Regulation D enables business owners to making offerings of securities without having to register the transactions with the Securities and Exchange Commission (SEC). The regulation is ideal for small business owners who need to raise capital quickly without getting bogged down in paperwork. It’s also perfect for issuers who want to attract a large number of investors into a syndicate so they can all take part in an opportunity.
Real estate provides a perfect example of such a syndicate. A securities issuer may have identified a real estate development opportunity that costs millions of dollars. Instead of trying to find the money themselves, they can use Regulation D to create a syndicate of investors, all of whom put a portion of money towards the investment total. Each member of the syndicate typically purchases some equity in the deal, meaning they get a return once the development ends and all resulting properties get sold.
While Regulation D offerings give business owners more opportunities, it also comes with some restrictions. One of the most important of these restrictions relates to what the Regulation calls “accredited investors” in Regulation D, Rule 501(a). Several of Regulation D’s rules ask issuers to only work with these accredited investors.
So, you need to know who they are if you wish to issue securities under Regulation D.
Here, we provide you with an accredited investor definition and dig into the various individuals and entities that the SEC considers accredited investors.
The Basic Accredited Investor Definition
We can break our accredited investor definition down into three categories:
- Investing entities
- Individual investors
Each has different requirements in place to achieve the accredited status.
Broadly speaking, this accredited investor definition covers any business entity that the SEC believes can invest in your securities without requiring the protection it offers.
These entities include the following:
- Many banks, loan associations, savings associations, or similar businesses as described in the Securities Act of 1933. These institutions can act in both their financial and individual capacities while still being considered accredited.
- Any investment advisor who has achieved registration under Section 203 of the Investment Advisors Act. Some advisors can still be accredited investors if they’re exempt from Section 203 of this act.
- All insurance companies, the definition for which is outlined in the Securities Act under Section 2(13).
- Registered brokers and dealers registered according to the Securities Exchange Act of 1934. The broker or dealer must abide by the registration criteria in Section 15 of the act.
- Small business investment firms that operate under the Small Business Investment Act of 1958. These firms must follow Section 301(c) of this act and have licensing from the U.S. Small Business Administration.
- Similarly, rural business investment companies can be accredited investors if they meet the criteria of Section 384A of the Consolidated Farm and Rural Development Act.
Beyond the above types of businesses, the entity-based accredited investor definition stretches to private business development firms. These firms are defined in the Investment Advisers Act of 1940 under Section 2020(a)(22).
Finally, organizations described in the Internal Revenue Code under Section 501(c)(3) have the accredited investor classification. These include some corporations, business trusts, limited liability companies, and partnerships. However, the SEC places strict requirements on these types of businesses. They must own assets with a total value of more than $5 million. Furthermore, these entities cannot be created with the sole purpose of buying the securities you offer under Regulation D.
The accredited investor definition extends to two types of plans.
The first covers any investment plan offered by the state you’re operating in, any of its political subdivisions, or agents operating on behalf of the state. These plans must own assets totaling over $5 million and be in place for the benefit of any employees operating under the plan.
Building from this, Regulation D also grants accreditation to some employee benefit plans created to help employees invest their earnings in preparation for retirement. These plans must be overseen by a relevant entity to ensure their accredited status. These entities include:
- A relevant plan fiduciary, such as an insurance company, savings and loans association, bank, or an investment adviser who’s registered with the SEC.
- Self-directed plans where all investing decisions are made by individuals who fall under the accredited investor definition.
Furthermore, these employee benefit plans can also qualify for accredited status if they hold assets worth more than $5 million.
This accredited investor definition may be the most important for you as it’s likely you’ll predominantly work with individual investors when creating a syndicate. An individual is an accredited investor if they meet at least one of the following criteria:
- Their net worth, either individually or held jointly with a spouse or spousal equivalent, is at least $1 million. However, this net worth total cannot include the individual’s primary home. Despite this, the SEC considers any debts or liabilities held against the individual’s home when calculating their net worth.
- They’re an executive officer, director, or general partner of the securities issuer. These individuals are commonly referred to as “insiders” because they work directly with you when you’re developing your offering.
- If the individual has a yearly income of at least $200,000 and can prove this income for at least two years, carries accredited investor status. This income figure rises to $300,000 if the individual shares their income with a spouse or spousal equivalent. These people also usually have to demonstrate that they expect to earn at least $200,000 during the current year, as well as demonstrate their past income.
More recently, the SEC has expanded its criteria to include what it deems knowledgeable people. These are typically people who have some sort of professional certification that demonstrates their understanding of investing in the securities you’re offering. The directors, partners, and officers mentioned above all fall into this knowledgeable category. So too do individuals who hold professional certifications, credentials, or designations gained from a qualifying educational institution.
