Big Game Permit: Let’s Talk About Accredited Investors…
“Risk comes from not knowing what you are doing.” - Warren Buffett
As a continuation from our last post about real estate syndications, we would like to discuss what it means to be an accredited investor.
Some of this discussion may be a review to many of you as you may already be familiar with the term accredited investor some of this discussion may be a review. But, in August 2020, the SEC updated the what it means to be “accredited,” so our hope is to provide some clarity on this update and any other nuances to the definition.
(For the purposes of this discussion and our usage of private syndicates, you can assume that anything in this post is relevant to one’s eligibility to participate in CF Capital’s investment offerings.)
Defining “Accredited Investor”
An accredited investor is an individual or a business entity with a status that allows them to buy and sell securities not registered with financial authorities, like the SEC. This privileged access is given to them by satisfying certain requirements from these same financial authorities. It is worth mentioning that there is a status above accredited, called “qualified purchaser,” and these types of investors are given the same access (plus more).
Let’s get straight to the important points and go through the requirements to be labeled an accredited investor (in the US set by the SEC):
Income* - Exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year.
ORNet Worth - An individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase, excluding the value of the primary residence of such person.
ORFinancial Knowledge (NEW) - Based on certain professional certifications, designations or credentials or other credentials issued by an accredited educational institution, which the Commission may designate from time to time by order. In conjunction with the adoption of the amendments, the Commission designated by order holders in good standing of the Series 7, Series 65, and Series 82 licenses as qualifying natural persons.
If you are curious to learn more about the definition directly from the SEC, click here to go to the relevant page on the SEC website.
Changes to Definition in August 2020
Historically, individuals who do not meet specific income or net worth criteria, regardless of their financial sophistication, were not given the opportunity to invest in private markets. However, as of August 2020, new amendments** to the definition of accredited investor have been improved, effectively identifying individuals with sufficient knowledge and expertise to participate in those private market investments.
Essentially, individuals will be allowed to participate in private capital markets not only based on their income or net worth, but also based on established, clear measures of financial sophistication.
Of course, all of these measures are based on defined criteria of professional knowledge, experience or certifications, such as being a holder of the Series 7, Series 65, and Series 82 licenses.
Understanding Accredited Investors
Many companies decide to offer non-SEC-registered securities to accredited investors directly, known as a private placement. Because this decision allows companies exemption from registering securities with the SEC, it can save them a lot of money.
The real privilege is accredited investors’ ability to invest in venture capital, hedge funds, private real estate, angel investments, and complex investments. With that said, these private placements have the potential to be extremely risky and are often illiquid. Therefore, it is imperative that financial authorities ensure that accredited investors are financially stable, experienced, and knowledgeable about their risky ventures (a topic that is discussed more in the next section).
When companies go through with offering their shares to accredited investors, the role of the SEC is limited to verifying or providing the necessary guidelines for determining who qualifies as an accredited investor.
We would like our readers to know that there is no formal process for becoming an accredited investor. Instead, it is on the seller of the securities to take the necessary steps in order to verify the status of investors who wish to be treated as accredited. A seller may ask the investor to respond to a questionnaire that may include the following: financial statements; tax returns; W-2 forms; salary slips; and even letters from reviews by CPAs, tax attorneys, investment brokers, or advisors.
In our case, we would need to administer the verification process, which is relatively painless in our opinion.
Why does accredited investor designation exist?
As we alluded to in the previous section, any regulatory authority of a market must safeguard investors. Although individual investors may receive a large return, private investments, including non-registered real estate securities, are risky, and may be focused on unproven concepts with a high chance of failure.
For those reasons, we believe it is completely understandable for regulators to create a different class of more qualified investors. The division exists to protect less knowledgeable individuals who may not have the financial cushion to absorb high losses or truly understand the risks associated with their investments.
Simply stated, an accredited investor designation exists to protect everyday investors.
We won’t discuss it in this post, but there are new innovative options for non-accredited investors to access the private markets, like real estate. For instance, the new crowdfunding regulation allows for most investors to access the private markets. In many cases, these investments may offer a lower return profile, but sometimes with more extensive research you may find the right platform for you to invest in a private placement.
Main Takeaways
An accredited investor is one who meets certain criteria regarding income, net worth, and financial knowledge qualifications. Often, they are wealthy individuals who are allowed access to investments that many people are not allowed. Investments such as those offered by CF Capital.
Pros of being an accredited investor include access to private and restricted investments, potential higher returns, and increased diversification to their investment portfolios. However, these investments can be more risky and can be more illiquid. Investors in CF Capital offerings will often have their investment capital committed for a (roughly) five-year period or greater, depending on the business plan strategically tailored for the specific offering.
The accredited investor exists so that financial authorities (i.e. the SEC) can protect everyday investors from the potentially great risks associated from private market investments.
The obligation of proving an individual is an accredited investor falls on the seller of the securities rather than the investor. That means, CF Capital needs to do the verification.
If you, our readers, would like to discuss this further, please feel free to contact us!
*for individuals the requirement is different (i.e. lower) than business entities
** The amendments revise Rule 501(a) of the Securities Act
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