What is an Accredited Investor? (And The Arbitrary SEC Rules That Hurt Young Investors)
“It takes money to make money.”
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It’s a saying that many of us have heard before, and in a lot of cases it can be used as an excuse to victimize oneself or blame the unfairness of the system. That type of mindset can be dangerous and misleading. Here on BiggerPockets, we know that there is always opportunity for the enterprising investor regardless of his or her current level of wealth.
But there is one category of investments where the statement “it takes money to make money” rings particularly true. These types of investments are available only to the already established wealthy elite and in my opinion unfairly exclude younger investors who have yet to meet the somewhat arbitrary qualifications required to get exposure to this asset class.
I’m referring to those investments that are only open to “Accredited Investors,” placements that can offer enterprising investors some of the best returns around. These investments are for the most part not open to those of us who are just getting started with our investing portfolios. In fact, they aren’t even open to some of us who are well on our way.
Here, I want to delve into what an Accredited Investor is, how they are qualified, and then make an argument about some of the disadvantages of certain rules that disadvantage younger investors — and society as a whole.
What is an Accredited Investor?
Boiled down simply, as an individual you must meet one of the two following criteria to be considered accredited:
- You earn more than $200,000 per year singly ($300,000 per year for married couples) and expect to do so again in the following year.
- You have more than $1,00,000 in assets outside the value of your primary residence.
You can refer to Rule 501 of Regulation D to get a more thorough understanding of the criteria behind the government’s definition of an “Accredited Investor.” The details are likely not meaningful for most.
Why that specific salary level and/or that level of accumulated wealth? You tell me.
These qualifications — and the rules surrounding them — exist to prevent the vast majority of “unqualified” investors from investing in placements that are not registered with the SEC. Investments that are not regulated by the SEC and subject to their regulations, such as having an audit by a qualified third party, can have misleading or inaccurate financials and other information that has the potential to cost unwary investors big. The goal of this legislation is to give the distinction of “Accredited Investor” only to those individuals who are “sophisticated” enough to invest in non-public investments intelligently.
If you ask me, I believe that this is a somewhat less than optimal way of qualifying investors, as there are many ways that one can come into possession of $1 million (or a salary of $200,000 annually, for that matter) that are not reflective of sophisticated investing — a large inheritance from Uncle Jimmy, for example. On the other hand, a younger investor like myself who is willing to put time into researching and qualifying off market investments is disadvantaged in not being able to access these investments because of regulations that incentivize business owners to seek capital from Accredited Investors first.
What Function Do Accredited Investors Serve?
When companies want to raise money, they have several options, among the most intuitive of which are:
- Apply for a loan (debt financing) from an individual or lending institution.
- Register with the SEC and allow the public to buy equity in their company.
- Find an individual investor or investors, and privately offer them shares in the company.
The Accredited Investor really comes into play in the third case.
Let’s suppose that tomorrow you wanted to go start a Real Estate enterprise and purchase your first property. You could always go to Dad or Uncle Jim for some money, but if you wanted to raise a significant amount of money on the order of a couple hundred thousand to a couple million dollars, you’d need either a really rich Uncle Jimmy or equivalent, or you’ll need to go to individuals outside your immediate network of family and business partners.
Enter Accredited Investors.
These are the folks that will give you the $100,000 to $1,000,000 (or more) you need to purchase your next flip or to renovate and rent out that mixed-use property. These are the folks with the money, the time, and the inclination to give you a shot.
The SEC regulates the offer and sale of securities in the United States. If you wish to make shares in your company available to the general public, you are required to go through a number of expensive steps that can have negative consequences: filing annual reports, making financial data available to the public, and paying for audits are examples of some of these hurdles.
If your company is of a smaller nature, you may opt instead to find an “exemption” to these rules — a way to raise money without having to file expensive and time-consuming paperwork with the SEC. Among the most commonly used exemptions is Rule 506. Under this rule, you can solicit an unlimited number of Accredited Investors and up to 35 non-accredited investors, which on the surface might seem like a very reasonable solution, but there are two major caveats to this type of offering:
- The company offering securities may “not use general solicitation” in seeking funding. This limits the reach of the offering, which disadvantages the company looking to raise capital.
- The offering company must provide all non-accredited investors documentation that is generally the same as that made available in public offerings.
Instead of adhering to these requirements, many companies choose to offer their securities only to Accredited Investors by taking advantage of a subsection of Rule 506(c). Simply put, if you offer your company’s securities only to Accredited Investors (and take reasonable steps to ensure that they are accredited), you don’t have to file all that paperwork, and you can more easily market your offering to a larger group of potential investors.
