand the business and potential risks or may be preyed upon by opportunistic fraudsters.
How do you become accredited?
There is no formal process for acquiring accredited investor status, and verification is the responsibility of the unregistered security’s issuer. There are several ways an issuer may verify income, net worth, or assets under management.
The issuer may send a questionnaire that requires the submission of financial statements, tax returns, and other documents that prove the investor meets the income or net worth limits, or an entity exceeds $5 million in assets under management.
- The issuer may utilize a third-party verification service that will request similar documentation.
- A CPA, lawyer, or investment advisor may be able to draft a letter that states they are an accredited investor.
It should be noted that accredited investor status must be updated every five years. Once a third party has issued an accreditation confirmation letter, an investor can use that letter for five years; however, the investor must submit a letter to the sponsor confirming that they continue to meet the definition of accredited status and a material change in their net worth or income has not occurred that would change their status.
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