Qualified Purchaser vs. Accredited Investor — What’s the difference and why does it matter?

The dark period of the Wall Street stock market crash of 1929 is etched in U.S. history. The effects of the Great Crash reverberated across the country and around the world, contributing to the Great Depression in the U.S. that lasted for ten long years. And it was only in late 1954, a full 25 years after the Great Crash, that the Dow Jones Industrial Average regained its previous peak of 1929.

Speculative investment from uninformed investors had contributed to the preceding rise of the stock market throughout the Roaring Twenties, which saw the Dow increase by a factor of ten over a nine-year Bull Run. The fallout from the crash was immediate and brutal, with many investors losing everything and sending many banks and businesses broke.

That is why the U.S. Government stepped in.

The Securities Act of 1933 and the Securities Exchange Act of 1934

In response to the Great Crash, the Federal Government passed into law the Securities Act of 1933 to create more corporate financial transparency, control fraudulent activity, and protect investors. The following year saw the introduction of the Securities Exchange Act of 1934 and then the formation by Congress of the Securities and Exchange Commission (SEC) to regulate the securities markets.

Fast forward to the 1960s and 1970s, during which time Congress and the SEC reviewed and introduced rules around the information and disclosure requirements for private offerings outside of public markets, culminating in the introduction of the term ‘Accredited Investor’ into the Securities Act in 1980. Details of the accredited investor history can be found in this SEC paper .

In essence, the Securities Act of 1933, the Securities Exchange Act of 1934, and the SEC were created to protect uninformed investors from themselves by requiring rigorous disclosure requirements for companies making public stock offerings. The modifications to the Act in 1980 reduced these disclosure requirements for some suitably qualified Accredited Investors based on factors such as ‘ financial sophistication, net worth, knowledge, and experience in financial matters, or amount of assets under management. ‘

The Investment Company Act of 1940

Rewind now back to 1940, when the Investment Company Act of 1940 was passed. While the Securities Act focused on investors, the Investment Company Act focused on companies and the regulatory framework for investment products. Another measure in response to the Great Crash, the objective of this act was to facilitate a more stable financial market.

Now let us hit the fast forward button again to 1996 when Congress enacted the National Securities Markets Improvement Act and introduced another category of investor called a Qualified Purchaser and determined that ‘ the amount of a person’s investments should be used to measure a person’s financial sophistication for purposes of the Investment Company Act ‘.

What is an Accredited Investor?

An Accredited Investor can purchase some securities that are not sold on public markets and not registered with the SEC. Often these shares are issued by private companies such as startups. While the risks of being an Accredited Investor may be high, the rewards can also be high.

The threshold for Accredited Investors exists to protect people who do not have sufficient investment knowledge and / or financial reserves to manage the high-risk nature of private equity investments, their illiquidity, and the potential for loss of some or all of their capital.

Until recently, the SEC had stated that the Accredited Investor definition is ‘ intended to encompass those persons whose financial sophistication and ability to sustain the risk of loss of investment or fend for themselves render the protections of the Securities Act’s registration process unnecessary .’ In late 2020, the SEC introduced a new rule that expanded the definition to include people who have ‘ the ability to assess an investment opportunity-which includes the ability to analyze the risks and rewards, the capacity to allocate investments in such a way as to mitigate or avoid risks of unsustainable loss, or the ability to gain access to information about an issuer or about an investment opportunity-or the ability to bear the risk of a loss .

Defining Accredited Investor Status

The SEC defines an Accredited Investor as any of the following:

• A person with an income exceeding $200,000 in each of the two most recent years (or $300,000 in joint income with a person’s spouse) and a reasonable expectation to reach the same income level in the current year.
• A person with a net worth exceeding $1 million (individually or jointly with a spouse), excluding the value of their primary residence.
• A trust with total assets in excess of $5 million and directed by a ‘sophisticated person’ with appropriate financial and business understanding to evaluate the potential risks and rewards of specific investments (note the trust must not have been created for the purpose of specific alternative investments).
• An entity where each individual in the ownership is an Accredited Investor.
• A person with professional qualifications or certifications recognized by the SEC such as a Series 7, Series 65, or Series 82 financial services license.
• A ‘knowledgeable employee’ of a private investment fund.

What is a Qualified Purchaser?

Similar to an Accredited Investor, a Qualified Purchaser can purchase some stocks that are offered through a private placement that is not registered with the SEC. Meeting the requirements of a Qualified Purchaser are more onerous than for an Accredited Investor. Since the level of financial sophistication and investment capability is considered higher, a Qualified Purchaser can access a wider range of investments than an Accredited Investor.

