April is just around the corner, which means that Securities and Exchange Commission will soon vote on how to adjust the definition of an “accredited investor.” A change to this rule could effectively broadening or limiting the pool of who will be able to invest in private equity markets. While the SEC’s primary goal is to protect investors, tweaking the qualifications for accredited investor status will inevitably affect how startups raise capital. So what does this mean for tech companies looking to transform the real estate industry?
The SEC has created the accreditation rule to protect investors. The hope behind the distinction, at least in the SEC’s mind, is that an accredited investor would be savvy (i.e. wealthy) enough to withstand a significant loss if they find themselves investing in the wrong venture. The strict conditions for net worth, professional expertise, and income are in place to protect investors who may lack the necessary cash reserves to weather large losses. Less experienced investors, in the view of the SEC, may be in over their heads, especially since these offerings often have high minimum amounts.
If the subject of changing the requirements for accredited status is stirring up déjà vu, it’s because the SEC broadened the definition just a few years ago. As of now, the current financial criteria for an individual or business entity to qualify for “accredited” status involves either a sustainable year-to-year income of at least $200,000 (or $300,000 if combined with a spouse), or a net worth of $1 million or more, excluding the value of the primary home (either individually or with a spouse). This had been the initial standard for some time.
However, in December of 2020, the SEC expanded the definition to include investors and entities with proven financial acumen. Under former SEC Chair Jay Clayton, the accredited investor criteria expanded to include a third option, anyone who holds a valid Series 7, 62, or 85 licenses or is deemed a “knowledgeable employee” of certain investment funds.
Inflation threatens the party
For those seeking investors, opening the door for more potential investors sounds like an overwhelming positive. But the access to accredited investor status may get restricted in proportion to recent expansions thanks to skyrocketing inflation.
In 2019, prior to the most recent amendment that opened the door for the third option, the number of accredited investors in the United States in 1983 made up about two percent of the population, according to the SEC. In June of 2020, before the criteria was expanded, 10.6 percent of all households in the U.S. were accredited.
When the SEC expanded the requirements to include a third option, there were no adjustments to income and net worth thresholds. Then COVID-19 reared its ugly head, setting off an economic spiral that ultimately resulted in record inflation rates which climbed to 7.9 percent as of last month.
While this rate of inflation has inevitably prompted an increase in investors who qualify for accredited status, private real estate syndicators and PropTech startups who thought that the expanded accredited investor’s requirements would ultimately increase their investor pool should hold their breath. Considering how out of control the inflation rate has become, it’s incredibly likely that the SEC will consider indexing the financial thresholds for inflation on a periodic basis come April.
As it stands, the accredited investor characterization is a deciding qualification for access to private securities offerings, especially for both 506b and 506c of Regulation D (which is the crowdfunding iteration). Reg D is especially important for PropTech companies as it has been utilized by nearly every successful U.S. tech company to raise funds from investors. This is a specific approach to organizing a deal so that it is compliant with securities laws (presumed to comply if the specific rules are followed).
The SEC issued new guidelines last fall for “exempt offerings,” which allow companies to obtain cash by selling securities. This security exemption is the most common way for potential private companies to obtain essential development funding. The market is massive, with over $1 trillion in annual revenue, and it is a significant source of capital formation. But, when the SEC meets to finalize the definition for accredited investors, they will also be locking down the metrics for exempt offerings as well.
These revisions don’t address a major problem for early-stage companies complying with securities requirements in the “friends and family” round. Ultimately, these alterations to the definition of an accredited investor do not alter the criteria in such a way that entrepreneurs can now accept investment from their non-accredited friends and family members without difficulty. But, these revisions would certainly shrink the number of investors that would be able to participate in private deals which could make it harder for startups and private real estate deals to find non-institutional sources of funding.