Pixabay/Gerd Altmann
Many issuers and investors are not familiar with the term
“Accredited Investor,” but it’s a concept that is core to capital raising.
Previously, capital raises were restricted to private networks of accredited
investors. It was hard for companies to find those investors and hard for those
investors to find companies. New legislative developments have opened up access
to accredited investors through general solicitation in exchange for accredited
investor verification. Here’s your chance to learn how accredited investor
verification works and how it may work in your favor.
New Rules Improve Access to Capital
Typically, the securities laws enforced by the Securities and
Exchange Commission (SEC) requires registration of securities offerings.
However, there are certain exemptions to keep in mind. For example, while
raising capital, companies may use Rule 506(b) of
Regulation D as an exemption, but as part of the rule,
they will be prohibited from advertising and generally soliciting for their
offering.
A newer exemption, Rule 506(c) of Regulation D, was implemented
in 2013 as part of the Jumpstart Our Business Startups Act (also known as the
JOBS Act), and it allows for an alternative method of raising capital. This
rule permits general solicitation and advertising to anyone so long as eventual
sales are made only to
accredited investors. Examples of general solicitation
include print, TV, radio, and all sorts of internet advertising. Contrast this
with the older Rule 506(b) which doesn’t require the newer accredited investor
verification process but also doesn’t allow companies to solicit or advertise
their private offerings.
According to the new rule, issuers of 506(c) offerings must take
“reasonable steps” to
verify an investor’s accredited status. Since
unregistered investments may pose a higher risk and have a greater chance of
loss, this mix of permitted advertising and required verification of
accreditation may strike a balance for capital markets. It allows easier access
to capital while narrowing the pool to more knowledgeable investors, as well as
those who are financially equipped to bear the risk.
What Is an Accredited Investor?
“Accredited investor” is defined
in
Rule 501 (a) of Regulation D. It’s important to
note that accredited investors have crucial criteria they must meet, as
outlined in this SEC
investor bulletin.
The rule reads as follows:
An accredited investor
can be one of the following, or who the issuer reasonably believes comes within
any of the following categories, at the time of the sale of the securities to
that person:
(1) Any bank as defined
in section 3(a)(2) of the Act, or any savings and loan association or other
institution as defined in section 3(a)(5)(A) of the Act whether acting in its
individual or fiduciary capacity; any broker or dealer registered pursuant to
section 15 of the Securities Exchange Act of 1934; any insurance company as
defined in section 2(a)(13) of the Act; any investment company registered under
the Investment Company Act of 1940 or a business development company as defined
in section 2(a)(48) of that Act; any Small Business Investment Company licensed
by the U.S. Small Business Administration under section 301(c) or (d) of the
Small Business Investment Act of 1958; any plan established and maintained by a
state, its political subdivisions, or any agency or instrumentality of a state
or its political subdivisions, for the benefit of its employees, if such plan
has total assets in excess of $5,000,000; any employee benefit plan within the
meaning of the Employee Retirement Income Security Act of 1974 if the
investment decision is made by a plan fiduciary, as defined in section 3(21) of
such act, which is either a bank, savings and loan association, insurance
company, or registered investment adviser, or if the employee benefit plan has
total assets in excess of $5,000,000 or, if a self-directed plan, with investment
decisions made solely by persons that are accredited investors;
(2) Any private
business development company as defined in section 202(a)(22) of the Investment
Advisers Act of 1940;
(3) Any organization
described in section 501(c)(3) of the Internal Revenue Code, corporation,
Massachusetts or similar business trust, or partnership, not formed for the
specific purpose of acquiring the securities offered, with total assets in
excess of $5,000,000;
(4) Any director,
executive officer, or general partner of the issuer of the securities being
offered or sold, or any director, executive officer, or general partner of a
general partner of that issuer;
(5) Any natural person
whose individual net worth, or joint net worth with that person’s spouse, exceeds
$1,000,000.
