Become an Accredited Investor: Requirements, Benefits and Drawbacks

Accredited investors are individuals who meet specific requirements related to income, net worth, and qualifications. They have access to investment opportunities that are not available to the general public. As an accredited investor, you can enjoy certain advantages, such as accessing unique and exclusive investment opportunities, achieving high returns, and increasing diversification in your investment portfolio. There are several downsides to being an accredited investor, such as high risk, large minimum investment requirements, costly fees, and a lack of liquidity for the investments.

Basics

Recognized by the Securities and Exchange Commission (SEC), accredited investors have access to exclusive opportunities that others do not. They can delve into the realms of private equity, hedge funds, venture capital, and more. The SEC plays a crucial role in defining who can seize these prospects.

Contrary to popular belief, individuals have no predefined procedure to become accredited investors. No government body or independent agency reviews their credentials, and no certification exam or document certifies their status. Instead, it is the responsibility of companies issuing unregistered securities to assess potential investors' eligibility through a diligent screening process.

In this article, we will delve into the criteria for becoming an accredited investor, provide guidance on assessing your qualification, and shed light on the thorough screening process carried out by investment managers to confirm accredited investor status.

Accredited Investor Requirements

Within Regulation D of the Securities Act of 1933 (Reg. D), Rule 501 outlines the requirements for individuals or entities to be considered accredited investors. The SEC employs a two-fold approach based on income and net worth:

1. Income Criteria: A natural person with an income exceeding $200,000 in both of the last two years or a joint income with their spouse surpassing $300,000 during those years, with a reasonable expectation of maintaining the same income level in the current year.
2. Net Worth Criteria: A natural person with an individual net worth, or a joint net worth with their spouse, exceeding $1 million at the time of investment, excluding the value of their primary residence.

The Significance of the Dodd-Frank Act

A significant amendment was introduced during the enactment of the Dodd-Frank Act in 2010. It excluded the value of the primary residence from the calculation of an individual's net worth, a departure from the previous approach. Individuals holding accredited investments before passing this law were granted an exemption.

Statistics on Accredited Investors

Currently, it is estimated that 10% of US households are accredited investors. These households control 75% of the wealth. Rule 501 extends its provisions to corporations, partnerships, charitable organizations, trusts, company directors, equity owners, and financial institutions. However, the subsequent formulas and screening procedures focus on individuals or couples seeking accreditation. Exploring the requirements for accreditation, categorization, and verification processes is crucial for those seeking to enter the realm of accredited investing.

Expanding the Definition of Accredited Investors: SEC Amendments

In a significant development, the U.S. Securities and Exchange Commission implemented amendments to the definition of accredited investors on August 26, 2020. The SEC's press release highlights that these amendments introduce additional qualifying measures beyond the traditional income and net worth tests. They now allow investors to qualify based on professional knowledge, experience, certifications, or other defined measures. Moreover, the list of entities eligible for accreditation has been expanded to include entities meeting specific investment criteria.

The revised definition of accredited investors encompasses various categories:

1. Professionals with specific certifications, designations, or credentials.
2. "Knowledgeable employees" of private funds.
3. SEC- and state-registered investment advisers.

Furthermore, individuals holding Series 7, Series 65, and Series 82 licenses are now considered accredited investors. Going forward, the SEC has the authority to include additional certifications and designations while also welcoming proposals from the public for consideration. Additionally, employees classified as "knowledgeable employees" of a private fund are now recognized as accredited investors for that particular fund.

The SEC has also broadened the definition to include several other entities. This includes Indian tribes, governmental bodies, funds, and foreign entities with investments exceeding $5 million, provided they were not specifically established for investing in the offered securities.

Other entities that may qualify for accreditation encompass limited liability companies with assets totaling $5 million, SEC- and state-registered investment advisers, exempt reporting advisers, and rural business investment companies.

These expanded definitions serve to enhance opportunities and broaden participation in the realm of accredited investing.

Qualifying as an Accredited Investor: Income and Net Worth Criteria

Determining whether you meet the requirements to be classified as an accredited investor is straightforward. If your income exceeded $200,000 in the previous two years or your combined income with your spouse amounted to $300,000 or more, you automatically qualify. Additionally, if your net worth, excluding the value of your primary residence, stands at $1 million or higher, you also meet the criteria. It's worth noting that the primary home only impacts net worth calculations if you have an underwater mortgage or a balance on a home equity line of credit.

Verification Process for Accredited Investors: Due Diligence

To ensure the accreditation status of an investor, a diligent verification process has been undertaken since September 2013. It is no longer sufficient to rely on self-declaration or a simple checkbox to establish qualification. The SEC mandates specific steps for sellers targeting accredited investors.

