By Aaron Cartwright
Where All Good Stories Begin
On October 9, 2014, the Investor Advisory Committee (IAC) submitted a list of recommendations to the Securities and Exchange Commission regarding changes to the definition of ‘Accredited Investor’ that will have the potential for a significant financial impact on the startup industry. The effect will be a much larger pool of potential investor capital.
In order to fully paint a picture of what is going on, I will cover several points: 1) the current definition of accredited investor, what ‘general solicitation’ means and why it matters and the impact of the Jumpstart Our Business Startups Act (2012); 2) the recommendations presented to the SEC and their potential effect; and 3) summary and the mandatory warning.
Where We Are Now
Section 230.501 of Title 17, Code of Federal Regulations (commonly known as 501 Reg. D) currently defines accredited investor. There are many ways a person or entity can be considered accredited but for the purposes of this article, I will address two of the personal ones. For the two previous years and with reasonable expectation of earning the same in the current year, a person must either have an income of $200,000 on an individual basis or $300,000 filing jointly. A person with a net worth of $1,000,000 individually or jointly with a spouse will also be considered accredited. According to Ken Marienau, CEO of Mission Markets, only “[a]round 7% of the US population could qualify as accredited investors.”
Section 230.502 of Title 17 (502 Reg. D) governs general solicitation. It says that “neither the issuer nor any person acting on its behalf shall offer or sell the securities by any form of general solicitation or general advertising” including articles, notices, and other communications published in newspapers, magazines, and similar media, or over television and radio. It is commonly accepted that this restriction includes the internet.
Here, some would ask “But what about sites like Kickstarter and Indiegogo?” This goes back to the distinction made in the first paragraph. Kickstarter and Indiegogo are not selling ‘securities’ under the definition of the word. When you fund a project on those sites, you are buying a product, even if it is a keychain, or a shirt, or the promise of a completed system in the future. You are not buying a piece of the company, therefore, those projects/companies do not have to jump through the compliance hoops of Regulation D. Regulation D governs ventures seeking to raise money through sale of securities and that is where the term ‘accredited investor’ starts to play a role.
Prior to the Jumpstart Our Business Startups (JOBS) Act of 2012, issuers could only solicit people with whom they had an established relationship. There were ways around this and businesses still got funded (cold call – warm call, anyone?) but Title II of the JOBS Act has eased this restriction. The prohibition against general solicitation “shall not apply to offers and sales of securities made [under][506 Reg. D], provided that all purchasers of the securities are accredited investors.” Accordingly, the accredited investors may now be approached without the limitations of the past but we are still at 7% of the American population considered ‘accredited investors’.
Although Title III of the JOBS Act (short title: Crowdfund Act) does not specifically address accredited investors, I mention it here because it has been said that Title III puts this type of direct investment into the hands of all Americans. Title III of the JOBS Act allows for some investment by non-accredited investors in certain ventures. The restrictions are as follows:
- For the trailing 12 month period, the total amount of equity sold by the issuer cannot be more than $1,000,000.
- Investors with a net worth or annual income less than $100,000, may contribute only up to $2,000 or 5% of annual income or net worth. Whichever is greater.
- Investors with a net worth or annual income greater than $100,000 may contribute up to 10% of their annual income or net worth with a maximum contribution limit of $100,000.
In the alternative, accredited investors may contribute what they want with no limitation. For a startup to use this, the raise would have to be for less than a million dollars or have the ability to enable the raise to be spread out over multiple months. Again, this article addresses the changes to the definition of ‘accredited investor’.
And now for the part to which everyone has either skipped or patiently dealt with my musings to find: The recommendations put to the SEC by the Investor Advisory Committee regarding a change in the definition of accredited investor. There are five of them and they can be found on the IAC’s website. They are:
- Revise the definition to better identify a class of individuals who do not need the protections of the ’33 Act.
- Revise the definition to enable individuals to qualify based on their financial sophistication.
- Consider alternative approaches to setting the financial thresholds for investment in private offerings.
- Take concrete steps to encourage development of an alternative means of verifying accredited investor status to shift some burden away from poorly equipped issuers.
- In addition to changes in the accredited investor definition, strengthen the protections that apply when non-accredited individuals qualify to invest based on advice from a representative.
Within the first recommendation, the IAC says that the SEC should “evaluate whether the accredited investor definition . . . is effective in identifying a class of individuals who do not need the protections afforded by the ’33 Act” and to initiate rulemaking to revise the definition to better achieve that goal. The rationale behind this is that the current definition uses financial thresholds which are an imperfect proxy for sophistication, information access, and ability to withstand losses.
The report states that “individuals who fail to meet the financial thresholds in the current definition may possess the financial sophistication and access to information necessary to make an informed investment decision.” It also points to current measures of net worth that do not work well together. For instance, a person’s primary residence is not counted as part of their net worth but a family farm is counted as well as the person’s retirement savings. A family farm may be just as illiquid as the primary residence and, depending on the age of the investor, a person may not have enough earning years remaining to absorb the potential loss to their retirement account.