Defining Qualified Purchasers

A Qualified Purchaser is any of the following:

• A person or family-owned company who owns at least $5 million in investments.
• A person or entity who invests at least $25 million in private capital on other people’s behalf or for their personal financial accounts.
• An entity owned only by Qualified Purchasers.
• Trusts that are sponsored or managed by multiple individual Qualified Purchasers.

Professional investment managers and corporations often come into the above list.

To be considered a Qualified Purchaser entity, every beneficial owner of the entity must be a Qualified Purchaser.

Accreditation requirements

There are no certification or accreditation requirements to “become” an Accredited Investor or Qualified Purchaser; you either are or you are not, based on the rules as stated.

Private equity funds, venture capital firms, hedge funds, and other such entities managing private investment offers are likely to require proof of an investor’s financial status as part of their own due diligence associated with a capital raising. While the government does not verify Accredited Investors or Qualified Purchasers, the SEC does require the entity handling the investment to confirm the qualified or accredited status of each investor.

If you are not sure you qualify as an Accredited Investor, you can take the Propel(x) Accredited Investor quiz .

What investments can an Accredited Investor or Qualified Purchaser make?

An Accredited Investor or Qualified Purchaser can access private equity opportunities such as angel investing, venture capital, real estate investment funds, private equity funds, hedge funds, and other specialty investment funds that may focus on sectors such as cryptocurrency.

These types of entities sell private placements, which are usually SEC Regulation D offerings. The SEC Regulation D guidelines exempt certain securities from full compliance with SEC requirements. A Regulation D offering requires companies to submit basic information about the company, but any additional information given to investors is up to the discretion of the company.

While a company issuing stock to the public must fill out a lengthy application with the SEC, companies offering private placements such as a startup investment are not subject to these strict requirements. Note these are high-risk investments where due diligence is critical.

Investment Opportunities for Accredited Investors & Qualified Purchasers

Both Accredited Investors and Qualified Purchasers can invest in 3(c)(1) funds. In addition, Qualified Purchasers can typically invest in 3(c)(7) funds. This is an important distinction for companies seeking capital, because a 3(c)(1) fund can only include 100 Accredited Investors* (or if the fund is below $10M, then up to 250 Accredited Investors can participate). On the other hand, a 3(c)(7) fund can include up to 2,000 Qualified Purchasers. For this reason, Qualified Purchasers are more attractive to investment funds than Accredited Investors.

* Note that under certain conditions, a fund could technically include up to 35 non-accredited investors, but many funds don’t allow this because of the associated additional regulatory risk and disclosure requirements.

Accredited Investor vs. Qualified Purchaser

It is important to note that if a group of Accredited Investors use a single LLC as a Special Purpose Vehicle (SPV) for a specific investment, they would each still be considered as individual investors. However, if a group of Qualified Purchasers use a single LLC as an SPV, they would collectively be considered as a single investor — this is a significant advantage for a company making a private offering, because it limits the total number of investors.

Often a company will split LLCs into Accredited Investors and Qualified Purchasers to control the total number of investors.

The following table summarizes the main differences between Accredited Investors and Qualified Purchasers:

How do I calculate my net worth?

As noted above, investors must calculate their net worth to determine if they meet the Accredited Investor status. This is calculated simply by adding the value of all their assets and then subtracting all their liabilities. The calculation must exclude the primary residence and any mortgages or loans on the primary residence (note if the loan on the primary residence exceeds the fair market value of the residence, then the loan amount that is over the fair market value must be deducted as a liability in the calculation).

Note that when investing with a spouse, the assets do not need to be held jointly to count toward net worth, so anything that each spouse owns individually may be included in the calculation.

Financial statements, W2 forms, tax returns, and other documents showing a person’s income and assets may be required as supporting evidence as part of the qualification process.

Why Accreditation is Important

As noted above, the SEC not only protects the interests of investors but also regulates companies and how they raise capital; these two functions do conflict to some degree. Public equity is tightly regulated to protect investors, but private equity is less regulated so as not to restrict the ability of private companies to raise capital. That is where Accredited Investors and Qualified Purchasers come in.

Entrepreneurial activities have a high likelihood of failure, which often means the loss of large amounts of capital. Rather than regulate the entities offering private placements, the SEC determines who is permitted to participate in those investments by determining who is qualified to assess the risks and has the ability to remain solvent if they lose some or all of their investment.

Accredited Investors and Qualified Purchasers represent a pool of potential funding from people with the experience to participate in an unregulated market and the financial resilience to withstand the losses that come with high-risk private equity investing.

As with any investment, past performance is no guarantee of future performance, and any investment decision must balance the risk against the potential return.

If you are interested in building your portfolio by adding investments in startups, you can find more information here on how to start angel investing and how to find opportunities for angel investing on the platform.

Originally published at https://www.propelx.com on February 22, 2022.