The term “accredited investor” is actually more of a regulation set forth by the US government. It means, in its most basic sense, that if you are an accredited investor, you can invest in unregistered securities. Whether you are an investor or a startup looking for investment, this is an important term to understand.
If you’re going to be an angel investor in venture capital startups, pretty much all venture capital securities, such as SAFE notes and preferred common equity, are unregistered. This means they don’t register with the SEC and therefore depend on you to be an accredited investor. The SEC allows companies and private funds to skip registering certain investments, as long as those companies and funds sell those investments only to accredited investors.
How do you become an accredited investor?
There are different ways individuals can actually qualify as an accredited investor:
- Annual earnings. The simplest way to qualify is by making $200,000 per year and then be able to demonstrate or prove that you make that much. If you are married, you actually only have to earn $300,000 as a couple. You can see right away that this is a pretty big number. By setting such a high figure, the government is trying to make sure the investor is someone who is financially sophisticated, as well as a person who understands the risk they are taking by investing in an unregistered security. The government is essentially using a set income figure as a proxy for investment sophistication.
- Assets. Another way of qualifying as an accredited Investor is by having $1 million in assets but there is a catch. You can’t actually use your primary home value in that $1 million. Over the last five to 10 years the real estate market has gone crazy, especially in Silicon Valley. There are a lot of people who carry a lot of value in their homes, but that value can’t actually be used to pass the test. Therefore, what you are really looking at are stock and bond portfolios and other forms of liquid assets. Maybe even former angel investments – things that are now liquid.
- Qualifications and credentials. In 2020, the SEC added more ways to qualify as an accredited investor. Now individuals who have certain professional designations, certifications, and credentials can qualify. These include individuals who are “knowledgeable employees” of a private fund, and registered investment advisers, like people who hold Series 7, Series 65, and Series 82 certifications.
Entities that meet specific criteria can also be accredited investors. These requirements are more complex and technical, but include corporations, partnerships, LLCs, trusts, and other entities with more than $5 million in assets; entities where the owners are accredited; and financial institutions like banks, insurance companies, and registered investment companies. So, many angel investors can invest through their trusts, and you’ll often see trusts listed on a startup’s capitalization table.
Definition of accredited investor
An accredited investor is a person or entity that has a special status under financial regulations that allows them to invest in more risky or illiquid investments. This status is a benchmark that shows they are financially solvent enough to take on the risk. Above we’ve listed the specific tests that an investor can pass to become one, such as the income test or the assets threshold.
When did angel investing start?
For a bit of context and some really good Silicon Valley trivia: The first angel investors were mostly dentists and doctors. In the seventies and eighties these were the people who were making a lot of cash income, but the tax rates were really, really high.
This led to the doctors and dentists rethinking their situation. They decided they would rather make investments and pay taxes on capital gains – which generate tax at a much lower rate. On top of this strategy, even if they had some losers or some companies that didn’t work out, they would still get a really big tax write-off from the losses.
Who checks accredited investors?
There’s a common misconception that the government approves or reviews people to approve them as being accredited. That’s not accurate – no one receives a certificate stating that they are an accredited investor. Actually, the companies that are selling unregistered securities determine who is an one by conducting due diligence prior to selling to that individual or entity. Normally, the issuer of unregistered securities will provide potential investors with a questionnaire to verify their qualifications, and will probably require financial statements and other account information to verify the investor’s status. Even if an investor is part of an angel group, it is smart for the startup to verify their status. This is yet another reason that founders should work with experienced lawyers, since the nuances of taking an investment into a private company are complex.
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