SEC Invites Comment on Definition of Accredited Investor

SEC Definition of Accredited InvestorHat Tip to Joe Wallin for noting the SEC has requested public comments as to whether and how they should revise the definition of “accredited investor.”

As I’ve previously noted, for most tech startups it’s very important that they only sell stock to accredited investors. It comes down to this: the securities laws impose a number of onerous obligations on startups whenever they sell securities to someone who is not an accredited investor.

The SEC’s definition of accredited investor, when it comes to individuals, is fairly simple. The following are individual accredited investors:

  • a director, executive officer, or general partner of the company selling the securities;
  • a person with individual net worth (or including spouse’ net worth), that exceeds $1 million at the time of the purchase, excluding the value of the primary residence of such person; or
  • a person with income exceeding $200,000 in each of the two most recent years (or joint income with a spouse exceeding $300,000) and a reasonable expectation of the same in the current year.

The SEC is currently considering revising this definition of accredited investor. They have asked the public to comment on the following questions:

  1. Are the net worth test and the income test… appropriate tests for determining whether a natural person is an accredited investor? Do such tests indicate whether an investor has such knowledge and experience in financial and business matters that he or she is capable of evaluating the merits and risks of a prospective investment? If not, what other criteria should be considered as an appropriate test for investment sophistication?
  2. Are the current financial thresholds in the net worth test and the income test still the appropriate thresholds for determining whether a natural person is an accredited investor? Should any revised thresholds be indexed for inflation?
  3. Currently, the financial thresholds in the income test and net worth test are based on fixed dollar amounts (such as having an individual income in excess of $200,000 for a natural person to qualify as an accredited investor). Should the net worth test and the income test be changed to use thresholds that are not tied to fixed dollar amounts (for example, thresholds based on a certain formula or percentage)?

You can submit comments to the SEC on these questions here.

My personal view is that I like the simple, relatively bright-line approach of the net worth and income tests. Yes, some small number of people who might otherwise successfully invest in private transactions may be excluded from investing in early-stage startups, but in virtually all cases that is probably a good thing (the vast majority of investment opportunities that will present themselves to persons below those thresholds are highly speculative, with perhaps less than a 1 in 20 chance of ever getting your money back, much less make a profit).

Additionally, the bright-line rules give startups certainty: if they sell to persons who qualify as accredited, they can be relatively secure in the knowledge that their determination will not be second-guessed later. If the new definition were changed to something more qualitative, that would reduce startups’ (and their investors’) certainty that they are acting in accordance with the law.

So, I wouldn’t change the threshold approach, and I think the thresholds themselves do not require revisions or indexing to inflation (which would only lead to greater confusion among startups as to the rules). However, I would adjust for the inequality to same-sex couples that Joe has recently taken a lead in addressing.

However, I would add a new category to the definition of accredited investors. It strikes me that there are many people, particularly young people, that operate in the startup community and would like to responsibly invest in other projects, often as a means of diversifying their risk from their own project. Though they may not meet the thresholds, they still may have assets that could responsibly be invested in their peers’ ventures. Consider a 25 year-old that starts and sells a company with a modest exit, netting $500,000 in the sale after taxes. This person knows various high-potential founders, and would like to put a small amount of his cash into helping them get off the ground. Certainly this individual has more startup investment sophistication (not to mention a greater risk profile) that a middle-aged dentist with a million in assets.

My proposal is to include in the definition persons who can demonstrate professional experience of at least one year with either the issuer’s operations, early stage investments generally, or the industry in which the issuer operates, and who do not invest more than 5% of their liquid net worth in the issuer. This would allow persons who do not meet the net worth and income thresholds but who are employees, advisers, mentors and others who are relatively experienced with startups to put a small amount of money into an investment they believe in (and possibly working to help succeed).

What do you think? Let the SEC know!