When you start investing outside of the stock market, you'll see a term come up often – accredited investor.
When I started angel investing, I saw the term come up quite a bit. As I left that world, with my tail tucked a little between my legs, and started looking at real estate – it came up again.
If you want to raise a sizable sum of money, there are rules in place to protect investors. Anyone can claim to set up a company, take on investors, and then disappear. Sadly, you see it far too often in the cryptocurrency world. If you want to go public, you have to register with the SEC.
The rules surrounding accredited investors exists to loosen up those registration rules so that companies can solicit investment without registering. But they have to solicit from folks who, based on income or net worth, kind of know what they're doing. Or at least can afford to lose it. 🙂
So, let's learn more.
What does it mean to be an accredited investor, where is it defined, and what do you have to do to become one?
Who Decides an Accredited Investor?
If you're a company and you want to sell a security, like a share of stock, the U.S. Securities and Exchange Commission (SEC) requires you to register that security. When companies go public, they have to file an SEC Form S-1, the initial registration form.
There are several exemptions – or ways you can sell a security – without registering. Rule 506 of Regulation D enumerates the exemptions.
Many of the exemptions involve this definition of an accredited investor. Rule 501 of Regulation D defines what it means to be an accredited investor.
I won't bore you with the specifics but one exemption (Rule 506(c)) is if all the investors are “accredited investors” and the company takes “reasonable steps to verify that the investors are accredited investors, which could include reviewing documentation, such as W-2s, tax returns, bank and brokerage statements, credit reports and the like” then they can solicit investments and advertise an offering.
This may surprise you but the accredited investor term was first defined in 1982. In 2012, President Obama signed the Jumpstart Our Business Startups (JOBS) Act. The JOBS act amended the definition because they wanted to loosen the rules on investmen. This was so that smaller companies could raise funds without the onerous reporting requirements of the SEC.
Are You an Accredited Investor?
Most real estate crowdfunding sites require that you be an accredited investor.
To be an accredited investor, you must:
- Have made $200,000 in annual income ($300,000 for joint investors) for the last two years with the expectation that you'll earn the same or more this year, or,
- Have a net worth over $1,000,000, individually or jointly, excluding their primary residence.
A company may ask for some additional information to verify that you are accredited but in many cases they take your word for it. You are often asked to sign a document attesting to the fact that you are an accredited investor and they end the verification process there.
Why Does It Matter?
The requirement exists because the SEC wants to make sure that the folks who are investing in unregistered securities can afford to lose it.
These deals are often called private placements and they don't need to register with the SEC, so they don't provide as much information as you'd expect from, say, a publicly traded company. This makes one big assumption – accredited investors can do the due diligence on their own.
For some investors, that bar might be too high. Or perhaps it's the timing of it. You need that level of income for three years (two in the past plus the current year), perhaps that's not possible. Either way, if you want to invest in real estate crowdfunded sites and you can't an accredited investor, there are options.
The rules also limit how much the issue can raise using the crowdfunding exemption ($20 million per 12 month period for Tier I or $50 million for Tier II). The limits are pretty restrictive so many crowdfunding platforms haven't yet adopted it, but its time may be coming.
How About Inflation-Adjusted Figures?
The JOBS Act is recent but the definition of an accredited investor was set in 1982 when the SEC adopted Regulation D. Did you know that the figures used to determine an accredited investor have not changed since 1982? They are not inflation adjusted!
If you were to adjust those figures for inflation, using the BLS' CPI calculator (we use June 1982 to June 2018), the rules today would be:
- Have made $519,564.95 in annual income ($779,347.42 for joint investors) for the last two years with the expectation that you'll earn the same or more this year, or,
- Have a net worth over $2,597,824.74, individually or jointly, excluding their primary residence.
Chew on that for a moment. 🙂
How Many Accredited Investors Are There?
The bar is pretty high, even with 1982 dollars, so I wondered – how many accredited investors are there?
The best source for this was an event held by the SEC in 2014. At the Forum on Small Business Capital Formation, the SEC held a discussion about the rules for accredited investors and included a presentation with some juicy information.
In this presentation, they showed that there were over 9 million households that would qualify based on net worth alone. If you include income rules, that number increases to over 12 million households.
Those are figures from the SEC themselves, so you'd imagine it's accurate, and they seem to match up with the average income figures we can find from the Social Security Administration.
Should You Become One?
If only it was a matter of choice. 🙂
Formally, there's no “accreditation process.” There's no stamp or a certificate, or anything like that. You have to have the assets or the income (with proof if someone asks) and you're considered an accredited investor.
This is a different question than whether you should make investments where being accredited is required. 🙂
Personally, I believe that someone who should entertain an investment where being accredited matters should only do it if they're well within the definition.
If I only met the net worth requirement and did not have the income, I may dabble in some less risky investments like real estate. I would consider smaller investments in physical property locally or on a crowdfunded real estate platform. Joining a real estate investing syndicate if the minimums are low are OK too. I would not enter in anything sizable where it might be like a $50,000 minimum investment. You want your investments to remain relatively predictable since your income can't help smooth out any fluctuations.
If you just meet both, I'd dabble in investments but not push too hard. You can do just fine sticking with public markets, some real estate, and avoid any startup investing until much later.
Just because you're accredited doesn't necessarily mean you should be entering into investments that require it!