The Securities & Exchange Commission´s Relaxed “Accredited Investor” Definition is Opening More Opportunities to More Investors than Ever Before
For many investors, investing in private company securities has long been a question of “Legally, can I?” Consistent with much other governmental line-drawing, the answer to the question of whether someone can invest in private companies, i.e., is an “accredited investor,” has historically been answered quite arbitrarily. The good news, however, is that the rules around private company investment, although slowly, are starting to take a more common-sense form.
The Securities & Exchange Commission (SEC), the government agency that oversees these issuances of securities by private companies, generally, has historically taken the position that only those individual investors who make in excess of $200,000 per year (or $300,000 with their spouse) or who have a net worth in excess of $1,000,000 were eligible to participate in non-highly regulated private securities offerings. Incredibly, these income and net worth tests have not changed in amount since 1982! Failing to adjust even for inflation, we think, furthers our own intuition that the SEC sees the flaws in its own standards and understands the value in opening private markets to more investors and the companies in which they invest.
The rationale around creating barriers to entry related to income and net worth has always, from a judicial and regulatory perspective, been that only those people who can meet one of these tests can truly “fend for themselves” when making investment decisions about private, less-heavily regulated securities offerings. Supposedly, the idea is that private markets are more risky than trading in public securities and that only those who meet this net income or net worth test can (1) appropriately analyze that risk and (2) withstand the risk of loss that these private investments carry. One could argue that public markets, in fact, are more risky for investors given their often volatile nature and downside risk in many cases connected to general market forces rather than the performance of any one company they invest in. Nonetheless, we work within the rules that we are given.
What is the Problem Here?
Of course, determining whether someone can make an intelligent investment decision (and thus should be an “accredited investor”) requires a consideration of more factors than just their income or net worth. There are many people who, either through education or experience, for example, earn less income or have a smaller net worth than these SEC income or net worth tests require but who are more than competent to evaluate the merits of an investment opportunity. The inverse is also true. Many people who the SEC would say could “fend for themselves” when considering investments based on their income or net worth would not even know where to begin when it comes to, say, evaluating a company’s financial statements or the material terms of a company’s largest business contracts. We are not the first to point out the flaws in this historical accredited investor test.
Thankfully, for investors and the companies looking for their investment capital, the SEC has recently, although slowly and with a one-toe-in-the-water approach, recently amended its historical accredited investor definition.
Amending the Accredited Investor Definition
On August 26, 2020, the SEC released its final rule “Amending the Accredited Investor Definition”. In this article, with a focusing on helping (1) you as an investor determine whether you can now participate in private company offerings and (2) those companies who are looking to broaden their base of investors, we want to detail the additional categories of persons and entities that the SEC will now consider to be “accredited investors”, making them eligible to participate in “accredited investor-only” private securities offerings.
In introducing this concept of accredited investors above and the much-needed changes to the SEC´s definition, we focused on the lack of congruity between the accredited investor definition and the individual investors who should be able to participate in private company offerings in order to demonstrate the most common example of this misalignment. The SEC´s accredited investor definition has been outdated, however, not just for individual investors, but also for entities that qualify as accredited investors and those who control the investment decisions of those entities. Therefore, we want to discuss in this article all relevant changes from the SEC´s August 2020 final rule so that all readers are aware of how they personally or, for example, through the entities they form, can now participate in these private offerings.
Accredited Investors Based on Professional Qualifications
The first big move that the SEC made to expand the accredited investor definition was to broaden the definition to include certain people based on their professional qualifications irrespective of their net worth or income.
While in our opinion somewhat limited in its initial expansion, accredited investors now also include natural persons, regardless of income or net worth, who hold Series 7, Series 65 or Series 82 licenses from with the Financial Industry Regulatory Authority (FINRA) and who are in good standing with FINRA under the applicable license. We expect that the list of professional qualifications someone can rely on to be an accredited investor will continue to expand. Under the final rule, the SEC reserved the right to add additional qualifying professionals to this new list by issuing an order and posting the criteria on its website.
Net Worth / Income Test Now Includes “Spousal Equivalents”
While the SEC´s test for accredited investor status has always permitted the inclusion of a spouse’s income and net worth to determine whether someone meets the accredited investor definition, the final rule further clarifies that this flexibility will now be extended to cover “cohabitants occupying a relationship generally equivalent to that of a spouse.” The final rule lacks some preciseness here, but the obvious point is that one can now rely on the income and net worth of their “spousal equivalent” even if they are unmarried.
Investing in Private Companies through a Limited Liability Company (LLC)
Many of our Legacy Group clients invest through their LLC either alone or with their business partners. Historically, there has been some ambiguity around whether the relevant test for accreditation is to look at the income and assets of the LLC or the income and assets of the owners of the LLC.
Under the final rule, now, officially, LLCs can be found to be accredited investors if they (1) have total assets in excess of $5 million and (2) were not formed for the specific purpose of buying shares in any one offering even if all of the partners in that LLC would not individually be accredited investors. In other words, once an LLC hits $5 million in assets, the LLC can invest as an accredited investor even if some of the partners are non-accredited.
Family Offices and their Clients
Family offices also comprise a large amount of the capital that flows into private market securities offerings. The SEC set forth in the final rule that family offices and their clients who invest through the family office structure now also officially qualify as accredited investors if the family office (1) holds at least $5M in assets under management, (2) it was not formed for the specific purpose of buying shares in any one offering and (3) the person making the investment decision is a sophisticated person.
Catch-All Category for Investing Through Any Entity Form
Once and for all, removing the longstanding ambiguity around this point, the SEC also through the final rule created a “catch-all” category for entities in all forms, foreign and domestic, to qualify as accredited investors irrespective of ownership structure.
Now, any entity that (1) has in excess of $5 million of assets held as investments or to be used for investment purposes (i.e., not land, assets of the entity itself) and (2) that was not formed for the specific purpose of buying shares in any one offering can qualify as an accredited investor. These assets of the entity must generally be composed of securities; real estate, commodity interests, physical commodities, and financial contracts held for investment purposes and cash and cash equivalents intended to be used for investment purposes. The key feature under this catch-all is that the assets to be evaluated must be investment assets, versus, for example, the LLC exception above, which can include assets used in business operations.
Without question, the private markets are opening more than ever before to investors interested in private equity and venture capital investing and the companies in search of investment capital. We will continue to monitor changes to the accredited investor definition, with the expectation that the greatest near-term change will be additions to the list of investors that qualify as accredited investors through the SEC´s new “professional qualifications” standard.
About Legacy Group
Legacy Group is distinguished by a singular tradition of service to our portfolio partners; the mutual commitment to, and the seamless collaboration of, a true partnership; formidable financial and legal talent across multiple disciplines and jurisdictions; and shared professional values that focus on client needs.
We provide experience and investment to a wide range of private companies spanning many industries, including real estate, hospitality, tourism, agriculture and technology. Contact us to learn more and to discuss current investment opportunities available to you in our portfolio companies.
*This publication/newsletter is for informational purposes and does not contain or convey legal advice. The information herein should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer. Any views expressed herein are those of the author(s) and not necessarily those of our clients.