The Types of Investments Accredited Investors Can Make
As you can see, the accredited investor definition is fairly expansive. When offering securities under Regulation D, you have access to a wide pool of investors, even if the specific rule you’re operating under states that you can only sell to accredited investors.
But what can an accredited investor purchase without having to register the transaction with the SEC?
They can buy any securities offered under the private placements that Regulation D allows. Many entities can offer such securities, including:
- Real estate syndicates
- Some types of hedge funds
- Venture capital firms
- Private equity funds
- Angel investment firms
Some specialist funds can also operate under Regulation D, with recent funds involving cryptocurrencies being good examples.
Accreditation is often required for these types of investments because of the lack of SEC oversight they offer. Under Regulation D, a securities offeror does not have to register their sales with the SEC. While this allows for faster sales, it also places investors at greater risk. Without SEC oversight, the investor does not benefit from the same protections as those who purchase registered securities or similar assets. As such, the accredited investor definition is in place to ensure that investors who buy these unregistered securities have the necessary knowledge to invest without placing themselves at serious risk.
The Benefits of Being an Accredited Investor
Falling under the accredited investor definition comes with several benefits for the entity or individual in question. Typically, these benefits enable access to more opportunities that, if handled well, allow the accredited investor to build wealth faster than a non-accredited investor may be able to.
Benefit No. 1 – Access to More Opportunities
The SEC’s investor protections exist to ensure that unsophisticated investors don’t pour their money into unfeasible opportunities that could damage them. While these protections are crucial, they also limit the opportunities available to non-accredited investors.
Regulation D is a good example. Under many of Regulation D’s rules, non-accredited investors cannot purchase unregistered securities. For example, offerings made under Rule 506(c) are only open to accredited investors, with the issuer having the take steps to confirm that each investor who purchases from them carries the accredited status.
Even when a rule does allow non-accredited investors, as we see with Rule 506(b), the SEC often places strict limits on the number of non-accredited investors who can buy. With Rule 506(b), a securities issuer can only sell to a maximum of 35 non-accredited investors. What’s more, these non-accredited investors must receive more detailed disclosure documents that may not be relevant to accredited investors.
Another example of this benefit comes from hedge funds. These funds typically operate at the higher end of the investment sector. As such, they only welcome investment from individuals and entities that have high incomes and net worth. Naturally, most of the investors into hedge funds fall under the accredited investor definition. Most hedge funds will reject non-accredited investors simply because they don’t have the capital necessary to help the fund achieve its objectives.
Ultimately, this means that accredited investors have access to more opportunities that can help them to build wealth. The old idea that money can make more money applies here. An accredited investor is already a high-income or high-net-worth individual. They can use their accredited status to capitalize on this fact by investing in more opportunities.
Benefit No. 2 – Lack of Registration Means Faster Purchases
The fact that the SEC offers less oversight for the private investments made by accredited investors means that these investors can purchase securities quickly.
Again, Regulation D offers a good example of this. Both the securities issuers and the accredited investors who buy the securities benefit from the speed of the process. The issuer receives a rapid injection of capital into their venture. An accredited investor quickly receives an ownership stake in the venture or creates a debt security that provides them with a regular source of income.
Without the burden of registration, accredited investors get to cut down on the paperwork so they can focus on the important business of making more money.
Benefit No. 3 – Increased Diversification
Any investment advisor will tell you that it’s important to diversify your portfolio. Putting all of your eggs into a single basket can wreak havoc on your finances if that single investment falls through.
With the increased access to opportunities that come with accredited status, investors also have more chances to diversify. For example, they may buy securities offered by several syndications while also investing in hedge funds and private equity firms. This ability to spread their investments more widely means they can protect themselves in the absence of SEC oversight and registration.
The Drawbacks of Being an Accredited Investor
Most of the benefits of coming under the accredited investor definition relate to being able to purchase unregistered securities. However, there are some drawbacks to consider.
Drawback No. 1 – Taking On More Risk
Many of the funds and businesses that offer unregistered securities come with a higher risk attached to them.
Let’s say you’re an entrepreneur creating a real estate syndicate. You’ve found a development opportunity that you want to explore. However, you have minimal experience in real estate, even though your issuing partners can advise you. So, you offer securities under a Regulation D rule.
Any accredited investor who takes up this opportunity faces several risks. Your lack of personal experience in real estate could lead to you making mistakes that reduce returns or lose money. What’s more, the unregistered status of the securities you offer means the investor does not benefit from SEC protection. Adding to this, it’s likely that your securities are restricted, meaning the investor can’t liquidate them until they’re registered or a set period passes.
All of these risks could lead to an accredited investor losing money. However, many accept these risks because the opportunity presented gives them a chance to get ahead of the market. As a securities issuer, you need to demonstrate that your opportunity is worth the risk the accredited investor takes.
