Last month, the SEC Small Business Capital Formation Advisory Committee (SBCFAC) told the Commission to make the definition of an Accredited Investor more inclusive. This is not the first time the Committee has advised the Commission to update the definition and make it more rational and attainable by less wealthy individuals.
Currently, an Accredited Investor is an individual who earns over $200,000 a year or has a net worth of over $1 million (not counting a primary residence). If you are married, the income threshold jumps to over $300,000 a year. While there have been some slight modifications in recent years, access to these private securities remains exclusive. Accredited Investors may participate in Reg D securities offerings. Reg D is the most popular security exemption used by private firms. Just about all of the most promising early-stage firms and successful public firms raising money
The number of public companies has declined in recent decades due to the rising cost of being a public firm – a cost that is moving higher as Congress and the SEC add new burdensome rules. Successful private companies aim to remain private for as long as possible. This means much of the early capital gains only benefit the wealthy, and big VC firms, cutting out smaller investors. Big funds and family offices have learned to jump to the head of the queue to participate in these securities offerings to capture these gains. At times, a public listing appears as more of an exit opportunity for early investors.
The current wealth metric for an Accredited Investor does not consider sophistication, which is a better measure of an individual’s ability to understand risk. While this is obvious to everyone, the Commission, under the leadership of Chairman Gary Gensler, has wanted to increase the wealth hurdle to participate in these securities offerings – effectively making them more exclusive. Reg D and the simple Reg D filing document remain a top item of the Gensler team. It is the simplicity of this process that has made the Reg D ecosystem so effective and beneficial to innovators and the economy.
As was previously reported, the SBCFAC posted its recommendations in a letter dated May 1, 2024. The recommendation letter explains that the Committee “explored ways the definition might be amended to work better for small businesses and investors across the country.”
The SBCFAC said there was a need to enable “greater access to capital for founders, particularly underrepresented founders.” The letter pointed to the “tension in regulatory policy between accessibility and government paternalism.” While commenting on the need for “investor risk awareness,” the members want to see a more “balanced approach” to the definition.
The recommendations by the Committee are as follows:
- With respect to the definition of “accredited investor,” the Committee recommends that the Commission leave the current financial thresholds in place, and not adjust such financial thresholds for inflation (either retroactively or going forward).
- Given the imperfect proxy that financial thresholds provide for measuring investors’ sophistication, the Committee recommends that, for individuals who do not meet the wealth and income thresholds, there be a way to qualify as accredited by satisfactorily completing an educational program, which would then allow such person to invest up to 5% in total of the greater of their income or net worth over a 12-month rolling period. While the Committee defers to the Commission to further develop and implement these criteria, the Commission is encouraged to consider the analogous framework used in Regulation Crowdfunding (Reg CF).
- Having discussed the importance of investors being aware of the risks of investing in private securities, the Committee further recommends that the Commission look at ways to ensure that certain information be made available which identifies key investment risks of this asset class in a clear and concise manner. In particular, the Committee identified the following key investment risks: risk of total investment loss; limited liquidity; and that loss of investment (absent fraud) does not give an investor a legal claim against the company.
This is not the first time the Committee has recommended that Reg D offerings be made available to more individuals, removing the current state of disenfranchisement of less wealthy investors.
In 2022, the Committee explained to the Commission in a letter:
“Accredited investors are a critical source of early-stage capital for small businesses in communities across the country, and changes that would shrink the pool of currently accredited investors would have a detrimental effect on small business capital formation. The ripple effects of limiting access to early-stage capital would negatively impact access to future rounds of financing from funds and other later-stage investors, rippling further into the companies that will one day go public.“
The Committee also worried that raising the wealth hurdle would “have disproportionate impacts on various demographic groups, making the definition less inclusive and widening the nation’s already wide racial wealth gap.” The Committee said that increasing the wealth threshold would harm the diversity of entrepreneurs that raise growth capital.
The letter recommended the Commission not increase financial thresholds, perhaps consider indexing to inflation periodically, but more importantly, provide alternative methods to be deemed Accredited, measuring sophistication, as the current monetary proxy is “imperfect.”
In 2019, the Committee provided similar recommendations to those delivered to the Commission in 2022. Once again, members told the SEC not to change the financial thresholds while directing the Commission to change the definition to allow criteria based on sophistication.
So, will the SEC listen to the experts and make the definition of an Accredited Investor more accessible and inclusive? Probably not. The Commission is currently heavy on paternalism and an extreme social agenda and not so interested in improving capital formation and opportunity for smaller investors.