Being an angel investor isn’t something you simply decide to do. Startup investments are limited to a specific class of individuals the Securities and Exchange Commission (SEC) classifies as “accredited investors.”
The designation is the subject of much scrutiny in the VC world (which we’ll cover). Nonetheless, before making your first startup investment, it’s important to understand the accredited investor rules and ensure you qualify.
Accredited investor definition
“Accredited investor” is a regulatory designation coined by the SEC as part of Regulation D of the Securities Act of 1933 to describe individuals or entities financially sophisticated enough to handle the risks and potential losses associated with certain kinds of investments, such as early-stage startups.
To qualify as an accredited investor, an individual must meet at least one of the following criteria related to income, net worth, or professional financial experience:
- Individual income exceeding $200k or joint income with a spouse exceeding $300k, in each case, in each of the prior two years along with a reasonable expectation of the same income level in the current year,
- Individual net worth or joint net worth with a spouse of at least $1M, not including the value of his or her primary residence,
- An individual holding in good standing the general securities representative license (Series 7), the investment adviser representative license (Series 65), or the private securities offerings representative license (Series 82), or
- A knowledgeable employee, as defined in rule 3c-5(a)(4) under the Investment Company Act, of the issuer of securities where that issuer is a 3(c)(1) or 3(c)(7) private fund. This includes directors, executive officers, or general partners (GP) of the company selling the securities (or of a GP of that company), or knowledgeable employees of a private investment fund.
An individual can also invest through an entity if the entity qualifies as an accredited investor by meeting the following criteria:
- All owners of such entity are accredited investors,
- The entity owns investments in excess of $5M, provided such entity was not formed to specifically acquire the offered securities,
- The entity’s total assets exceed $5M in the case of corporations, partnerships, LLCs, trusts, 501(c)(3) organizations, employee benefit plans, “family office” and any “family client” of that office, provided such entity was not formed to specifically acquire the offered securities.
Banks, insurance companies, registered investment companies, broker-dealers, and other institutions can also qualify as accredited investors. More information on qualification criteria for these entities can be found on the SEC website.
What can accredited investors do?
Accredited investors have access to a broader range of investment opportunities than non-accredited investors. Notably for angel investors, accredited investors can invest in “private placements,” which are securities not registered with the SEC and not available to the broader public (i.e., listed on a public stock exchange). The equity securities issued by early-stage tech startups commonly fall under the category of “private placement.”
Accredited investors can also invest in venture capital funds, given these funds qualify as 3(c)(1) venture capital funds. These funds can allow up to 100 accredited investors (or 250 accredited investors, if the fund size is less than $10M).
Purpose of the accredited investor designation
The illiquidity and lack of standardized reporting and disclosures in private placement offerings make this type of asset riskier than public offerings. The SEC created the accredited investor designation in an attempt to protect investors who may not have the means or financial know-how to bear the risk of those types of investments. Investors unable to meet the aforementioned criteria are presumed not to have the sophistication or financial cushion one might need if an investment doesn’t work out (keep in mind, a vast majority of startups fail).
Accredited investors, by contrast, are expected to be financially savvy and good stewards of capital (either their own, or capital they’re investing on behalf of others). It’s an accredited investor’s responsibility to assess the risk of various investments and perform due diligence before making a decision. Accredited investors benefit from receiving information that may not be publicly available, given that privately-held startups aren’t required to disclose as much information as publicly traded companies.
Who checks accredited investor status?
There is no formal process for confirming the status of an accredited investor. It’s incumbent upon the issuer of the unregistered securities to confirm that an individual meets accredited investor status. When investing directly in a startup, the issuer is the company. If an investor is putting money into a venture capital fund, the issuer is the fund.
The verification process depends on the type of security offering. For a Rule 506(b) offering, a company is not allowed to broadly solicit investors (i.e., publicly advertise), so the process for confirming accreditation is generally more relaxed. For 506(c) offerings, which allow companies to generally solicit investors, the company must take “reasonable steps” to verify accreditation. This may include requesting to review an investor’s financial information, including financial statements, credit report, W-2, and tax returns. Some issuers assign this responsibility to their lawyer, accountant, or another qualified third party.
If an issuer wants to raise from unaccredited investors, they may lose their SEC exemption and be required to register their stock—a large and expensive undertaking that most early-stage startups shy away from.
Potential changes to accredited investor laws
Early-stage startup investments have proven to be tremendous sources of wealth creation. As such, regulators have increasingly heard calls to loosen accredited investor requirements so that more individuals can benefit from the wealth creation associated with startup investments (i.e., not just individuals who are already wealthy). This call is amplified by the fact that startups stay private longer than ever, meaning most of the public doesn’t get the opportunity to invest in these businesses and participate in the wealth creation opportunities they offer.
