Everyone in VC is an Accredited Investor

Key Takeaways: A proposed law would create an exam for non-accredited investors to become accredited. But due to venture fund limits and other regulations, the impact may be closer to zero. Three recommendations to fix that: Increase the number of LPs allowed per fund, open up equity crowdfunding to funds, and ease legal restrictions on qualifying investments in VC funds.

This past week, securities lawyers have been bombarded with breaking news updates. Amid the noise, one interesting headline stood out:

• The?U.S. House passed a bill?with strong bipartisan support (383-18 vote) allowing potential investors to qualify as accredited investors through a test ??

Many people thought this was a good idea:

Others weren’t so sure:

One securities lawyer lamented that the bill must still pass Senate approval where:

“It will die, as usual.”1

But even if the legislation was eventually enacted into law, would anything change?

To answer that question, we will start with an understanding of accredited investor laws, review the new law and its potential impact, and make some recommendations.

I. Understanding Accredited Investor Laws

In 1982, the SEC established accredited investor rules to define who is qualified to invest in private securities offerings. Accredited investors are those eligible to invest in unregistered offerings not generally available to the public.

Around 13% of US households qualify as accredited investors, but less than 1% of eligible accredited investors actively invest in US venture capital, while nearly 100% of non-accredited investors are locked out of venture capital funds.

The SEC has 13 accredited investor categories which can be split into two groups:

• Operators
• LPs and Funds

Operators

Operators such as fund managers, knowledgeable employees and other industry professionals, automatically qualify as accredited investors, including:

• Exempt reporting advisers (ERAs) filing with the SEC
• SEC- or state-registered investment advisers
• Registered broker-dealers
• Professionals in good standing with Series 7, 65, or 82 licenses

In 2020, the law was amended to qualify certain operators as accredited investors, including (1) venture capital fund advisers, (2) private fund advisers, and (3) knowledgeable employees, even if they would not otherwise meet the criteria of accredited investors on their own.

This means that?every venture capitalist?should be deemed to be an accredited investor of their own fund—regardless of their wealth, income, net worth, or sophistication.

But what if you’re investing as a limited partner (LP) of a fund—are the rules different?

LPs and Funds

For LPs and funds, the accredited investor rules differ. They must meet certain wealth-based standards instead.

Individuals

• The standards for natural persons are based on net worth and income criteria, including:
• A net worth of?$1+ million?(excluding one’s primary residence); or,
• An annual income of?$200,000?(or joint income of?$300,000?for a couple).

Entities

• Under this category, corporations, LLCs, limited partnerships, family offices, and trusts must generally have “in excess of”:

--$5 million in total assets

• A catch-all rule that qualifies entities which have at least:

--$5 million in investments

• Entities whose equity owners are all accredited investors also qualify as accredited investors

Self-Certification

What are the securities laws related to accredited investor rules?

Section 4(a)(2)

• Section 4(a)(2): This private placement exemption allows funds to sell LP interests without having to register with or disclose the sale to the SEC.

To qualify for this statutory exemption, investors must:

• Be?sophisticated investors;
• Have?access to the same type of information?that would normally be provided in a prospectus for a registered securities offering (PPM); and,
• Agree not to?sell or distribute the securities to the public.

Rule 506(b)

• Rule 506(b): This exemption allows an?unlimited number of accredited investors?and?an unlimited amount of capital.

To qualify for this safe harbor, the fund must:

• Not advertise or generally solicit?their offering;
• Have a?reasonable belief?all investors meet the accredited investor rules;
• No more than 35 non-accredited investors.

Regulatory oversight of the venture capital industry is limited. It relies heavily on self-regulation. As a result, LPs often self-certify their own accredited investor status.

Reasonable Steps to Verify

Rule 506(c)

But there are exceptions. Any fund manager who either (i) publicly advertises their offering or (ii) generally solicits LPs without a substantive, pre-existing relationship must take “reasonable steps to verify” each LP is an accredited investor.