The IAC suggests using alternative approaches such as basing the definition on liquid assets or restricting the percentage of assets that individuals could invest in private offerings. The IAC cites Canada’s policy of considering individuals accredited when they have either $1 million in liquid assets or total assets in excess of $5 million. Both approaches would increase the amount of funds available for startups because if the asset requirement is lowered, it logically follows that more Americans will be covered by the definition. Although not every newly minted accredited investor will be interested in funding startups, maintaining the same contribution percentage over a larger pool will be beneficial.
I will address the restriction of assets to invest in the discussion of Recommendation 3.
Here, the IAC proposes that the Commission change the definition to allow people to “qualify as accredited investors based on their financial sophistication.” The logic behind this is that some sophisticated investors “may be better equipped to assess the appropriateness of investing in private offerings than are individuals who meet the financial thresholds but lack financial sophistication.”
The Committee explores three primary methods of measuring financial sophistication: professional credentials, investment experience, and a test of relevant financial knowledge. The first question tackled is which credentials should matter. “Two credentials that are commonly mentioned as satisfying this standard are the Series 7 securities license and the Chartered Financial Analyst designation.” The risk here being that many other credentials that are less relevant to financial acumen, may be clamoring to be included on the list of qualifying credentials.
The second method is to qualify based on investment experience. A UK policy is referenced which allows individuals to qualify based on participation in a group of angel investors that has experience investing in “unlisted companies” among other factors. “Given the important role that angel investors play in the funding of Reg. D offerings, this seems like an avenue that is worth further exploration.”
The third avenue of measuring financial acumen discussed is developing a test that individuals could take to in order to qualify as accredited.  The Committee puts forth options of the SEC working with FINRA or a third party developing a rigorous exam to test a “reasonable level of financial expertise.”
Keep in mind that the IAC is trying to increase the amount of accredited investors in the marketplace so there is a likelihood that the financial qualifiers will not go away if this recommendation is considered. Personally, and it should be noted that this is my favorite Recommendation, I am a fan of using credentials (Series 7 or CFA) or developing a test to determine accredited status. One of the primary reasons for the status is to filter people who are able to invest in small business. However, because of the current financial markers, there may be some people who are considered accredited who have no interest in private offerings.
The impact on the startup industry if the SEC adopts this Recommendation is fairly straightforward. With a test, a significant majority of the people taking it will be those who are seeking to invest in startups. The same goes for giving the status to those participating alongside other qualified angel investors. These will be people who want and are actively funding projects. By lowering the barriers of entry, the SEC would be widening the investor base meaning, of course, more potential startup capital available.
With this proposal, the IAC suggests that if the SEC wishes to continue using financial thresholds, it should consider different approaches to setting those thresholds. It argues that having an “on/off switch” such as the current practice is illogical. For example, individuals making $200,000 are allowed to invest everything they are able to while individuals making $199,000 are precluded from investing anything in a current Rule 506 offering. The same would apply to a person with $999,000 in net worth as opposed to $1 million. The former would not be able to invest anything in a startup.
The recommendation here is to “limit investments in private offerings to a percentage of assets or income” which would serve the dual purpose of protecting the investors and not shrinking the pool of accredited investors. After all, another of the original purposes for the Rule was to protect some investors from themselves. Those that were considered unable to bear the losses of an illiquid and highly risky private offering were rendered incapable of participating from the outset.
I would like to point out a similarity here and, as was mentioned above, I will discuss asset limitation in the discussion of Recommendation 1. Let’s go back to Title III of the JOBS Act. Title III of the JOBS Act has provided for investment in certain ventures by non-accredited investors. It limits contribution to the greater of $2,000 or 5% of annual income or net worth. The difference between the JOBS Act and Recommendation 3 is the rolling $1 million limitation on the project in Title III versus no limitation on project size in the Recommendation.
Recommendation 1 suggests “restricting the percentage of assets that individuals could invest in private offerings could lessen the risks for investors without further limiting the pool of accredited investors.” From where I am sitting, Recommendation 3 is sufficiently similar to the JOBS Act which is sufficiently similar to Recommendation 1 that a minor change to the JOBS Act would be sufficient to accomplish the major goals of the IAC’s recommendations. As it stands, the impact on companies raising capital is the same as that of Recommendation 1; the pool of people able to become investors will increase.
I will discuss a change to the JOBS Act that may meet the IAC’s goals in the Summation.
This proposal is less about a change in the definition of accredited investor than it is about an issue relating to the change in that status.
The IAC urges the SEC to “take concrete steps [to]encourage development of an alternative means of verifying accredited investor status that shifts the burden away from issuers who may . . . be poorly equipped to conduct that verification” if the definition is made more complex.
The issuing community runs into concerns with verifying an investor’s status. Currently, SEC Rule 506(c) (ii) requires issuers to take reasonable steps to verify that purchasers of securities sold in any offering. This is accomplished by:
[R]eviewing any Internal Revenue Service form that reports the purchaser’s income for the two most recent years (including, but not limited to, Form W-2, Form 1099, Schedule K-1 to Form 1065, and Form 1040) and obtaining a written representation from the purchaser that he or she has a reasonable expectation of reaching the income level necessary to qualify as an accredited investor during the current year.