Individuals seeking accreditation can approach a fund and request detailed information about potential investments. The issuer of securities will then provide a questionnaire to assess the individual's status as an "accredited investor." This questionnaire typically requires the submission of financial statements and supporting documentation to verify asset ownership, as illustrated in the accompanying balance sheet.

Companies may further scrutinize the individual's credit report to evaluate any existing debts. For those relying on annual income to qualify, tax returns, W-2 forms, and additional wage-related documents are typically required. Letters of review from CPAs, tax attorneys, investment brokers, or advisors may also be considered supporting evidence of eligibility.

Through this meticulous due diligence process, the verification of an individual's accredited investor status is conducted to ensure compliance with SEC regulations.

Consequences of Falsifying Accredited Investor Status

Fund or investment vehicles are responsible for verifying an investor's accreditation status. The blame typically falls on the fund if an investor falsely claims to be accredited. In certain regions, non-accredited investors are entitled to rescission rights, allowing them to withdraw their investment and receive a refund by asserting their non-accredited status. However, providing forged documents, like fabricated tax returns or financial statements, to gain investment access is ill-advised and may lead to legal consequences in the future.

International Accredited Investor Standards

Accredited investor designations extend beyond the United States to other countries with comparable criteria. Countries like Canada, Australia, and Singapore mirror the U.S. by imposing similar income and net worth requirements. However, each country may have its own specific regulations.

In the European Union (EU) and Norway, for instance, three tests are used to determine accredited investor status. The first test assesses the individual's expertise, knowledge, and experience, ensuring they can make informed investment decisions. The second test examines the fulfillment of two quantitative criteria:

1. Conducting significant transactions at an average frequency of 10 per quarter over the previous four quarters on the relevant market.
2. Possessing a financial portfolio exceeding EUR 500,000.
3. Working or having worked in the financial sector for at least one year.

Additionally, the client must declare in writing their preference to be treated as a professional client, with the respective firm obligated to inform them of the potential loss of certain protections. In countries like India and Switzerland, explicit requirements are not stipulated. Instead, individuals are advised to consult local counsel to determine their accredited investor status before engaging in investment activities.

Pros and Cons of Accredited Investor Status

Benefits 

1. Expanded Investment Opportunities: Accredited investors gain access to a broader range of available investment options for individuals with lower wealth levels. This provides the potential for increased financial growth.
2. Higher Returns: These exclusive investments often offer the potential for higher returns, potentially allowing accredited investors to accumulate wealth at an accelerated rate.
3. Enhanced Diversification: Accredited investors can achieve greater portfolio diversification by participating in various investment opportunities not accessible to non-accredited individuals.

Drawbacks 

1. Heightened Risk: Many investments exclusive to accredited investors involve higher risks due to the strategies employed to outperform the market. This exposes investors to potential losses.
2. Substantial Minimum Investment: Accredited investor investments typically require significant minimum investment amounts, ranging from hundreds of thousands to millions of dollars. This increases the risk of losing a substantial sum of money if the investment fails.
3. Performance Fees: Accredited investor investments often come with additional performance fees on top of standard management fees, typically ranging from 15% to 20% of profits.
4. Capital Lock-up: Investments as an accredited investor may have extended lock-up periods, ranging from one to several years. This limits the liquidity of the invested capital, reducing flexibility in accessing funds.

Considering both the advantages and disadvantages, becoming an accredited investor entails the potential for higher rewards but also carries increased risks, larger financial commitments, and limited liquidity compared to traditional investments.

Verification Process for Accredited Investor Status

Firms employ the SEC's guidelines to assess an individual's accredited investor status. To determine eligibility, firms typically require the completion of a questionnaire, along with the following documents for review:

1. Bank and Account Statements
2. Credit Report
3. W-2 or Earnings Statements
4. Tax Returns
5. Relevant Credentials from FINRA (if applicable)

These documents aid firms in evaluating an individual's financial qualifications and investment expertise, critical factors influencing accredited investor status.

Conclusion

Accredited investors, typically affluent individuals, meet specific requirements based on income, qualifications, or net worth. They gain access to exclusive investments offered by private equity funds, hedge funds, venture capital firms, and others. While these investments provide the potential for high returns, they also come with significant risks and minimum investment amounts. To confirm an investor's accredited status, companies must comply with SEC regulations. If you qualify as an accredited investor, exploring these exceptional investment opportunities can potentially accelerate your wealth-building journey.