Under this rule, self-certification is not enough. Acceptable methods include:

• Income: IRS tax documents along with investor’s representations;
• Net Worth: Bank statements (or similar reports) with investor’s representations;
• Third-Party Verification: A third-party verification letter from the investor’s financial adviser, attorney or CPA issued within the last 3 months;
• Re-Verification: If a person has been previously verified as an accredited investor, the issuer can reconfirm their status via self-certification, valid for up to 5 years.

The SEC takes a “principles-based approach” to verifying accredited investor status, which means that the methods listed above are not the only ways to take reasonable steps.

Venture funds are frequently relying on third-party software platforms for this. But is it possible for a conflict of interest to arise when a venture-backed platform, which stands to gain from new investors, is also in charge of confirming their investors’ suitability? Might this be a situation that casts doubt on whether these platforms can actually take “reasonable steps” to filter out non-accredited folks? Maybe, but who cares?

II. Reviewing The Exam

Let’s review what the Equal Opportunity for All Investors Act of 2023 provides.

It would create an exam-based certification process for non-accredited investors to become accredited investors, free of charge.

As accredited investor laws are primarily based on wealth and income thresholds, this would open new regulatory pathway for non-traditional investors to participate in private securities offerings.

The exam would have to be designed by the SEC within one year and administered by FINRA to ensure it has an appropriate level of difficulty such that an individual with financial sophistication would be unlikely to fail it.

Key Topics to be Covered?

• Different types of securities
• Private and public company disclosure requirements
• Corporate governance
• Understanding financial statements
• Identifying potential conflicts
• Aspects of unregistered securities, including risks associated with limited liquidity and disclosures, among other potential pitfalls

Importantly, the exam will not require an annual license, unlike the current accredited investor rules which require a “license in good standing” after passing one of the Series 7, Series 65 or Series 82 exams.

III. Impact on the VC Landscape

For argument’s sake, let’s assume the Equal Opportunity for All Investors Act is enacted into law. The likely outcome is that without further regulatory changes, it won’t have any impact in terms of new accredited investor participation in funds.

How many limited partners invest in US venture funds currently?

According to the NVCA-PitchBook 2023 Yearbook, as of 2022, there are 3,756 active VC investors with assets under management of approximately $1.2 trillion, including $330 billion in dry powder.

AngelList says it has more than 2,225 active fund managers with approximately 15,000 venture capital funds listed on their Form ADV in 2023. Most of these funds are solo GPs and it would be hard to estimate how much LPs are in each fund.

But if we know the industry’s average number of limited partners per fund, we can estimate the total number of limited partners across the ecosystem.

According to the SEC, between 2009 and 2019, the average number of investors per VC fund was 15. There was a spike in VC fundraising activity between 2020-2022, which roughly doubled the size of funds in those two years, but has since come?down 90% or more.

Estimated number of active venture capital funds in the US:

• 4,000 funds to 6,000 funds

Estimated average number of LPs per fund:

• 15-20 LPs

Total Number of LPs investing in venture in the US:

• Lower bound:?60,000 LP positions
• Upper bound:?120,000 LP positions

Adjust our estimates to account for duplicates (assuming 2 funds on average):

• Lower bound: 60,000 LP positions / 2 =?30,000 unique LPs
• Upper bound: 120,000 LP positions / 2 =?60,000 unique LPs

These are just estimates, but the actual LP investors may be far lower.

What about the # of limited partners allowed?per?venture capital fund?

One of the main reasons the house bill will have little impact on venture capital funds is because of the limitations set by the?Investment Company Act (ICA).

• Section 3(c)(1). Funds with any accredited investors are limited to accept only 100 persons (or 250 persons for venture funds less than $10 million).
• That means for a $10 million fund, with 250 available LP slots, the average LP commitment must be?$40,000.
• That means for a $50 million fund, with 100 available LP slots, the average LP commitment must be?$500,000.

Again, these are?hypothetical?LP minimums.

