How to Know if You're an Accredited Investor
Some of the most lucrative investment opportunities are available exclusively to a select group known as accredited investors. Accredited investors are individuals who meet specific income and asset requirements detailed under U.S. federal securities law.
Some examples of highly-lucrative opportunities restricted to accredited investors include access to venture capital, hedge funds, private equity funds, angel investments, and certain real estate deals.
According to the Securities and Exchange Commission (SEC), the reason these types of investments are limited to accredited investors is to “ensure that all participating investors are financially sophisticated and able to fend for themselves or sustain the risk of loss, thus rendering unnecessary the protections that come from a registered offering.”
The investment products available to accredited investors are certainly lucrative, but they also present unique risks. Investors interested in gaining access to these products should understand the basics of private investment offerings and whether or not they qualify as accredited investors.
What Rules Apply to Accredited Investors?
In general, companies are prohibited from selling securities without first providing detailed information to the SEC. This information becomes public after filing and may be examined for compliance with applicable disclosure and accounting requirements.
In some cases, however, the SEC does not require companies to file detailed information prior to a securities transaction. One such exception is the sale of private placements to accredited investors. Private placements are investments offered by companies to small groups of select individuals. The sale of private placements to accredited investors may be attractive to a company because they avoid the expensive and time-consuming process of preparing filing information with the SEC, maintain valuable confidentiality about the nature of their business, and secure access to new and diverse sources of capital.
However, due to the lack of disclosure requirements and regulations surrounding the sale of private placements, these investments tend to have a higher risk factor than stock purchased from a publicly-traded company. As such, accredited investors demand higher returns on their investments.
How to Become an Accredited Investor
There is no process by which an individual “becomes” an accredited investor. No government agency checks an investor’s qualifications prior to a private placement transaction.
Rather, it is the responsibility of the company offering private placements to determine if the investor is accredited. The company will typically ask the prospective investor for proof of income and net worth as part of their pre-sale due diligence.
An accredited investor is defined in Regulation D of the Securities Act of 1933, and in the case of an individual investor, includes anyone who:
- Earned income that exceeded $200,000 (or $300,000 together with a spouse) in each of the prior two years, and reasonably expects the same for the current year, or
- Has a net worth over $1 million, either alone or together with a spouse (excluding the value of the person’s primary residence).
The income part of this definition is relatively straightforward. The company offering you a private placement may seek to verify your income by requesting copies of your IRS income reporting form(s), such as Forms W-2, 1099, or 1040. It is important to point out, however, that you have to select and provide the same type of income reporting (individual or together with your spouse) for all three years.
The second part of the definition requires a bit more scrutiny.
Net worth is the difference between assets and liabilities. In the case of the accredited investor definition, the only asset you cannot use in the calculation of your net worth is the value of your primary residence (i.e., the home you live in most of the time), and the only liability you do not have to include is the amount of your mortgage/home equity line of credit on your private residence.
There are two exceptions to the exclusion of one’s mortgage/home equity line of credit as a liability. One exception is if the amount of debt on the primary residence increased within 60 days prior to the transaction. If this is the case, the amount of the increase should be included as a liability. The other exception is if the amount of debt on the primary residence exceeds the fair market value of the residence (i.e., an underwater mortgage). If this is the case, the excess should be included as a liability.
In order to determine if you qualify as an accredited investor based on your net worth, it may be helpful to list your assets and liabilities.