Startup investors fall under a number of regulatory categories, which determine whether investment possibilities are available to them (whether on AngelList or elsewhere). This piece will concentrate on two of the most prevalent types: accredited investors and qualified purchasers.
We’ll walk you through the most important distinctions between an accredited investor vs a qualified purchaser and how the SEC rules apply to them in this guide, including how you can qualify for these designations and how they affect your investment prospects.
Who is a Qualified Purchaser?
A “qualified purchaser” is an individual or a family-owned business with interests worth $5 million or more. The phrase “investments” should not include a residential house or other commercial property.
The benchmark for a qualified purchaser is investments, not net assets, as you may be used to seeing for investor certification.
Stocks, bonds, futures contracts, cash and cash equivalents, commodities futures contracts, real estate, financial contracts, and other alternative assets held for investment purposes are all included in the word “investments.”
Other qualified purchaser groups include:
- An individual or company (such as a fund manager) that invests at least $25 million in private capital on its own behalf or on behalf of other qualified purchasers;
- A trust established and administered by qualified buyers; or
- A company that is wholly owned by qualified purchasers
There is one important exception to these rules:
The relevant company or family-owned business cannot be founded exclusively to invest in a fund in order to meet the qualified purchaser criterion.
Aside from qualified purchasers, two more key investment qualifications exist accredited investors and qualified clients. These certifications have varied legal and regulatory positions in terms of investment.
The Investment Company Act of 1940 and Qualified Purchasers
Privately held capital businesses are considered investment companies under the terms of the 1940 Investment Company Act (“the ’40 Act”) when they make — or seek to make — public offers in which qualified purchasers are not the only holders of the company’s outstanding securities.
Qualified purchasers are individuals who meet the conditions listed above, according to the ’40 Act. As a result, funds that sell only to qualified purchasers are immune from regulation under the ’40 Act. In other words, when investment firms opt to engage exclusively with the qualified purchaser, they are exempt from certain SEC rules.
A “qualified purchaser” is defined as follows in Section 2(a)(51) of the Investment Company Act:
- A person who has at least $5 million in investments.
- A $5 million firm or investments owned by close family members
- A trust, albeit not one formed particularly for the investment in question, with at least $5 million in assets.
- An investment manager who manages at least $25 million in assets.
- A corporation with investments worth at least $25 million.
Qualifications for a Qualified Purchaser
At least one of the following conditions must be met in order to be regarded as a “qualified purchaser”:
- The purchaser is an individual or family-owned business with interests worth $5 million or more. If the purchaser is a family-owned company, it cannot be founded primarily to invest in the fund.
- The purchaser is a trust sponsored and managed by qualified purchasers that was not founded solely to participate in the fund.
- The purchaser is an individual or other entity that invests at least $25 million for their own account or on behalf of others. Entities, like the other criteria, cannot have been founded specifically for the purpose of investing in the fund. A professional investment manager or a business are two examples of this category.
- Any entity if all of its owners are qualified purchasers.
“Investments” include, but are not limited to, stocks, bonds, and other securities, as well as investment real estate, futures contracts, physical commodities, financial contracts, and cash and equivalents.
A “qualified institutional buyer” is a different but related word that often refers to institutions that own and invest $100 million or more in securities, as well as banks that hold and invest at least $100 million in securities and have an audited net worth of at least $25 million.
Example of a Qualified purchaser
Assume three investors apply to a private equity fund:
- The first has a $1.5 million interest-bearing savings account and a $4 million retirement account at a brokerage in a well-diversified mutual fund.
- The second example is a wealth manager who invests $30 million on behalf of his clients, not all of whom are qualified purchasers.
- The third is a wealth manager who invests $20 million on behalf of his customers, all of whom are qualified purchasers.
Only the first investment in these scenarios would be considered a qualified purchaser.
Why is this the case?
In accordance with the criteria, the first investor retains total investments in excess of $5 million. While the second investor meets the $25 million criteria, some of its investments are made on behalf of non-Qualified Purchasers, which is prohibited. Finally, the third investor does not fit the criterion because they would need to contribute at least $25 million on behalf of others to qualify.
What are the SEC Exemptions for Funds with a Qualified Purchaser?
A private fund, hedge fund, or venture capital fund that only takes qualified purchasers as investors and does not intend to make an initial public offering qualifies for the Investment Company Act of 1940 (the “ICA”) 3(c)(7) exemption.
What is the significance of this point?
The ICA involves a large and complex set of regulatory standards, and most funds are not set up to comply with them.
In the example, by qualifying for an exemption from the ICA, the fund issuer will avoid having to register with the SEC as an investment business and make onerous continuing public disclosures about its investment strategy and positions.
Most funds seek to avoid SEC registration since it is an expensive and time-consuming process.
Furthermore, funds that are not excluded from the ICA face substantial restrictions when it comes to using leverage, specialized trading contracts, or functioning under complex corporate structures.