Additionally, it involves reviewing “[b]ank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessments, and appraisal reports issued by independent third parties.” This puts a significant burden on smaller issuers and if the definition changes to anything more complex than the basic financial thresholds, the burden will only increase.
The IAC notes that there have been benefits of relying on third parties to perform verification before. The IAC states that brokers, investment advisers, accountants, and attorneys would be well situated to provide this type of service.
I will not go into further detail as this recommendation does not address the changes from the perspective for which this article was written.
This proposal, like Recommendation 4, also does not address changes to accredited investor specifically. It deals primarily with purchaser representatives.
Under the current rules, up to 35 non-accredited investors may participate in a raise. Those non-accredited investors must still be deem “sophisticated” either alone or with a purchaser representative “Relying on a purchaser representative enables individuals who might not otherwise qualify as accredited investors or as sophisticated non-accredited investors to invest in Rule 506 offerings.”
In 2012, the SEC completed a study finding that although some restrictions were placed on the individuals acting as purchaser representatives, the representative was still allowed to be paid by issuer as long as the investor was made aware of the arrangement. “Such disclosures are notoriously ineffective in protecting investors from harm, as was well documented in the SEC’s 2012 financial literacy study.”
The IAC is now recommending “the Commission prohibit individuals who are acting as purchaser representatives in a professional capacity from having any personal financial stake in the investment being recommended, prohibit such purchaser representatives from accepting direct or indirect compensation or payment from the issuer, and require purchaser representatives who are compensated by the purchaser to accept a fiduciary duty to act in the best interests of the purchaser.”
It is impossible to put a solid number on how many accredited investors will be added to the pool if the SEC adopts any of these recommendations. And if the regulations are changed, we do not know how much capital from the new accredited investors will actually be available. What we do know is that each of the recommendations is intended to better the climate for potentially getting small businesses and startups off the ground.
For getting new businesses funded while still protecting the investor, my hat is still hung on Recommendation 3 as the best. I did mention that there was a modification that would be just as effective although an action by Congress would be necessary as opposed to a rulemaking by the SEC. That change would be to modify the first restriction of Title III JOBS Act which currently reads “For the trailing 12 month period, the total amount of equity sold by the issuer cannot be more than $1,000,000.”
First, the trailing 12 month period should be done away with because it brings up issues of dilution, fully capitalizing the project at a crucial stage, and investor confidence. If the company has to continually raise on a rolling basis, the risk of a change in market circumstance that would impede market entry increases which does not benefit the entrepreneur or early stage investors.
Second, I would raise the limit past one million dollars. I have seen projects that required more and some that required less. My exposure should not be used as a barometer, though, and I was unable to find data on the average request per project.
By modifying the JOBS Act, investors would still receive the protections that come with capping investments at a percentage of income and more projects would be able to raise under Title III. I believe this is a win-win for the industry.
And now for the mandatory warning. Investing in startups is still risky. A modification of the rules does not decrease that risk, it will only bring about more companies that have the same risk and increase the number of investors participating in that risk. And wherever money goes so go people intent on making a buck by fraud. A thorough examination of the company raising money and the intermediary claiming to have done the necessary due diligence will be even more crucial. A good friend of mine once said “Startups need more than hype, they need impact.” Newly minted and less seasoned accredited investors should make sure that the company they are investing in has a product the people will pay for and not just a lot of media coverage.
 17 C.F.R. § 230.501(a)(6) (2011)
 17 C.F.R. § 230.501(a)(5) (2011)
 SEC Mulls Changes to Accredited Investor Standards, 18 Crowdfunders React, http://www.forbes.com/sites/devinthorpe/2014/07/15/sec-mulls-changes-to-accredited-investor-standards-18-crowdfunders-react/ (last visited Feb. 26, 2015)
 17 C.F.R. § 230.502(c)(1) (2011)
 Jumpstart Our Business Startups Act of 2012, Title II, § 201(a)(1) (2012)
 Will Crowdfunding For Businesses Succeed or Fail, http://www.forbes.com/sites/chancebarnett/2012/07/26/will-crowdfunding-for-businesses-succeed-or-fail/ (last visited Feb. 26, 2015)
 JOBS Act of 2012, Title III, § 302 (2012)
 Securities and Exchange Commission, Investor Advisory Committee, Recommendation of the Investor Advisory Committee: Accredited Investor Definition. http://www.sec.gov/spotlight/investor-advisory-committee-2012/investment-advisor-accredited-definition.pdf (Oct. 9, 2014)
 Id. at 2
 Id. at 3
 Id. at 6
 Id. at 7
 Id. at 7
 Id. at 8
 Id. at 9
 Id. at 6
 Id. at 9
 17 C.F.R. § 230.506 (c)(2)(ii)(A) (2011)
 Securities and Exchange Commission, Investor Advisory Committee, Recommendation of the Investor Advisory Committee: Accredited Investor Definition at 10. http://www.sec.gov/spotlight/investor-advisory-committee-2012/investment-advisor-accredited-definition.pdf (Oct. 9, 2014)
 Id. at 11