The average minimum LP commitments rose between 2018 and 2020 from ~$400,000 to $1.43 million, and the median 2x’d from $250,000 to $500,000.

Even though LP investments are “capital commitments”—meaning they will be spread over years with multiple capital calls—non-accredited investors generally have fewer resources to invest. And these LP minimums are high even for people with the means to invest, making it difficult to attract enough newly minted accredited investors to reach the VC fund’s target fund size. Additionally, managing a large number of smaller LPs can be administratively burdensome and increase costs for venture funds.

Even if Congress opens up the doors to non-accredited investors, the math does not make sense for them to participate in venture funds as they are currently regulated.

IV. Recommendations

Despite these challenges, there is interest in democratizing venture capital and expanding the pool of potential investors who can participate as LPs in venture capital funds.

Emerging regulations like equity crowdfunding and technology-focused venture platforms make it easier for smaller investment amounts, which could gradually make venture investing more accessible to more emerging LPs.

Here are three sensible legislative recommendations:

1. Increase the Number of LPs Allowed Per Fund

Venture funds are currently limited to accepting 100-250 investors under the SEC rules. Increasing this limit, even modestly, could open up more opportunities for more investors to participate as LPs.

For example, the policy team at the National Venture Capital Association (“NVCA”) and fund managers are speaking up to Congress about increasing the LP limits of venture funds under $150 million from 250 to 600 persons and larger venture capital funds from 100 to 200 persons.

On February 8, 2023, VC Mac Conwell spoke at a Congressional hearing about this:

2. Open up Equity Crowdfunding to Funds

Equity crowdfunding allows non-accredited investors to invest in startups, but current regulations (such as Regulation A and Regulation Crowdfunding) explicitly prohibit venture funds from raising capital through crowdfunding portals. Allowing venture funds to crowdfund, even partially, could help them attract more small investors who want to invest $500-$50,000, for example. Venture funds would still be subject to the 100-250 maximum investor limit, but equity crowdfunding could count as one limited partner through a special purpose vehicle used to invest directly into the fund.

3. Ease Restrictions on “Qualifying Investments” in VC Funds

Under current SEC rules, to qualify as a “venture capital fund,” at least 80% of a fund's investments must be in “qualifying investments”:

Qualifying investments are defined as direct issuances of equity and equity-like instruments from startups. Common examples are SAFEs and preferred stock. Under current rules most secondary purchases and fund-of-funds do not count as “qualifying investments”.

However, secondary purchases and fund-of-funds have become increasingly common and important ways for venture capital industry to grow. They allow capital to flow in and out more efficiently, allowing new investors to participate indirectly, and startup companies to exit earlier.

The NVCA has expended significant resources to advocate to fix this:

In short, the DEAL Act would effectively categorize fund-of-fund investments into VC funds and secondary investments as “qualifying investments.” That would allow fund-of-funds to qualify as VC funds, which would reduce their regulatory burdens and allow more beneficial ownership in VC funds.

In summary, while creating an exam-based pathway for non-accredited investors to become accredited could help open up venture capital fundraising, the impact would likely be limited under current regulations. Funds are still restricted in the number of accredited investors they can accept, LP minimums are high, and many non-accredited investors would struggle to meet minimum investments.

More effective reforms would focus on:

? Increasing the limits on the number of accredited investors a fund can accept to allow for lower minimum investments

? Leveraging equity crowdfunding platforms to enable funds to raise capital from smaller investors

? Broadening the SEC's definition of "qualifying investments" to include secondary purchases and fund-of-funds to grow the venture capital industry

While not a fix-all, these sensible and targeted regulatory recommendations have the potential to open more doors for underrepresented investors and democratize access to venture capital opportunities.

Subscribing to the Law of VC newsletter is free and simple. ??

If you've already subscribed, thank you so much—I appreciate it! ??

As always, if you'd like to drop me a note, you can email me at [email protected], reach me at my?law firm’s website?or find me on Twitter?@chrisharveyesq.

Thanks,

Chris Harvey