In The United States, an accredited investor is someone who has a net worth of at least one million dollars, excluding the value of their primary residence, or has income of at least $200,000 a year for the last two years or $300,000 together with a spouse, with the expectation to make at least as much every year going forward.
Once you become an accredited investor, you're now allowed to invest in certain types of private investments, which are usually less liquid, potentially more risky, and sometimes more complex than public equities and bonds.
These investments include: private equity, venture capital, angel investing, limited partnerships, hedge funds, and some real estate crowdfunding investments.
I've written consistently about how I think an adjusted gross income of roughly $250,000 is the ideal income for maximum happiness. At this level of income, you can max out your 401(k) each year, contribute to a taxable investment portfolio, and live a solid middle-class lifestyle.
Now we can include being an accredited investor as yet another reason to shoot for a $250,000+ household income.
Who Determines The Definition OF An Accredited Investor?
The Securities And Exchange Commission Investment Advisory committee determined the current accredited investor definition back in 1982. As you know, $3 million is the new $1 million due to inflation. Therefore, it seems like the SEC needs to do some updating. 33 years is quite a long time! Actually, in 2011, they did put into new law that the $1 million net worth must now exclude your primary residence.
What's interesting is that the Dodd-Frank financial reform law requires the Securities and Exchange Commission to revisit the accredited investor standard every four years. July 2014 marked the fourth anniversary of the law's enactment, and the SEC is considering creating an “accredited natural persons” class, which states that the person must be both an accredited investor and also own not less than $2.5 million in investments.
$2.5 million sounds like a reasonable level thanks to inflation over the past 32+ years. The question is: are the income and net worth minimums fair?
Modernization Of The Accredited Investor
Thankfully, on August 26, 2020, the SEC finally modernized the accredited investor definition to include the following:
- add a new category to the definition that permits natural persons to qualify as accredited investors based on certain professional certifications, designations or credentials or other credentials issued by an accredited educational institution, which the Commission may designate from time to time by order. In conjunction with the adoption of the amendments, the Commission designated by order holders in good standing of the Series 7, Series 65, and Series 82 licenses as qualifying natural persons.
- include as accredited investors, with respect to investments in a private fund, natural persons who are “knowledgeable employees” of the fund;
- clarify that limited liability companies with $5 million in assets may be accredited investors and add SEC- and state-registered investment advisers, exempt reporting advisers, and rural business investment companies (RBICs) to the list of entities that may qualify;
- add a new category for any entity, including Indian tribes, governmental bodies, funds, and entities organized under the laws of foreign countries, that own “investments,” as defined in Rule 2a51-1(b) under the Investment Company Act, in excess of $5 million and that was not formed for the specific purpose of investing in the securities offered;
- add “family offices” with at least $5 million in assets under management and their “family clients,” as each term is defined under the Investment Advisers Act; and
- add the term “spousal equivalent” to the accredited investor definition, so that spousal equivalents may pool their finances for the purpose of qualifying as accredited investors.
These new amendments to the definition of accredited investor go into affect at the end of October 2020. Then it will be another four years or so before the SEC revisits the definition of accredited investor.
Is The Definition Of Accredited Investor Fair?
The primary mission of the U.S. Securities and Exchange Commission is to protect investors. When you've got Bernie Madoffs running around promising 10% returns and bilking investors for billions, something is not right. Anyone who has seen Boiler Room and The Wolf Of Wall Street knows that there are a lot of scams in the wild.
But why $200,000/$300,000 and $1 million in net worth before a person can decide to invest in private offerings? The theory is that someone with at least such income and net worth is more sophisticated than someone who doesn't have such financial metrics.
Further, accredited investors are more able to withstand investment losses than other investors. The U.S. Supreme Court even decided last century that someone who has a lot of money “can fend for themselves” when it comes to investments.
Accredited Investors Aren't Necessarily Smarter
I don't know about you, but I'm well aware of plenty of accredited investors who lose a lot of money in their investments all the time. A lot of people with money also made their fortune not from investments, but from a small business, sale of their business, or an inheritance.
Further, it's not like someone who has a $100,000 net worth is investing the same amount of money as someone who has a $1 million net worth. The investment is likely much smaller or proportionate to one's net worth.
What about all the financial advisors who advise on various investments, but who can't invest in the same investments themselves? Should your financial advisor be wealthier and smarter than you? I think so, but that's oftentimes not the case.
Is the SEC saying that the financial advisor or investment analyst who spends 50 hours a week investigating good investment opportunities can't invest? However, someone who might have made their millions running convenience store franchises can? Seems odd to me.
Thankfully, the SEC has modernized the definition of accredited investor in 2020+ to help account for these inconsistencies.