Activists continue to advocate for making private market investing more inclusive, meaning the future of the accredited investor designation remains in flux. As an initial response to such calls, the SEC amended the accredited investor definition in 2020 to include individuals who have “professional knowledge, experience or certifications,” such as holding a Series 7, 65, or 82 license, as well as “knowledgeable employees” of a private fund.
Becoming an accredited investor with the Series 65 exam
The SEC’s recent amendment to the accredited investor definition has created new ways for individuals to qualify as accredited beyond their financial means. One of the most accessible ways is by passing the Series 65 exam, otherwise known as the Unified Investment Adviser Law Exam.
Unlike the Series 7 or Series 82 exams, the Series 65 does not require a firm sponsor, meaning anyone can take it. The exam itself is 130 multiple-choice questions. Students are given 180 minutes to complete the exam and must score a 94 or higher to pass. Topics covered on the exam include financial markets, investment vehicles, investment strategies, financial regulation and compliance, and ethics. Note there is also a registration fee of $187.
To become an accredited investor via the Series 65 exam, one must also register with either the state or SEC as an Investment Advisor Representative for a Registered Investment Advisor (RIA) once they pass the exam. The RIA can be the individual's own firm.
At Hustle Fund’s Angel Squad, we pay the registration fee for members who wish to take the Series 65 to become accredited. Angel Squad members also get access to free resources, including study guides and peer groups, to help them prepare for the exam. Angel Squad member Brendon Ross also operates a startup called Regdee that helps individuals take the Series 65 exam and set up their RIA.
To learn more about Angel Squad, click here. To learn more about Regdee, click here.
Accredited investor vs. qualified purchaser
Accredited investors aren’t the only class of investor that can access private placements. The SEC also provides this privilege to qualified purchasers. To meet the requirements for qualified purchaser status, an individual must:
- Have an investment portfolio of $5M or more (not including their primary residence), or
- Manage an investment portfolio of $25M or more on behalf of themself and other qualified purchasers.
A trust can also hold qualified purchaser status if it meets the following criteria:
- A portfolio value of $5M or more that is owned by two or more close family members (i.e., spouses, siblings, etc.), or
- The trust was not formed for the specific purpose of investing in a specific fund, AND its trustees granting assets to the trust are qualified purchasers.
The key difference between qualified purchasers and accredited investors is that the qualified purchaser designation is determined by the value of one's investments, not their net worth, income, or credentials. Like accredited investors, qualified purchasers can invest in 3(c)(1) funds. Additionally, qualified purchasers can invest in 3(c)(7) funds, which allow for up to 2k qualified purchasers, as opposed to the 100/250 accredited investors permitted by 3(c)(1) funds.
Accredited investor FAQs
How much does an accredited investor need to earn?
To qualify as an accredited investor based on income, an individual must have earned at least $200k, or have a joint income with a spouse exceeding $300k, in each case, for each of the past two years, with a reasonable expectation of the same income level in the current year.
Regarding earnings related to an accredited investor’s angel investing activity, this income is entirely dependent on the performance of the underlying startup investments and can vary greatly. Generally speaking, startups are high-risk, high-reward investments. While many fail, successful startups have the potential to return many multiples of the original investment amount.
Can I invest without being an accredited investor?
Up to 35 non-accredited investors can invest in a 506(b) offering. Per the SEC, “any non-accredited investors in the offering must be financially sophisticated or, in other words, have sufficient knowledge and experience in financial and business matters to evaluate the investment.”
If the issuer sells to non-accredited investors, it must disclose additional information about itself, including its financial statements.
Are you automatically an accredited investor?
Anyone who meets the aforementioned criteria is automatically considered an accredited investor. There is no formal application process.
Is there a loophole to becoming an accredited investor?
Because there is no formal vetting process, anyone can technically claim to be an accredited investor in a 506(b) offering—which is why issuers of unregistered securities should be sure to run a background check on all their investors. In a 506(c) offering, the issuer must take “reasonable steps” to verify accreditation.
Businesses that unknowingly accept capital from non-accredited investors could face serious consequences. In most cases, the disclosure requirements for a company selling to non-accredited investors are much more onerous. If a company has non-accredited investors on its cap table without realizing it, it’s likely violating these disclosure requirements. Non-accredited investors are also granted the right of rescission, meaning they can undo the investment transaction and get their money back, often years after the initial investment.
Angel Squad helps members become accredited investors
As a member of Hustle Fund’s Angel Squad, we’ll support you through preparing for and taking your Series 65 exam to earn accredited investor status. To date, hundreds of members of Angel Squad have earned accreditation by taking the Series 65. Hustle Fund members can access study guides, practice exams, and peer support groups to help them prepare, all at no additional charge.
To learn more about Angel Squad, visit our website.