(i) Except as provided in paragraph
(a)(5)(ii) of this section, for purposes of calculating net worth under this
paragraph (a)(5):
(A) The person’s primary residence shall
not be included as an asset;
(B) Indebtedness that is secured by the
person’s primary residence, up to the estimated fair market value of the
primary residence at the time of the sale of securities, shall not be included
as a liability (except that if the amount of such indebtedness outstanding at
the time of sale of securities exceeds the amount outstanding 60 days before
such time, other than as a result of the acquisition of the primary residence,
the amount of such excess shall be included as a liability); and
(C) Indebtedness that is secured by the
person’s primary residence in excess of the estimated fair market value of the
primary residence at the time of the sale of securities shall be included as a
liability;
(ii) Paragraph (a)(5)(i) of this section will
not apply to any calculation of a person’s net worth made in connection with a
purchase of securities in accordance with a right to purchase such securities,
provided that:
(A) Such right was held by the person on
July 20, 2010;
(B) The person qualified as an accredited
investor on the basis of net worth at the time the person acquired such right;
and
(C) The person held securities of the same
issuer, other than such right, on July 20, 2010.
(6) Any natural person
who had an individual income in excess of $200,000 in each of the two most
recent years or joint income with that person’s spouse in excess of $300,000 in
each of those years and has a reasonable expectation of reaching the same
income level in the current year;
(7) Any trust, with
total assets in excess of $5,000,000, not formed for the specific purpose of
acquiring the securities offered, whose purchase is directed by a sophisticated
person as described in §230.506(b)(2)(ii); and
(8) Any entity in which
all of the equity owners are accredited investors.
While the definition can seem unwieldy, for the most part,
accredited investors are certain types of financial institutions, companies
with more than $5 million in assets or whose equity owners are all accredited
investors, or individuals that have high income or high net worth.
How to
Get Verified as an Accredited Investor?
There are multiple ways to get verified as an accredited investor. If investors
need to get verified through the income method, they should use official tax
records such as tax returns, W-2, K-1, 1099, or other government documents, if
possible. If that type of official documentation is not available, they may be
able to provide evidence through earnings statements, pay stubs, a letter from
their employer certifying their income, or perhaps bank statements that show
that they received that income.
If investors choose to get verified through the net worth method,
they must prove both liabilities and assets, and the positive value of their
primary residence may not count toward net worth. The basic math for accredited
investor verification is as follows:
i) Add Assets (ignoring the value
of the primary residence)
ii) Subtract the amount of
debt on primary residence incurred in prior 60 days
iii)
Subtract the amount of debt on primary residence exceeding value of
primary residence (without duplicating item (ii) above)
iv) Subtract the amount of debt
shown on credit report (without duplicating items (ii) and (iii) above)
v) Subtract other liabilities
(without duplicating items (ii), (iii) and (iv) above)
For liabilities, if investors have U.S. credit reports, the verifier
should review it to confirm liabilities. In addition, investors should be asked
for a written disclosure of all other liabilities.
For assets, investors would need to evidence enough assets to
demonstrate a net worth of at least $1,000,000 USD, ignoring the value of their
primary residence and after discounting all their other liabilities to be
excluded per the above definition. These assets could be bank accounts,
brokerage accounts, property that is not their primary residence, boats,
automobiles, art, or anything that has value. To prove the value of those
assets, they would need to provide bank statements, brokerage statements and
other statements of securities holdings, certificates of deposit, tax
assessments and appraisal reports. All documentation must be no more than
90 days old, with certain exceptions. It’s important for investors to
distinguish between assets that they hold versus assets held by companies that
they may have some ownership interest in.
For example, if investors own real estate property outright under their name,
then the real estate property is their asset.
If investors hold real estate property through an entity, such as an
LLC, then the investors’ asset is not the real estate property but their ownership
interest in the LLC instead. In that
case, they would need to show a valuation of their ownership interests in the
LLC.
For the purposes of verification of trusts or entities on the
basis of assets, a trust or entity cannot be formed for the specific purpose of
acquiring the securities being offered. Charter documents can sometimes show whether
the trust or entity was formed for a particular purpose of acquiring the
securities being offered; otherwise, one would generally have to rely on
statements of the trust or entity officers to confirm this. With respect to
minimum asset requirements, typically, one would evidence this by providing
bank statements, audited financials, or perhaps an appraisal of assets held by
the trust or entity.