A Better Solution To Determine Who Can Invest In What
We're all adults here. Some of us may have stronger risk-taking tendencies than others. But instead of using the $200,000/$300,000 income and $1 million net worth metrics to determine who can invest in what, let's offer up some other solutions.
1) Any person can invest in private offerings so long as they limit their total investments to no more than 20% of their net worth.
2) Any person who wants to become an accredited investor must pass an accredited investor exam, which tests a person's investment knowledge.
3) A combination of the above two.
Do you know who all the private investors are in firms like Uber, Airbnb, Palantir, Zoom, etc? Already very wealthy people who are going to get wealthier once there's a liquidity event.
Wealthy investors will continue to get first looks on the most promising investment opportunities. As a result, I would caution against angel investing. You don't have an edge and you will likely only get shown the rejects.
Life As An Accredited Investor
As an accredited investor myself since 2003, I can tell you that I haven't had that many more opportunities to invest than a non-accredited investor. One of the reasons why is because I haven't been actively looking.
I've sunk about $75,000 in Bulldog Gin Co., $150,000 in a Venture Debt fund, and $100,000 in a Japanese private real estate fund, and $810,000 into real estate crowdfunding to take advantage of lower valuations and higher net rental yields in the heartland of America.
Bulldog Gin signed a great distribution contract with Campari, and finally paid out 10 years later. I made about a 70% return, and am happy to have not lost money. But a 70% return after 10 years has underperformed the S&P 500.
The venture debt fund will provide a 9% minimum preferred return + any upside. Not bad.
The Japanese private real estate fund has returned a solid 24% IRR since 2009. I wish it would continue forever, but the fund is returning all money to investors by 2017.
Investing In Real Estate
I'm most exciting about my investments in real estate crowdfunding because I think there's a multi-decade trend towards lower cost of areas of the country due to technology and the rise of remote work.
My favorite platform is Fundrise, which offers private real estate funds mostly invested in residential and industrial in the Sunbelt region. It's free to sign up and explore. You don't even need to be an accredited investor. The returns have shown to be quite steady, especially when the S&P 500 loses money or is especially volatile.
If you are an accredited investor, then my favorite real estate crowdfunding platform is CrowdStreet. It enables you to invest directly with the sponsors in individual deals. The deals are pre-vetted by CrowdStreet to increase the level of quality.
Further, CrowdStreet is focused on faster growing, less pricey, 18-hour cities. With migration shifts away from 24-hour cities like NYC, to less dense cities like Charleston, SC, I think there's a lot of opportunity. It's good to sign up and automatically get e-mailed the deals for you to review.
I like real estate crowdfunding the best for building passive income because it combines the ability to generate 100% passive income with owning a tangible asset.
Invest In Private Growth Companies
Finally, consider diversifying into private growth companies through an open venture capital fund. Companies are staying private for longer, as a result, more gains are accruing to private company investors. Finding the next Google or Apple before going public can be a life-changing investment.
Check out the Innovation Fund, which invests in the following five sectors:
- Artificial Intelligence & Machine Learning
- Modern Data Infrastructure
- Development Operations (DevOps)
- Financial Technology (FinTech)
- Real Estate & Property Technology (PropTech)
Roughly 35% of the Innovation Fund is invested in artificial intelligence, which I'm extremely bullish about. In 20 years, I don't want my kids wondering why I didn't invest in AI or work in AI!
The investment minimum is also only $10 and you don't have to be an accredited investor. Most venture capital funds have a $250,000+ minimum. In addition, you can see what the Innovation Fund is holding before deciding to invest and how much. Traditional venture capital funds require capital commitment first and then hope the general partners will find great investments.
Money Doesn't Just Come To You As An Accredited Investor
The funny assumption some people make about being an accredited investor is that money just comes to you. Some believe that you're automatically going to get richer just because you are an accredited investor. This is simply not true.
To maximize your opportunities as an accredited investor, you must:
1) Actively look for private investment opportunities
2) Be smart and savvy enough to recognize investment opportunities
3) Be connected enough so that you are invited to invest
4) Take risks by deploying capital
There are plenty of investments out there that lose accredited investor's money. It's not like you suddenly are guaranteed higher returns just because the SEC now says you are savvy and tolerant enough to invest.
Every investor must do their due diligence and take calculated risks. It doesn't matter how much you make or how much you are worth.
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The definition of an accredited investor is still the same today. This is despite tremendous inflation and massive investment gains in equities, real estate, cryptocurrencies, and other assets. Therefore, I suspect income and net worth hurdles may be changed to reflect the wealthier environment today. Or, the requirements may be dropped to enable more retail investors to invest in private investments.