The Securities and Exchange Commission (SEC) recently adopted changes to the definition of an accredited investor that could open up new possibilities for private capital investments, including those in family businesses. The regulation took effect in October 2020.
What Is an Accredited Investor?
In order to protect the public from unwittingly making risky investments, the SEC requires that securities be registered, or exempt from registration, before they are offered or sold. Registration of securities is a cumbersome and expensive process, and requires significant disclosures of information and other compliance measures.
However, there is a very useful exemption from registration called federal Regulation D that eases the disclosure and other rules for private investments by certain investors. The SEC has determined that individuals with sufficient "financial sophistication" are permitted to invest in unregistered private securities.
The SEC reasons that such individuals will be able to appreciate the risks of the investment and weigh the risks against the potential rewards. The SEC defines those with the requisite sophistication as "accredited investors." With access to private markets, accredited investors have unique business opportunities available to them that the general public does not.
For a broader discussion of how federal and state securities laws and regulations apply to family-owned businesses, we recommend you review our previous blog post here. Note that many, but not necessarily all, state law definitions of "accredited investor" track with the federal definition.
So, who or what counts as an accredited investor? Section 230.501(a) of Title 17 of the Code of Federal Regulations describes what it takes to qualify as one. Prior to August 2020, individuals could only qualify as accredited investors if they met one of two criteria:
- (1) Their net worth exceeded $1 million, excluding the value of their primary residence, as of the date of the investment, or
- (2) Their annual compensation for the past two years was in excess of $200,000 (or $300,000 with a spouse) and was expected to remain above that threshold for the current year.
There are also a number of non-individual entities such as private business development companies, non-profits, or trusts with assets in excess of five million dollars that qualify as well under the definition.
In August 2020, the SEC expanded the definition of an accredited investor in order to allow individual investors to demonstrate the required "financial sophistication" in ways other than their net worth or their compensation. The new definition allows people to qualify as accredited investors based on certain professional certifications, designations or credentials or other credentials issued by an accredited educational institution.
The SEC made a start by specifically including, with this expansion, holders of Series 7, Series 65, and Series 82 FINRA licenses. The SEC signaled that other credentials will be considered in the future for accredited investor status.
Additionally, family offices with at least $5 million in assets under management are now considered accredited investors. A family office is an independent entity established by a family to manage its wealth and provide services such as tax and estate planning services.
So, while there is plenty of room for continuing evolution of the definition, it is a good start to improving opportunities for private investment by those who have not historically fit within the definition of accredited investors. We can hope that the definition broadens in the future to include CPAs, securities lawyers and other business lawyers, and others who have actual sophistication with regard to private investment opportunities.
How Can Family Businesses Benefit From This Change?
These expansions can benefit family businesses and their owners in two key ways.
First, there are (or will be, at some time) now more opportunities to secure family and non-family investors without having to subject the business to greater compliance restrictions or securities registration risks and expenses. With more people qualified to take part in private offerings, family businesses will have an easier time finding investment capital in ways that won't subject them to prohibitive regulatory burdens at the federal and state levels.
Second, the new definition may allow certain family offices to make private investments on behalf of family members that do not themselves qualify as accredited investors. Family office investors now have certainty that they can invest in unregistered securities on behalf of their family members without having to structure a carve-out for those members that are not accredited investors in their own right.
There are many laws and regulations on both the federal and state levels that affect the sale of securities. Be careful to consult with securities legal counsel before taking any steps towards an offer or sale. And, watch this space for future developments as the accredited investor definition is expected to broaden further.