In the case of a trust that needs to evidence that purchase
decisions are made by a sophisticated person, a “sophisticated person” is
defined as someone (either alone or with his purchaser representative(s)) who
has such knowledge and experience in financial and business matters that he is
capable of evaluating the merits and risks of the prospective investment, or
the issuer reasonably believes immediately prior to making any sale that such
purchaser comes within this description.
Reviewing a sophistication questionnaire or obtaining an officer’s
certificate certifying this might be the most reasonable method of
verification.
For trusts or entities that do not meet the minimum assets test, they
might also be able to qualify as an accredited investor if all of its equity
owners are accredited investors. To evidence that, charter documents or officer’s
certificates that represent and warrant as to the complete list of the owners
would need to be obtained together with evidence that those equity owners were
all accredited investors.
Investors – Get Verified as an Accredited
Investor and Watch Out for Unregistered Offering Scams
Getting verified as an accredited investor gives you access to
more popular deals, but investors should also pay attention to the potential
risks for certain deals. Since unregistered offerings, or private placements,
lack the disclosure requirements and some other protections that apply to
registered securities, the SEC has issued a warning about
potential investment scams. Keep in mind that
“no-risk” offers and other aggressive sales tactics serve as strong warning
signs. Other red flags may include offerings with no income or net worth
requirements, sketchy sales documents, and companies that are not in good
standing in the state where they claim to have formed.
Issuers – Stay in Compliance and Verify Your
Investors as Accredited Investors
As part of the required “reasonable efforts” on the part of
issuers to verify their investors, the SEC specifically allows reasonable
reliance on third parties to conduct much-needed verification. Third parties
include SEC registered investment advisers, registered broker-dealers, licensed
attorneys who are in good standing under the laws of the jurisdictions in
which they are admitted to practice law, and certified public accountants who are duly
registered and in good standing under the laws of the place of his or her
residence or principal office. These third parties have certain registration,
licensing, and “good standing” requirements they must follow so they are deemed
to be trusted verifiers. Other safe harbor methods include proof of income
through tax documents and proof of net worth based on evidence of assets
through statements, etc., and evidence of liabilities through a U.S. credit
report and written disclosure of liabilities. The verification method can have
substantially different risk profiles to the issuers (and their investors) and
can also impact the buying process faced by investors. In general, the gold
standard is probably to utilize either a single law firm dedicated to doing
verification reviews or a third-party service that only contracts with outside
attorneys to conduct verification reviews.
Jor Law is a pioneer in building out the ecosystem for digitizing
and trading securities on the blockchain and other distributed ledger
technologies. A finance and securities attorney, he is most well-known for his
expertise in secured lending and alternative finance, including EB-5, venture
capital, crowdfunding, and tokenized securities, including initial coin
offerings (ICOs) or security token offerings (STOs). He co-founded
VerifyInvestor.com which was the dominant accredited investor verification
service in the world at the time it was acquired. A trusted consultant/adviser
to technology companies primarily in regtech, fintech, and crypto, Jor has
advised prominent companies such as tZERO, Polymath, and Prime Trust. Within
the crypto space, he’s most passionate about securities regulations affecting
tokens, identity for regulatory purposes vs privacy and anonymity, and
cross-ledger or cross-chain technologies.
Jenny Liang is an operations professional with a legal
background in the finance sector. She is serving as the VP of Operations for
VerifyInvestor.com, a leading accredited investor verification service
provider, a subsidiary company of tZERO. Her prior experience includes
operations of an overseas investment company in the EB-5 industry. Her career passion
focuses on assisting investors and issuers throughout the investment process.
Gareth Schumacher heads up sales and business development at
VerifyInvestor.com. A cryptocurrency and blockchain enthusiast, he studied
history at Columbia University and is particularly interested in how
technological innovation creates cultural and social change.
___
Equities Contributor: Jor Law
Source: Equities News
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