Accredited Investors and Qualified Purchasers: Understanding Investor Eligibility in Private Offerings
When a company raises capital through a private offering, one of the first legal questions is: who is eligible to invest? The answer depends on the exemption structure the company is using, and it turns on the legal distinction between "accredited investors," "sophisticated investors," and "qualified purchasers" — concepts that are frequently confused but carry materially different implications.
Getting investor eligibility right is not a bureaucratic formality. Selling securities to ineligible investors can destroy the legal exemption on which the entire offering is based, giving investors the right to demand their money back and exposing the company's founders and officers to regulatory and civil liability.
The Accredited Investor Definition
The term "accredited investor" is defined by SEC Rule 501 of Regulation A, and it sets the minimum eligibility threshold for most private securities offerings. An individual qualifies as an accredited investor under any of the following standards:
Income test: Individual income exceeding $200,000 in each of the two most recent calendar years, with a reasonable expectation of the same income in the current year. For joint income with a spouse or spousal equivalent, the threshold is $300,000.
Net worth test: Individual or joint net worth (with a spouse or spousal equivalent) exceeding $1 million, excluding the value of the primary residence. Note that net worth for this purpose is calculated by subtracting the primary residence mortgage from the calculation, and any mortgage in excess of the fair market value of the residence is counted as a liability.
Professional certifications: The SEC expanded the definition in 2020 to include individuals holding certain FINRA licenses in good standing — specifically, Series 7, Series 65, and Series 82 license holders. This expansion allows certain financial professionals who do not meet the income or net worth thresholds to participate in accredited investor offerings.
"Knowledgeable employees": Employees of a private fund who are knowledgeable about the fund's investment activities may invest in that fund as accredited investors regardless of their net worth or income.
For entities (rather than individuals), the accredited investor definition includes:
● Banks, insurance companies, registered investment companies, business development companies, and small business investment companies
● SEC-registered investment advisers and rural business investment companies
● Entities with total assets in excess of $5 million, not formed for the specific purpose of acquiring the securities being offered
● Any entity in which all equity owners are accredited investors (sometimes called the "all accredited entity" test)
● Limited liability companies, corporations, partnerships, or trusts with total investments exceeding $5 million
The Sophisticated Investor Standard
Under Rule 506(b), a company may sell to up to 35 non-accredited investors — but only if those investors are "sophisticated." A sophisticated investor is one who, either alone or with the assistance of a purchaser representative, has sufficient knowledge and experience in financial and business matters to be capable of evaluating the merits and risks of the prospective investment.
This is a functional standard, not a bright-line test. The SEC has given limited guidance on precisely what "sufficient knowledge and experience" means, but courts and regulators have generally looked at factors including the investor's prior investment experience, business background, professional qualifications, and the complexity of the investment.
The practical implication: if you are relying on the non-accredited sophisticated investor allowance under 506(b), you need to document your basis for concluding that each such investor meets the sophistication standard. A questionnaire alone is typically insufficient; you should have a substantive conversation with the investor and document your assessment.
Importantly, selling to a non-accredited investor under 506(b) also requires providing that investor with audited financial statements and other disclosure that would otherwise not be required in a 506(b) offering limited to accredited investors. Many companies find this additional obligation a sufficient reason to limit their offerings to accredited investors only.
The Qualified Purchaser Standard
"Qualified purchaser" is a higher standard defined in the Investment Company Act of 1940, and it is relevant primarily to private investment funds that need to exceed 100 investors without registering as an investment company.
Under the Investment Company Act, a fund with more than 100 investors must generally register as an investment company unless it limits its investors to either (1) fewer than 100 investors (under Section 3(c)(1)) or (2) "qualified purchasers" only (under Section 3(c)(7)).
The qualified purchaser definition is substantially more demanding than the accredited investor definition:
● An individual (and their spouse) who owns not less than $5 million in investments
● A company, trust, or other entity that owns not less than $25 million in investments
● A person acting for its own account or the accounts of other qualified purchasers who in the aggregate owns and invests on a discretionary basis not less than $25 million in investments
This threshold — $5 million in investments for an individual — is significantly higher than the $1 million net worth test for accredited investors. For many fund managers, the choice of whether to organize a fund under Section 3(c)(1) or Section 3(c)(7) turns on the likely composition of their investor base: 3(c)(1) allows up to 100 investors but has no qualified purchaser requirement, while 3(c)(7) requires qualified purchasers but can accommodate an unlimited number of investors.
Verification Obligations
As discussed in our post on Rule 506(b) vs. 506(c), the level of verification required for investor eligibility depends on the offering structure:
Under Rule 506(b): The issuer must have reasonable grounds to believe each investor is accredited (or, for up to 35 investors, sophisticated). Self-certification through an investor questionnaire is generally accepted as sufficient for accredited investor status, absent red flags that put the issuer on notice that an investor may not qualify.
Under Rule 506(c): The issuer must take affirmative, reasonable steps to verify accredited investor status before the investor's subscription is accepted. Self-certification is not sufficient. The SEC's non-exclusive safe harbor verification methods include reviewing tax returns or W-2s for the income test, bank or brokerage statements for the net worth test, or obtaining a written confirmation from a qualified professional (CPA, attorney, broker-dealer, or registered investment adviser) who has verified the investor's status within the prior three months.
For qualified purchaser determinations (relevant primarily to fund managers under the Investment Company Act), issuers typically obtain detailed representations in the subscription agreement regarding the investor's ownership of investments, along with supporting documentation.
Why This Matters Beyond Compliance
Understanding investor eligibility is not just about avoiding regulatory trouble. The composition of your investor base affects your deal terms, your ongoing obligations, your ability to exit or liquidate the investment, and — in the case of funds — your ability to grow without triggering Investment Company Act registration.
Getting investor eligibility analysis right before an offering launches — with the benefit of experienced securities counsel — is far less expensive than discovering eligibility problems after investors have subscribed, when the options for remediation are limited and the stakes are high.
Disclaimer: This blog post is provided for general informational purposes only and does not constitute legal, tax, or financial advice. Reading this post does not create an attorney-client relationship with me or my law firm. Reach out for a consultation and to obtain advice specific to your individual legal needs.