Redefining Accredited Investors: How the SEC's Proposed Investor Criteria Changes Will Affect Startup Capital

By Irinia Garcia Iglesias and Bo Howell

The definition of an accredited investor is crucial in the financial world as it determines who is eligible to participate in certain types of private investments (i.e., those not registered with financial regulatory agencies). This definition serves as a threshold for investor sophistication, financial stability, and risk tolerance. It's designed to protect less experienced investors from potentially risky or complex investment opportunities. The Securities and Exchange Commission (“SEC”) status allows individuals and entities to access a wider range of investment opportunities, such as private placements, hedge funds, and venture capital, usually unavailable to the general public. This distinction is essential for balancing investor protection and access to advanced investment opportunities.

The SEC is considering new standards for accredited investors that are likely to significantly impact the investment landscape. Adjusting the net worth and income thresholds for inflation may reduce the number of households qualifying as accredited investors. This could lead to a smaller pool of individuals eligible for certain private investment opportunities, potentially affecting the flow of capital into private markets. However, these changes are also aimed at enhancing investor protection, ensuring that those engaging in these higher-risk investments have the financial understanding and resources to bear potential losses. The overall effect is expected to be a more secure yet possibly exclusive investment environment.

In December 2023, the SEC published a report on the upcoming updates to the Accredited Investor definition as applied to natural persons. The Dodd-Frank Act requires the SEC to review the accredited investor definition every four years, and the latest review was performed in 2019. The SEC has now proposed changes to the accredited investor definition, specifically to the individual net worth and the individual and joint income threshold, to adjust them to account for inflation. The proposal is currently open for comments, but once approved, private funds must update their mechanisms to confirm investors' accredited investor status and Regulation D requirements.

Current standards

The accredited investor definition updates are intended to reflect an ongoing concern regarding inflation and the increasing number of investors that qualify for accredited investor status, along with the fact that many of them would not be able to protect their interests due to a lack of financial sophistication, or the capacity to sustain the risk of loss of investment and access to information that has been traditionally associated with an ability to fend for themselves.

• In 1983, only 1.8% of US households qualified as accredited investors.
• By 2022, this percentage increased to 18%.

With the current accredited investor definition, the SEC estimates that 30% of US households will qualify for accredited investor status by 2032.

Proposed standards

The new definition is based on individual net worth and joint and individual income, not on other factors such as the “knowledgeable employee” definition or persons holding a FINRA certification. Not enough information is available to estimate the number of knowledgeable employees at private fund managers. In 2022, the SEC estimated 47,088 US private funds were available to accredited investors, but many of these funds share the same manager and the number of knowledgeable employees fluctuates too often to determine a certain amount. In addition, the SEC cannot determine the number of accredited investors that qualify as a result of their professional certifications because some of them already qualify as accredited investors under their financial threshold, and also some of them hold several certifications that could overstate their accredited investor status.

In determining the updated net worth and income threshold to qualify as an accredited investor (the “Qualifying Threshold”), the SEC used the Consumer Price Index (“CPI-U”) and the Consumption Expenditures Chain-Type Price Index (“PCE”) to adjust the Qualifying Threshold. The chart below shows a range of proposed Qualifying Thresholds (in $ millions) based on each index that the SEC will consider for the final rule. There's no indication on which will be the final index to be used.

Recommendations from Interested Parties

In April 2023, the SEC hosted the 42nd annual Government-Business Forum on Small Business Capital Formation (“SBF”). The SBF participants provided several recommendations to the accredited investor definition and Regulation D, leading the SEC to consider (i) expanding the definition to include additional measures of sophistication and any person who invests not more than 10% of the greater of his or her annual income or net assets, and (ii) ensure capital raising rules provide equitable access to capital for underrepresented founders and investors.

The 2023 North American Securities Administrators Association (“NASAA”) Report analyzes the new accredited investor definition. NASAA recommends that Congress add an exclusion for the value of any defined benefit or defined contribution tax-deferred retirement accounts, as well as the value of agricultural land and machinery held for production. NASAA recommends (i) raising and adjusting the income and net worth thresholds for inflation, (ii) excluding from the net worth calculation the value of “any defined benefit or defined contribution tax-deferred retirement accounts, as well as the value of agricultural land and machinery held for production,” and (iii) requiring “demonstrable investment experience” for any metrics to measure sophistication.

Each of these measures will contribute to higher investor protection but, in most cases, will make it harder to access private investments. Private funds should preview the upcoming changes on who will be a prospective investor and reshape their marketing strategies and outreach. They also should improve their internal processes to verify the accredited investor status to avoid compliance issues and provide more guarantees to all their investors.

This blog summarizes the new AC definition proposal and the SEC's considerations. If you have any questions, need assistance with compliance and private offerings, or would like to submit comments to the SEC on this rule proposal, contact FinTech Law. and we will guide you through the process. If you already have comments on the AC definition, you can also follow the SEC's submission instructions.

Conclusion

In conclusion, the new accredited investor standards represent a significant shift in the investment landscape. By raising the net worth and income thresholds, these changes will likely create a more exclusive pool of investors better equipped to handle the risks associated with private market investments in terms of financial stability and sophistication. This could lead to a more secure and potentially more resilient investment environment.

However, for startups, this shift presents a dual-edged sword. On one hand, startups may face challenges in accessing a broader range of investors as the pool of accredited investors shrinks. This could lead to increased competition for funding and a greater emphasis on demonstrating strong potential and sound business models to attract investment. On the other hand, startups could benefit from having more financially robust investors who are potentially more committed and capable of providing capital, valuable expertise, and networks.

While these new standards might initially seem like a barrier to capital for startups, they could also pave the way for more meaningful and sustainable investor-startup relationships. As the landscape evolves, investors and startups must adapt their strategies to thrive in this new environment.