In this article we are going to explore what it means to be an accredited investor and why the idea of an accredited investor designation was created. Though the rule was put in place to protect unsophisticated investors from losing their net worth to a risky investment, it also restricts a large segment of the population from investing in private offerings.
The SEC created the accredited investor designation to protect unsophisticated individuals from participating in investments that are deemed risky. They did this by creating income and net worth criteria that an individual would have to meet to participate in these investments. They felt that if an investor investing in Deeds of Trust met these financial conditions, they would most likely have an understanding of the risk, and would be unduly burdened if the investment were to fail.
To qualify as an accredited investor, an individual must have an annual income exceeding $200,000 ($300,000 for joint income) for the past two years or have a net worth of $1 million or greater exclusive of their primary residence.
The most common option investors choose is the $1MM net worth test. To qualify using the net worth test, the investor may submit bank or brokerage statements, a schedule of real estate, or schedule of other assets valued at $1 million or greater. The investor will be required to complete a credit check, and all liabilities will be deducted from the gross assets (not including the loan(s) on a primary residence) to obtain the net worth figure.
The other common option is the income test. The income criteria can be fulfilled by an individual alone or with a spouse. In this scenario, the investor(s) will submit a tax return for the two prior years. They may also sign a disclosure stating that they expect to earn at least $200,000 or $300,000, if qualifying jointly, in the next year.
Moreover, the SEC considers a person to be an accredited investor if they are an executive officer, general partner, director, or hold at least a $5 million position in the company that is issuing the unregistered securities. Additionally, entities will fall under this category if it is a private business development company or has assets exceeding $5 million.
The list of categories for accredited investors now also includes individuals with specific professional certifications or designations, knowledgeable employees of private funds, SEC, and state-registered investment advisers. There is no formal process to become an accredited investor; it is the seller’s responsibility to verify the buyer’s status.
Under certain circumstances, an accredited investor designation may be given to a firm’s directors, executive officers, or general partners or even somebody managing a trust with over $5 million in assets.
The accredited investor rules aim to safeguard investors with limited financial knowledge from undertaking risky ventures. However, it also puts people starting with more abundant financial assets at an advantage over those with more modest means. Nevertheless, it is incumbent upon the individual opening the account and the financial institution to represent and verify the individual’s status explicitly.