Drawback No. 2 – Higher Minimum Investments
In many cases, accredited investors must invest more money to get involved with an opportunity. The hedge fund example demonstrates this. The counterpoint to hedge funds not accepting non-accredited investors is that the investors they do accept must offer large amounts of capital.
Again, this creates risk. When an investor must dedicate hundreds of thousands, or even millions, of dollars to an investment, they stand to lose substantially if the investment goes south. Of course, this risk comes with higher rewards than they’d achieve with an investment that comes with a smaller outlay.
There are exceptions to this drawback, such as Regulation D’s syndications. Even with an offering that can only attract accredited investors, a securities issuer under Regulation D can often work with as many investors as they want. As a result, they can offer securities at a lower price than an accredited investor might otherwise pay for an opportunity. Of course, the returns on securities offered at a low price may not be attractive enough for some accredited investors.
Drawback No. 3 – Restrictions on Liquidity
Let’s assume that a non-accredited investor purchases some stocks using an online platform. These are registered transactions, meaning there are no restrictions on the liquidity of the stocks. If the investor chooses to cash out, or they want to escape a bad investment so they don’t lose all of their money, they can do so with no obstacles.
Unfortunately, that isn’t the case for many of the investments an accredited investor takes part in. Securities issued under Regulation D typically carry restrictions from the SEC, as mentioned earlier. These tie the investor into owning that security for a set period. In some cases, they may not be able to sell at all unless the issuer registers the securities. The result is that the investor assumes more risk because they can’t escape the investment if it doesn’t go to plan.
Hedge funds often operate with similar policies. In addition to the high income barrier, many hedge funds require their investors to lock themselves into the fund for at least a year. If everything goes well, the investor benefits from high returns. But if the fund underperforms, the investor may lose money without any option to regain liquidity until the contracted period ends.
Accredited Investors and Verification
Some of Regulation D’s rules require you to verify the status of an accredited investor before you sell securities to them. Rule 506(c) has this condition. Under these rules, the responsibility for verifying the investor’s status falls onto the issuer. This means a non-accredited investor can lie about their credentials so they can buy your securities and you will be at fault for it. The SEC requires you to take reasonable action to verify that you’re selling to an individual or entity that fits the accredited investor definition.
There are three ways to do this:
- Confirm that the investor is an insider
- Examine their net worth
- Check their income
You’ll notice that these three techniques match up to the income, net worth, and knowledgeable insider criteria discussed earlier.
Method No. 1 – Confirming That The Investor is an Insider
This is the simplest method of checking an investor’s accredited status. Insiders are the general partners, directors, and executive officers who hold intimate knowledge about the nature of your securities offering. They understand the risks involved and the potential benefits because they’ve helped you to create your offer.
Your due diligence should provide you with all of the information you need about your insiders. Any registered transactions they’ve taken part in are available to you. Your investigation should also reveal information like their certifications and professional histories. Here, your role is to verify that the individual is an insider and that you’ve taken the necessary precautions to ensure they’re not a Bad Actor.
Method No. 2 – Examining the Investor’s Net Worth
An accredited investor must have a net worth of $1 million or more, without including the value of their primary residence. To demonstrate this net worth, an investor must provide the securities offer with relevant documents that essentially prove how much money they have in the bank.
This can be a simple process. If the investor can show you a recent bank statement that shows that hit or exceed the net worth limit, you don’t need to do much more. The value of any other assets they hold only supplement their status as an accredited investor.
However, if an investor doesn’t have $1 million or more in cash directly available to them, you need to dig a little deeper. Your research must confirm that they achieve the minimum net worth under the accredited investor definition.
Several documents help you to do this:
- Credit reports
- Proof of the investor’s ownership of any vehicles
- IRS forms
- Any consumer credit report that lists the investor’s assets and liabilities
- Evidence of the ownership of real estate beyond the investor’s primary residence
- Third-party valuations for the investor’s assets
- The values of any private securities holdings the investor has
Liabilities are also an important concern here. For example, an investor may own properties worth a total of $2 million. However, any mortgages or other loans held against those properties are liabilities that you may have to subtract from the individual’s net worth.
Method No. 3 – Checking Their Income
As mentioned, any individual accredited investor can attain the status if they’ve earned $200,000 or more for the last two years and they expect to earn the same again for the current year. If the investor has a spouse or spousal equivalent, the joint income between them must be $300,000.
Again, securities issuers can request several documents from these investors to confirm their status:
- Pay stubs
- Tax filings
- Any relevant forms from the IRS, such as K-1s and W-2s
- A letter from an employer that verifies the investor’s income
- A letter from an accountant to verify their income
Assets and liabilities are less of a concern here as you’re focusing solely on monetary income.
