There are classes of investments that are available only to certain investors, investments that offer potentially greater rewards – and greater risks.
These include hedge funds and private equity arrangements, such as angel investing and increasingly, crowdfunding. They’re not typically available to the average investor, since the Securities and Exchange Commission (SEC) deems them to be too risky.
Enter the Accredited Investor. This is a designation that the SEC assignments to certain organizations and wealthy individuals, who are deemed to have both the financial wherewithal and the sophistication to enter into more exotic investment arrangements.
Anyone can invest in publicly listed investments, such as exchange listed stocks, bonds and Treasury securities. But private equity investments are private placements, not available to the general public. This means that far less information is publicly available about them, which is why accredited investor status is required to invest in them.
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What is an accredited investor?
Nothing in my research, either on the SEC website or elsewhere, indicates that there is any official designation that makes someone an accredited investor. There is no specific license, no examination to pass, and no indemnity bond to place. But since hedge funds and private equity investments are typically offered through an investment firm or web platform, a person’s ability to invest money through those venues will require submission of financial statements indicating the level of financial strength of the investor. As such, one’s status is an accredited investor is essentially determined on a case-by-case basis. You could be an accredited investor one year, but fail to meet the requirements the next.
The SEC defines an accredited investor as follows:
“A term used by the Securities and Exchange Commission (SEC) under Regulation D to refer to investors who are financially sophisticated and have a reduced need for the protection provided by certain government filings. Accredited investors include individuals, banks, insurance companies, employee benefit plans, and trusts.”
As noted in the definition above, the SEC considers a number of different business entities, as well as charitable organizations and certain company executives, to qualify as accredited investors. But if you’re reading this article, you’re most concerned with how you can become an accredited investor, right?
Simple – but not so easy.
The qualifications to become an accredited investor
In order for an individual – or “natural person” – to be considered an accredited investor, you must meet certain financial criteria:
- Net worth
– You must have a minimum net worth of $1 million, individually or jointly with your spouse. Your home equity does not count toward that figure.
– You must earn a minimum of $200,000, or a joint income of at least $300,000, in each of the past two years. You must also expect to earn at least that much in the current year – OR,
- Own a trust
– The trust must have assets in excess of $5 million, and according to the SEC, “not formed to acquire the securities offered, whose purchases a sophisticated person makes.”
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What are the benefits of being an accredited investor?
Accredited investor status opens the doors to benefits that are not available to the average investor, which means that while you are always free to invest in any mainstream investment you choose, you are also in a position to participate in the less visible, higher risk, higher reward investments that you’ve only heard about in the past.
You are able to make investments in businesses that are exempt from SEC registration, which will allow you to get into various businesses “on the ground floor”, before the general public is aware of the offerings. Because the businesses are small, and their capital requirements are also small, they can make their investments available to accredited investors, who are in a position to be able to select from hundreds or even thousands similar investment situations.
Some of the investments that accredited investor status open up include:
If you’ve seen the TV show Shark Tank, then you already have a solid idea what an angel investor is. A small business grows to a certain point where it needs capital in order to grow to the next level. Rather than going through the expense and effort of registering a public company, they instead seek a private investor. Private investors will take an agreed-upon stake in the company. If that stake exceeds 50% of the value of the company stock, the angel investor effectively becomes the primary owner of the business. It’s more of a one-on-one investor/business relationship. The angel investor will typically invest in a business in which he has substantial knowledge, and may even be in a position to manage part of the operation.
Crowd funding has been around for decades, but it was given a shot in the arm by Congress through the JOBS Act of 2012, that will greatly expand its application. Even non-accredited investors can invest money through crowd funding, but they are restricted to do so within certain very strict limits. An accredited investor can invest significantly more money in crowd funding arrangements. This can enable an accredited investor to develop a portfolio of small business investments, with the potential for much more rapid growth than established companies listed on stock exchanges.
One of the big advantages to both angel investments and crowd funding is that you are buying stock in a small business, before it becomes big business. Once it does, the potential exists for the company to go public with its stock, and that can be the real payoff for an accredited investor.
You’ve undoubtedly heard of hedge funds in the past. They are sophisticated investment vehicles, generally comprised of investment derivatives, that enable large investors and institutions to hedge their investment positions against loss. As an accredited investor you’ll be able to invest in hedge funds, and take advantage of protection opportunities for your portfolio.
It’s important to understand that accredited investor status is entirely based on financial metrics. Once you reach certain financial levels, you’re “in the club”. But you will still need the kind of knowledge that is required for more sophisticated investments. Since accredited investor status means you have more money, it also means you have more money to lose. If you’re fortunate enough to reach that status, be sure that you fully understand what it is you’re stepping into.