What’s In A Label? Beyond The Accredited Investor Definition

What do all of these venture capital/securities terms mean? Gary J. Ross explains.

In the startup/venture capital space, and I guess in securities law in general, the “accredited investor” definition is crucial. I can’t remember the last time I encountered someone who was not familiar with the term. People are often unclear on why it’s important (“Um, I can sell my startup’s stock to unaccredited investors, right? Right??”), but everyone knows it refers to wealthy investors, and most folks even know the thresholds.

But is that it? Is that the only definition or threshold you need to know, so if you know that, you’re golden? Not on your life. That’s not how regulations work. Why have one threshold when you can have two? And for that matter, why have two when you can have four? Let’s see how many thresholds we can fit into one ATL column.

First, an “accredited investor” is:

  1. A person with earned income that exceeded $200,000 (or $300,000 together with a spouse) in each of the past two years, with an expectation of making the same this year;
  2. A person with a net worth over $1 million, either alone or together with a spouse (excluding the value of the person’s primary residence);
  3. An entity in which all of the equity owners are accredited investors; or
  4. A director/executive officer/general partner of the company that is issuing securities.

And there are a few other ways to qualify, which we won’t go into here because you’ll fall asleep.

Rule 506(b) is the most popular securities offering registration exemption by far. It allows a company to sell its securities to accredited investors without having to register the securities, and even allows the company to sell its securities to up to 35 non-accredited investors, as long as they’re sophisticated investors.

So what’s a sophisticated investor?

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A “sophisticated investor” is someone who has sufficient knowledge and experience in financial and business matters to make him/her capable of evaluating the merits and risks of the prospective investment. There are no hard and fast income or net worth thresholds, so this would include someone like a professor or a state securities regulator, who may not make enough to be an accredited investor but who knows financial markets inside and out.

Private investment funds use the same securities offering registration exemptions as everyone else, so maybe an investor just has to be accredited or sophisticated and they’re good to go? Meh, maybe not. Remember a couple of weeks ago I talked about the black gold and Texas tea of Wall Street? The carried interest? Carry keeps the world going around, and if a fund manager can’t charge it, his/her world will stop. Congress didn’t think the accredited investor threshold was high enough for a fund manager to be charging every single accredited investor performance fees, so a fund manager (at least one that is an RIA) can only charge a carried interest on your returns if you’re a qualified client.

So what’s a qualified client?

A “qualified client” is:

  1. A person or a company that has at least $1,000,000 under the management of the investment advisor;
  2. A person or a company that:
    • Has a net worth (individually, or together with a spouse) of more than $2,100,000; or
    • Is a qualified purchaser (see below); or
  3. A person who is:
    • An executive officer, director, trustee, or general partner of the investment advisor; or
    • An employee of the investment advisor who participates in the investment activities of such investment advisor.

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So once a fund identifies all its investors as qualified clients, is it good to go? Probably, but we have to make sure what kind of fund it is. Funds invariably take advantage of two exemptions from the investment company definition (just why a fund would want to do this is a topic for another day): the first exemption is for funds limited to 100 investors, and the second exemption is for funds in which the only investors are qualified purchasers.

So what’s a qualified purchaser?

A “qualified purchaser” is:

  1. A person with at least $5 million in investments;
  2. A company with at least $5 million in investments owned by close family members;
  3. A trust, not formed for the investment, with at least $5 million in investments;
  4. An investment manager with at least $25 million under management; or
  5. A company with at least $25 million in investments.

So thus far, you’ve at least learned that you want to grow up and be a qualified purchaser, not just an accredited investor.

Okay, so you’re one of the above and you’ve bought these securities of private companies. Who can you sell these securities to? You have some options, but you can use the very popular Rule 144A safe harbor if you sell your unregistered securities to a qualified institutional buyer.

So what’s a qualified institutional buyer (or QIB)?

A “qualified institutional buyer” is:

  1. A corporation, nonprofit, or certain other type of entity that owns and invests a minimum of $100 million in securities (e.g. big pension funds and the like); or
  2. Broker-dealers that own and invest at least $10 million.

We were only able to cover five definitions today, but if you’re at least aware of these and why they’re important, you’ll have a leg up on everyone else, and will have something to talk about at your next cocktail party or on your next date, if it so happens that you’re not particularly good at date talk. Speaking of dating, if you like, maybe now you can update your dating profile so it states you have higher standards than just accredited, and you don’t really care if a potential mate is sophisticated or not, as long as they’re qualified. (I once had a person make me tell her my income before she would agree to go out with me — clearly she was enamored of me! — so if nothing else, now you know a more discreet way of weeding out the scrubs.)

Disclaimer: The above is general information and there are many nuances to each definition presented. No attorney/client information is established by your reading this column (or any of my other columns), though I do appreciate your time and hope you got something out of it.


Gary J. Ross is a partner at Ross & Shulga PLLC, which he co-founded in 2017 after running his own firm for four years and after several years in Biglaw and the federal government. Gary handles corporate and securities law matters for venture capital funds, startups, and other large and small businesses, as well as investors in each. You can reach Gary by email at Gary@RSglobal.law.