Accredited investors: the basics
Part 1: What is an accredited investor?

If you've ever raised money by selling securities, it's likely that you've encountered the term "accredited investor." If you haven't, it's never too early to enrich your understanding. Knowing the ins and outs of accredited investors is fundamental to any business hoping to raise money.

In this article, I'll be walking through the theory behind and definition of an accredited investor.

What is an accredited investor?

Fundamentally, accredited investors are individuals or entities that the Securities and Exchange Commission has deemed to be so sophisticated that they can make an informed decision about purchasing a security without being provided exhaustive information on what exactly they are buying.

Before a company offers securities to be sold, it is usually required to prepare and distribute to potential purchasers dense documentation regarding the securities it is selling and to make corresponding filings with the SEC (often collectively referred to as preparing a "registration statement").

The SEC requires registration statements in order to force companies selling securities to provide to purchasers what it believes is essential information that purchasers should have regarding just exactly what they will be getting if they choose to buy (eg, answering questions such as: What does the company do? What risks will be involved in purchasing? What rights and powers will the securities have? Who else will have rights and powers moving forward and what will they be?). The SEC believes that requiring the company to document and distribute this information benefits purchasers by helping them to be more informed consumers.

Unfortunately, preparing a registration statement can be incredibly burdensome and prohibitively time and cost intensive. This burden can sometimes be so high in fact that if a company learns that it is required to file a registration statement and comes to understand the costs involved, it may give up on selling securities entirely.

Such a result causes market inefficiencies. Not only does this have the negative consequence for the company of limiting avenues for raising money, but it also deprives potential purchasers of the prospect of having beneficial ownership in whatever the company does.

To solve this problem, the SEC has created alternative requirements which, if met, exempt particular securities offerings from the requirement of creating registration statements, thereby streamlining the securities offering process.

One such alternative requirement is that the purchaser in the securities offering show it has such a high level of sophistication that it does not need to see all of the documentation usually required in order to make an informed decision on whether or not to buy (effectively a waiving of any rights to be provided a registration statement).

Such a person or entity is often referred to as an accredited investor.

Who qualifies as an accredited investor?

The SEC has made clear that particular qualifications legitimize purchasers' claims that they have the sophistication necessary to be deemed an accredited investor. That is, a person is guaranteed to be qualified as an accredited investor if he or she shows at least one of the following to be true. As you will see, each is linked to the purchaser's business savvy or financial well-being.

Below are the parties who certainly qualify as accredited investors:

  • A bank, savings and loan association, registered broker or dealer, insurance company, investment company, business development company, small business investment company, state plan, or employee benefit plan;
  • A private business development company;
  • A director, executive officer, or general partner of the issuer;
  • A 501(c)(3) organization with total assets in excess of $5 million which was not formed specifically to purchase the securities being offered;
  • A natural person who has a net worth over $1 million, either alone or together with a spouse, excluding the value of the person's or persons' primary residence;
  • A natural person who earned income exceeding $200,000, or $300,000 together with a spouse, in each of the two years prior to the potential investment and who reasonably expects to exceed that same level of earned income in the current year;
  • A trust with total assets in excess of $5 million which was not formed specifically to purchase the securities being offered and whose purchase is directed by a sophisticated person; or
  • An entity in which all of the equity owners qualify as "accredited investors" by means of any of the above.

Although this list may at first seem intimidating, verifying one of these items is a much easier task than preparing a registration statement. Accordingly, most eligible companies that want to raise money through the sale of securities seek out and utilize accredited investors.

For more on what issuers and purchasers must do to adequately show qualification as an accredited investor, take a look at my follow-up article, Accredited investors: the basics, Part II - proving accredited investor status.

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