On the other hand, truly enormous capital raises or investments — on the order of tens or hundreds of millions of dollars — can require extensive financial auditing, paperwork, and authentication. It makes sense to pay tens of thousands of dollars (or even larger sums) to ensure accuracy and quality in the financial statements for these larger institutions and investments. Once that paperwork and audit is complete, why not offer it to anyone and everyone to see who will pay the largest possible amount of money (price per share) to own part of your company?
Simple economics shows us that increasing the availability of securities will lower companies’ cost of capital, while simultaneously opening up more opportunities to individual investors.
What’s the Impact on “Non-Accredited” Investors?
By making it harder for smaller companies to offer their securities to the general public, the SEC seeks to protect those of us who haven’t yet accumulated a large net worth from investing with unrelated third parties that do not have audited financials. To give you a straw man example, it might be easy to convince 93-year-old Grandma Betty to part with her last $100,000 and put it into a shady-but-technically-legal investment if it isn’t registered by the SEC. It’s a little harder to do that (unless Grandma Betty happens to be a millionaire) due to the regulations imposed by the SEC.
I’m sure that many victims have been protected from bad investments because of these regulations. But I’d be willing to bet that an equal or greater number of would-be investors have missed out on great opportunities with wonderful companies — companies that might have gotten access to needed capital sooner and with better terms than under the current system.
Like any type of investment, security purchases in mid-sized companies can have mixed results. That startup you put $20,000 into could be the next Facebook and make you a millionaire overnight… or it might be something that is totally mismanaged and about to plunge into bankruptcy.
As previously stated, the biggest risk with these types of investments is the fact that these companies are often unaudited by professional, trusted firms in accordance with GAAP (Generally Accepted Accounting Principles). It’s on you to read, ensure accuracy, and understand the financials and other risk factors surrounding the business and to invest intelligently.
What’s My Take?
At the end of the day, what these rules do is prevent those of us who do not have the distinction of being accredited investors the opportunity to invest in a certain class of investments. Is that a game changer? Is that something that will prevent you from long-term success?
It’s not a game changer, and it won’t hold you back if you are motivated to succeed. But if you consider increased access to opportunity — good or bad — an advantage, then I’d argue that this is a law that disadvantages the 99% of the population who can’t call themselves “Accredited Investors.”
I may not be a millionaire or earn a six figure salary, but I do take pains to ensure that I practice sound finance with the money I do have. I work hard to earn a decent living, I live frugally and save as much as possible, and I put a lot of time and thought into my investments.
Why shouldn’t I be allowed to assume the risk and possible rewards of private investments? Why should the government make it harder for me to access these types of securities? My money is mine. By the time I become an Accredited Investor, I will have come across perhaps hundreds of small businesses, many of whom offer promising futures. And my money is just as good as the millionaire next door’s! I earned it. I saved it. I believe I should get to invest it at my discretion.
The rules that serve to “safeguard” the public from large private placements may well prevent some individuals from losing their shirts. I can’t argue that most of the investing public is able to intelligently invest in off-market investments — it sometimes seems like getting them to invest intelligently in the regulated marketplace of publicly traded companies is hard enough.
But to me as an individual, these rules represent a barrier. As a young and ambitious investor, I am edged out of this particularly interesting and lucrative category of investments and instead must invest with businesses that are either very, very small (like my landlording business or a family member or friend’s enterprise) or with corporations that are very, very large that go to the appropriate lengths to register and file the correct paperwork with the SEC.
I believe that this system operates in a manner that is unfair to younger investors. I attribute at least some of my inability to meet the requirements of the “Accredited Investor” described by the SEC as simply due to my age. I just haven’t had enough time in the workforce to command a salary of $200,000 per year or more, and I haven’t lived long enough to have accumulated $1,000,000 in assets. Does that make me “unsophisticated” when it comes to investing? I don’t believe so, and shouldn’t it be my right to determine myself capable or incapable of handling my own investments?
Instead, I see a system that prevents me — and countless other ambitious young investors — from taking advantage of the opportunities in this asset class. Instead, these rules and exemptions advantage the already established wealthy elite by funneling great investments in smaller companies to their review first.
The purpose of this article was to define what an accredited investor is, how that title is assigned, what role they serve in the economy, and my perception on the kind of impact the existence of SEC regulations and rules surrounding the issuance of securities have on the overall investing landscape for young investors.
I’d love to hear your thoughts on my article:
- Do you believe that the regulations surrounding private
investments make sense?
- Do you think that they have an impact, positive or negative, on the opportunities you have access to?
- Do you agree with me that these types of investments should be opened up to the general public — or at least those that are seriously interested in pursuing them?
Let’s have a conversation in the comments section below!