Using Third Parties to Verify Accredited Investors
If you’re only working with a couple of people who meet the accredited investor definition, manually verifying them is a fairly simple task. However, verification becomes much more difficult if you’re working with a large number of accredited investors. For example, a real estate syndicate may attract a hundred or more investors. Manually checking each investor places a heavy time burden on the securities issuer. Furthermore, more checks mean a higher possibility of human error, for which the issuer is liable.
Thankfully, the Regulation D rules that require investor verification also allow you to contract a third party to carry out the task for you. Beyond the time savings this option provides, using a third party also means you’re not liable if it turns out that one of your investors isn’t accredited. Typically, third-party verification comes in the form of a letter that confirms an investor’s accredited status. This letter places the issuer into a “safe harbor”, which means they’re not liable if the third party is incorrect. This only applies if the issuer has taken reasonable steps to confirm their third-party verifier is in a position to confirm an investor’s status.
There are four types of professionals who can act as third-party verifiers:
- Certified public accounts
- Registered broker-dealers
- Registered investment advisors
All of these professionals hold certifications that place them in good standing with the SEC. As such, the SEC allows you to assume that you can trust the evaluations these professionals provide. If you use third-party verification, ensure that your chosen evaluator provides a signed and dated letter for each investor.
Verifying a Trust or Entity
Verifying trusts, corporations, and similar entities is generally an easier process than verifying an individual’s status. These entities should already have detailed records, some of which are publicly available, that they can use to verify their accredited status. What’s more, it’s simple to verify if an entity was formed solely to buy your securities because it will have no prior business records to examine.
However, what happens if the entity does not have assets totaling more than $5 million?
This does not necessarily prevent the entity from buying your securities. If all of the organization’s equity owners are accredited investors, the entity may still be able to purchase your securities. In these cases, you must conduct verifications for each equity owner to confirm their status.
Frequently Asked Questions About Accredited Investors
With the accredited investor definition solidified and the issue of verification covered, there are a few more things you need to know. These frequently asked questions cover topics that don’t fit into a standard accredited investor definition but are still important to answer in the context of a capital raise under Regulation D.
How Do I Verify the Value of an Investor’s Cryptocurrency Holdings?
Cryptocurrency is an asset, which means you should consider it when calculating a potential investor’s net worth. To determine the value of an investor’s cryptocurrency, ask them to create a statement from their wallet or account that they’ll send to you. Also, ask them to provide a screenshot of the cryptocurrency’s value and exchange rate in U.S. dollars. You can check these rates and values online to confirm they’re accurate.
Finally, ask the investor to sign a letter confirming that they own the cryptocurrency in question.
Who Assumes the Burden of Proof for Verification?
Under Regulation D, the securities issue has to confirm that their accredited investors are who they say they are. This is the reason for the previously described verification process.
Verification serves several purposes. The most obvious is that it helps you to weed out investors who misrepresent themselves, which means you don’t sell securities to somebody who presents a risk to your offering. Verification also demonstrates to your potential investors that you’re dealing with your offering professionally. It shows them that you’re taking the steps necessary to ensure they don’t get involved in a fund or syndicate with non-accredited investors.
Finally, verification is critical from a legal standpoint. Failure to verify the accredited status of your investors may mean that you end up misinforming the people who buy your securities. Depending on the severity of the issue, you may face legal issues related to securities fraud, especially if you willfully withheld information about your investors. Federal securities fraud can be punished up to $5 million in fines per case and a maximum of 5 years in a federal prison per case. You may also face prosecution by the state.
In short, the securities issuer is responsible for verifying the status of all accredited investors.
How Much Can Accredited Investors Invest
The SEC doesn’t place limits on the amount of money that an accredited investor can spend on securities and other investments. The purpose of the accredited status is to demonstrate that the investor understands the risks they’re taking on and generally knows what they’re doing with their money.
Still, this lack of limits does not prevent the securities issuer from imposing limits. Your syndicate may implement rules to ensure each accredited investor can only buy securities up to a set limit to ensure that a single investor does not buy all of the securities you offer. These limits are especially important for company owners offering equity securities as they ensure no individual can acquire a large amount of voting power via your offering.
Working With Accredited Investors
If you want to create a syndication under Regulation D, you will likely have to work with accredited investors. Several of the regulation’s rules even prevent you from working with non-accredited investors. With the information in this article, you now understand the accredited investor definition and know that you, as the securities issuer, are responsible for verifying an investor’s status.
But you may have more questions. Or, you may need help putting together a Regulation D syndicate to ensure that it meets the SEC’s requirements for issuing securities without registration.
Whatever the case may be, the Moschetti Law team can help. Our firm specializes in helping entrepreneurs and businesses create Regulation D offerings. We can also advise you on related issues, such as investor verification and Private Placement Memorandums.
If you need legal support as you create your Regulation D syndication, we’re available to speak to you on (888) 606-0990. You can also contact us online at http://moschettilaw.com. Get in touch today to schedule a free consultation and start your journey towards developing a Regulation D syndication.