On December 18, 2015, the staff of the U.S. Securities and Exchange Commission (the “Commission”) issued its report reviewing the definition of “accredited investor” under Rule 501 of Regulation D to the Securities Act of 1933. The recommendations presented in the report could have significant implications for start‑up or small businesses looking to raise capital or for private equity and other venture funds engaging in fundraising.
Under Regulation D, the qualification as an “accredited investor” is an essential criterion for those private investors looking to make investments in hedge funds, private equity funds, venture capital funds, or even equity interests in privately held companies. For issuers of private securities, securing investments from “accredited investors” often ensures that safe harbors provided for in Regulation D are met. That is, making an offering in private securities to an “accredited investor” is a useful tool because the offering company can rely on the exemption from registration for the offering granted in Rules 504, 505, and 506 of Regulation D. Offerings made to non‑accredited investors require the offering company to make substantial disclosures, financial and otherwise, to potential investors.
Currently, an individual will be considered an “accredited investor” if he or she (i) 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 (ii) has a net worth over $1 million, either alone or together with a spouse (excluding the primary residence). Of course, there is a laundry list of standards that satisfy the definition of “accredited investor” based on the type of entity that may be involved. The current definition of “accredited investor” was promulgated by the Commission in 1982. Somewhat surprisingly, the income and net worth standards adopted in 1982 have remained unchanged since then. The Commission proposed an amendment to this definition in 2007, but that was never adopted.
Several other methods have been recommended to revise the definition of “accredited investor.” For example, the Commission staff recommends that “accredited investors” be qualified based on “other measures of sophistication,” such as total investments, professional credentials, or experience in investing in exempt offerings. While these recommended standards may have merit, the income and net worth calculations appear to be here to stay, although the numbers may be adjusted for inflation.
Why does this matter? In 2014, Regulation D offerings reported to the Commission accounted for more than $1.3 trillion raised. If the definition of “accredited investor” is revised, the potential pool of investors in Regulation D offerings likely decreases. The Commission will have to strike a delicate balance in this revised definition in order to continue to make capital available for investment, but also ensuring that investors are savvy and sophisticated enough to make these often risky investments. The Commission report contains some interesting analysis of the number of U.S. households qualifying as “accredited investors” under the proposed revisions to the definition.
Regardless of where the Commission may ultimately come down, the key consideration for companies – particularly start‑ups – is to consider the significant regulatory environment governing the sales of private securities and to be aware of the exemptions available, particularly those afforded to offerings involving “accredited investors.”