Accredited investors are able to invest money directly into the lucrative world of private equity, private placements, hedge funds, venture capital and equity crowdfunding.
However, the requirements of who can and who cannot be an accredited investor – and can take part in these opportunities – are determined by the SEC.
There is a common misconception that a “process” exists for an individual to become an accredited investor.
No government agency or independent body reviews an investor's credentials, and no certification exam or piece of paper exists that states a person has become an accredited investor.
Instead, the companies that issue unregistered securities determine a potential investor’s status by conducting diligence prior to sale.
This article breaks down the requirements to become an accredited investor, how to determine if you qualify, and the screening process completed by investment managers to verify accredited investor status.
Who Is an Accredited Investor?
Rule 501 of Regulation D of the Securities Act of 1933 (Reg. D) provides the definition for an accredited investor. Simply put, the SEC defines an accredited investor through the confines of income and net worth two ways:
“A natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year ...
“A natural person who has individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase, excluding the value of the primary residence of such person.”
The last passage of the second bullet is critical because it is an important change that was introduced during the 2010 passage of the Dodd-Frank Act.
Prior to the financial law’s passage, the primary residence was not excluded from determining a person’s net worth. Anyone who held accredited investments prior to the passage were grandfathered into the law.
Rule 501 also has provisions for corporation, partnerships, charitable organizations, and trusts in addition to company directors, equity owners and financial institutions.
However, the following formulas and screening processes are prepared for individuals or couples seeking the designation of being an accredited investor.
How to Determine if You’re Accredited?
Individuals who have earned $200,000 or more in income over the past two years automatically qualify as an accredited investor, as does a person whose income – when combined with a spouse's – totals $300,000 or more.
An individual can also maintain a net worth of $1 million or more, minus the value of a primary residence. The only situation where the primary home can weigh on a net worth is when an investor has either an underwater mortgage or a balance on a home equity line of credit.
For an individual to determine if her or she qualifies as an accredited investor, they should create a personal balance sheet like the one below by subtracting the total number of liabilities against the total assets.
| Allen | Brian | Carla | |
| Primary Residence | |||
| Home Value | $ 500,000 | $ 500,000 | $ 500,000 |
| Mortgage | $ 50,000 | $ 300,000 | $ 400,000 |
| Home Equity Line | $ 100,000 | ||
| Assets | |||
| Bank Accounts | $ 500,000 | $ 500,000 | $ 500,000 |
| 401(k)/IRA | $ 300,000 | $ 300,000 | $ 300,000 |
| Other Investments | $ 400,000 | $ 400,000 | $ 400,000 |
| Car | $ 25,000 | $ 25,000 | $ 25,000 |
| Total Included Assets | $ 1,225,000 | $ 1,225,000 | $ 1,225,000 |
| Liabilities | |||
| Student / Vehicle Loans | $ 100,000 | $ 100,000 | $ 100,000 |
| Other Liabilities | $ 100,000 | $ 100,000 | $ 100,000 |
| Underwater Mortgage | $ 100,000 | ||
| Balance Home Equity Line | $ 100,000 | ||
| Total Included Liabilities | $ 200,000 | $ 300,000 | $ 300,000 |
| Net Worth | $ 1,025,000 | $ 925,000 | $ 925,000 |
As noted in the example above, Allen qualifies as an accredited investor because his net worth is more than $1 million.
However, both Brian and Carla do not qualify due to additional liabilities tied to their primary residence.
In Brian’s case, he has a $100,000 home equity line that boosts his liabilities and drops his net worth below $1 million. Meanwhile, Carla’s underwater mortgage increases her liabilities and limits her net worth.
The Due Diligence
As mentioned, no formal agency or institution confirms the accreditation of an investor, and no certification is issued.
However, since September 2013, the SEC has required that anyone selling to accredited investors must take a number of different steps in order to verify this status.
Simply telling a firm or checking a box that signals a person is qualified is no longer allowed.
Individuals who feel they qualify can visit a fund and ask for information about potential investments. At this time, the issuer of securities will give a questionnaire to determine whether a person qualifies as an “accredited investor.”
The questionnaire will also likely require the attachment of financial statements and information of other accounts in order to verify the ownership of assets listed on a balance sheet like the one above.
Companies will also likely evaluate a credit report in order to assess any debts held by a person seeking accredited status.
Individuals who base their qualifications on annual income will likely need to submit tax returns, W-2 forms and other documents that indicate wages. Individuals may also consider letters from reviews by CPAs, tax attorneys, investment brokers or advisors.
The Bottom Line
Accredited investors have the opportunity to invest in non-registered investments provided by companies like private equity funds, hedge funds, venture capital firms and others.
But strict regulations from the SEC require that companies take a number of steps to confirm the status of an investor claiming accredited status.
In order to quality, an accredited investor must surpass a certain annual income level for the two previous years or maintain a net worth above $1 million (minus the value of a primary residence).