Although just about anyone can start a startup, not everyone can invest in them.
The rules and regulations behind who can and can’t invest in private companies is the subject of this installment of an open, ever-expanding guide to the VC industry that we on the Crunchbase News team are compiling.
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Part 1 of this series covered the very basics of venture capital and where it exists in the universe of investment opportunities. We explained that private-company equity is considered an alternative asset, and today we’ll explore the various regulatory hoops one must jump through to invest in startups.
One thing to note: we are not lawyers, nor do we play them on the internet. Please speak with our own legal and financial counsel before investing in a startup or startup investment fund. Books, seminars, or online articles are no substitute for personalized professional advice.
Who Can Invest In Startups?
As with answers to most questions about the venture capital field, this one starts with “it’s complicated, and it depends.”
First, before continuing, it’s important to note that we’re coming from a U.S.-centric approach here. So who gets to invest in startups? For the longest time, it was just “accredited investors” who could invest in private company equity. And that’s where we will start.
Being an “accredited” investor assumes you’re sophisticated enough to make risky financial decisions. And in this case, as in most, sophistication is a euphemism for wealth.
According to the latest U.S. rules, last updated with the passage of the Dodd-Frank Act in 2010, an accredited investor is an individual who:
- “Earned income that exceeded $200,000 (or $300,000 together with a spouse) in each of the prior two years, and reasonably expects the same for the current year, or”
- “Has a net worth over $1 million, either alone or together with a spouse (excluding the value of the person’s primary residence).”
One or more of these criteria must be met for three consecutive years before a person is considered an “accredited investor.” Alternately, certain investment professionals are also designated as accredited investors.
Other Investors And The Rules That Govern Them
There are other tiers of investors, like qualified clients and qualified purchasers, which correspond to higher levels of wealth and institutional backing. While sometimes relevant to the internal financial management of venture funds, the qualified client/purchaser designation is less relevant to the fundamental question of who gets to invest directly into private companies or the funds that back them.
Basically, it’s only accredited investors (and wealthier) who get to invest in private company offerings and VC firms.
Here’s why. The surpassing majority of capital raised by private companies in the U.S. is done through a “private placement,” 1 which is accessible accredited investors, or up to 35 non-accredited investors who are able to prove they are knowledgeable and fully understand the risks involved with investing in a given business. However, because the burden of proof for such knowledge is high, non-accredited investor participation in a private placement is a legal grey zone and seldom happens.
This being said, recent rule changes open up investing in startup equity to more people.
Although signed into law in 2012, Title III of the JOBS Act—the part of that legislation covering equity crowdfunding—didn’t get implemented until 2014. The new-ish crowdfunding regulations (appropriately named Regulation CF) allow companies to offer shares of stock in exchange for money from non-accredited investors. But there are limitations on the policy.
For example, a company can’t issue more than $1 million worth of crowdfunded securities within the same twelve-month period. And depending on retail investors’ income bracket, the amount they can invest per year is also limited. Regulation CF also imposes a number of reporting requirements that aren’t present in Regulation D.
Stay tuned for more installments of Crunchbase News’s VC guide. Next up on the docket: how VC firms are structured.
If you have any questions or topics you’d like to see covered, feel free to contact the author: jason [at] crunchbase [dot] com.
Illustration: Li-Anne Dias