A fund that qualifies for the 3(c)(7) exemption obtains access to an unlimited number of investors while retaining maximum flexibility in its corporate structure and investing approach.
Qualified Purchaser vs Accredited investor
The words “qualified purchaser” and “accredited investor” are frequently (and wrongly) confused. There are, nevertheless, some significant variances.
Most notably, the financial requirements for accredited investors are much lower than those for qualified purchasers. Accredited investors must have a net worth of more than $1 million (excluding their principal residence) or earned income of more than $200,000 per year ($300,000 combined with a spouse) for at least three years.
Meanwhile, qualified purchasers must have a minimum investment of $5 million. As a result, qualified purchasers are sometimes referred to as “super-accredited” investors, or some variant thereof.
What distinguishes a Qualified Purchaser from an Accredited Investor?
Accredited investors, like QIBs, are a subset of skilled investors for whom the SEC considers the safeguards afforded by the United States Securities Act to be less relevant.
The fundamental distinction here is that qualified purchasers are a relevant category for funds looking to optimize their assets under management. Accredited investors, on the other hand, are a key designation for the capacity to invest in specific types of assets (namely, private market securities).
An accredited investor has lower financial thresholds (measured in terms of net worth and income) than a qualified purchaser (measured in terms of investments).
Criteria for Accredited Investors
Individuals: an accredited investor is a natural person who has either:
1. earned more than $200,000 in income (or $300,000 with a spouse) in each of the previous two years, and reasonably expects to earn the same in the current year, or
2. a net worth of more than $1 million, which can be alone or with a spouse (but excluding the value of the person’s primary residence). Although various exemptions based on financial sophistication are available, these monetary thresholds are the most commonly used to determine accreditation status.
There are various ways for an entity to be considered an accredited investor. The two most common are having total assets in excess of $5 million and being solely owned by accredited investors. The company, like qualified purchasers, may not have been founded solely for the purpose of investing in a fund.
The SEC adopted a final rule on August 26, 2020, that will expand the definition of accredited investor to allow people to qualify based on certain professional certifications or designations, such as holding certain Financial Industry Regulatory Authority licenses (Series 7, Series 65, or Series 82 licenses, initially), in addition to the existing income or net worth thresholds.
The revised accredited investor definition also allows a natural person who is a “knowledgeable employee” of the fund to be considered an accredited investor when investing in a private investment fund such as a private equity fund, venture capital fund, or hedge fund.
These improvements will provide more individual investors with access to private investment firms.
Who Decides if a Person is an Accredited Investor or a Qualified Purchaser?
It is the issuer’s responsibility to ensure that an investor fits the criteria for an accredited investor or qualified purchaser. Because the LPs are purchasing ownership in the fund, the issuer is considered the GP when investing in a startup through a venture fund.
It should be noted that the actual measures required to identify accredited investors and qualified purchasers differ depending on the facts of the unregistered securities sale in question. Verification is sometimes delegated by GPs to a lawyer, accountant, or another third party.
What is the Importance of Investor Qualification?
As this study has demonstrated, investor qualification is a necessary part of participating in the private market ecosystem and operating an investment fund.
The type of investor influences, among other things:
- whether or not an investor is eligible to invest,
- whether or not the fund would have to register with the SEC, and
- the fee that can be levied
Understanding the various types of investor qualifications can help you build your fund better, stay legally compliant, and prevent the unintended consequences of collecting money from the wrong investor.
You now understand the many sorts of individual investors, as well as who qualifies as an accredited investor, qualified purchaser, or qualified client, as well as how and why these phrases are so significant.
Regulators, on the other hand, have recently come under great pressure to relax some of these rules in order to enlarge the pool of individuals eligible to invest in opportunities such as pre-IPO firms.
Why Does the SEC Place Restrictions on Certain Investments?
Venture capital funds, unlike mutual funds and exchange-traded funds in a 401(k) plan or brokerage account, are not required to register with the SEC. As a result, they can invest the majority of their resources in early-stage, non-public companies with relatively illiquid stock (i.e., startups).
Because of the illiquidity and absence of standardized reporting and disclosure in the private market, these investment opportunities are both riskier and, hopefully, more profitable. To safeguard investors, politicians and regulators endeavoured to limit access to these funds to those with the sophistication and financial means to understand and bear the risks of those investments, i.e., accredited investors and qualified purchasers.
Qualified Purchaser FAQs
Is an LLC a qualified purchaser?
If all of the beneficial owners of the company’s stocks are qualified purchasers, a partnership or LLC is a qualified purchaser.
What happens if you lie about being a qualified purchaser?
Syndication offering contracts may compel the investor to indemnify the Syndicator if they lie about their qualifications and it causes liability for the Syndicator later (ours do), thus there may be ramifications for investors in those circumstances.
Can an IRA be a qualified purchaser?
The IRA owner must be accredited in order for the IRA to qualify for an annual income of more than $200,000 single or $300,000 married in the previous two years.
