Who are Accredited Investors?

Welcome to the Venture Capital Podcast. This is John and Peter. I'm with Codebase. He's with the University Growth Fund. I cover founder stuff. He covers the VC stuff. Got it. We're starting a masterclass on common terminology that people need to know whether they're trying to raise funding or get a job in venture capital. So the first one is accredited investor. And according to the sec, I'm reading this from their website, an accredited investor is someone with a net worth over US$1 million, excluding primary residence, individually or with spouse or partner income, over $200,000 individually or $300,000 with spouse or partner in each of the prior two years and reasonably expects the same for the current year.

And that's not it. There's some new provisions that just came out in the last few years, which are. So the other provisions are if you are a knowledgeable investor, such as you work at a venture capital fund or a private equity fund or a hedge fund, you can also qualify. Another way to meet that qualification, I believe, is if you take the Series 7, Series 65. And I think there's one more exam you can take.

You talk about the difference. There's the financial criteria, which is part one, and. And there's the professional criteria, part two. So let's just read it so we don't get in trouble with the sec.

Go for it.

Okay.

I thought you were going to. To begin with.

I didn't see. I didn't see the professional one until after.

Go for it.

Okay. Professional criteria. Investment Professionals in good standing holding, the General securities Representative License Series 7, the Investment Advisor Representative License Series 65, or the Private Securities Offerings Representative License Series 82, directors, executive officers or general partners, GP of the company selling the securities or of a GP of that company or family client of a family office that qualifies as an accredited investor. And then last, the fourth bullet point for investments in a private fund. Knowledgeable employees of the fund.

That's right. So what's interesting is they added these new provisions in the last few years because you had a whole bunch of people that, you know, maybe you were an analyst or an associate that worked at a venture capital fund, and, you know, maybe you made like $150,000 but didn't cross the threshold for being accredited investor. And yet you had a better, deeper understanding of the underlying risks of making those types of investments than somebody that was making half a million dollars a year. And so it felt silly to exclude those types of individuals from those types of investments, largely because the whole reason why accredited investor qualification exists is to protect people from being scammed and taking on too high a risk investments than they should be in. The other thing that's really interesting about the accredited investor provision is that it's really about helping. Well, it's really about providing protection to the companies that are raising money. So whether it's a private equity firm or a venture fund or a company, you want to ensure that your investors are accredited because it can, it provides certain protections in the event that maybe things don't go well and you lose money, investors can't come back and say, well, hey, you, you, you, you convinced me to do this really high, high risk investment. I didn't realize it was going to be that high risk, et cetera, et cetera. And so by ensuring that your investors are accredited, it provides you some, some legal protections from those scenarios. Which is why most companies and venture and private equity and hedge funds and so forth that require credit investor status of their investors have that requirement is really to protect both themselves as well as the investors. And part of that too, from a more practical standpoint, is that sometimes Uncle Joe will invest in some somebody startup and then, you know, a year later the Uncle Joe will go back to him, be like, hey, you know that 10 grand I invested, well, I need it back, right? And so there's also kind of this misunderstanding that sometimes happens with investors. And so by having somebody that's, you know, hopefully making enough money or has a high net worth, they can afford to take that loss without it causing serious damage to their financial health. And usually also if they're in those income brackets, they've got some experience managing money and understand a little bit better how the game is played. That's not entirely always the case, but another important factor, if you're a founder raising money or you're a venture investor raising money to ensure that your investors have a really good understanding of what they're investing in. You know, we spend a decent amount of our time educating some of our LPs that, you know, when they first invest in University Growth fund, it's their first investment in a venture fund. And so we'll spend time really helping them understand a whole bunch of, you know, different aspects of the deal, such as like the J curve, the time to liquidity and exit, what they should expect to pay into the fund, over what time period, when they should expect to generate returns, etc. Etc. Which I think is another kind of important aspect to raising capital from investors.

Okay, let's talk about those two sides. I assume everyone who's. Because our audience is two parts people who want to be VCs themselves. So they want to understand the VC side and the founder side. Let's talk about the VC side first. So I'd assume that there's probably not a fund out there today where the, any, any manager would take money from someone who's not accredited. But what would you do in say I was to say hey Peter, here's a $50,000 check. What would you want from your side to make sure you're protected?

So what VCs will do is they have what's called a subscription agreement. And the subscription agreement is really just like at its most basic, a form that says hey, I'm going to invest this amount. I commit to invest this amount over whatever time period. But there's a lot more that goes into it. And one of the things that goes into it is the series of questions wherein the person subscribing affirms that they are an accredited investor. And in some cases depending on the fund size that not only are they accredited, but they're also a qualified investor, which is an even larger, higher threshold that has to be met. So yeah, I mean venture funds will have these subscription agreements. The subscription agreements walk through all of the different criteria that is required for somebody to, to make a commitment to their fund or be an investor. And one of those great criteria are whether or not they are accredited investors. And again depending on fund size but it's may also require qualified but they.

Self attest versus you go to their accountant and have their accountant sign off on it.

So it depends. Some companies and some funds will push extra hard and say, you know, we need to provide, we need to receive evidence from your accountant or we need to see tax returns or you know, we need to see some other evidence to prove that you are an accredited investor. So it just kind of varies.

Okay, let's talk about the founder side. Okay, first off, I think what the penalty is, correct me if I'm wrong. The penalty, my understanding is if you raise $100,000 from Uncle Joe, Uncle Joe comes back a year later, he says I wasn't accredited, I had different expectations. This is far riskier. Legal could get involved. So there's the cost of legal. But the general rule is a judge would say you need to pay back the individual's principal plus roughly 10% per year.

Corre this is assuming that they hadn't been accredited and you knew they weren't accredited and you took their money anyways, correct? Yeah, look, I'M I'm not a lawyer, so I don't know the ins and outs of that. And it's probably beyond our podcast to provide legal advice.

So we're not providing legal advice. This is my understanding. But again, not legal financial tax advice. But there's a fairly safe assumption you have to pay the principal back with interest.

Yeah, I mean, that seems reasonable.

Which could be financially stringent. Now let's say you were starting a company.

There may also be penalties. Right. Because the judge would be like, hey, look, you didn't do your job to ensure that Uncle Joe was an accredited investor and took his money anyways. And the onus is really on you because the judge. My, my assumption is, and again this, I'm not a lawyer and haven't litigated these types of things, but my assumption is that they are going to side on the side of the investor from a protecting investor perspective because there's just been so many people over the years that have lost so much money to all kinds of scams.

Even if Uncle Joe's 50 and you're a 20 year old college kid.

Yep.

Is my understanding, again, not financial legal advice, but that's my understanding as a founder.

Yeah. I mean, because the idea is that you're out selling, you're selling a product. Right. You're saying, hey, invest in my company. Right. That's what I'm kind of selling. And then Uncle Joe's deciding whether or not they want to buy shares in your company.

Now what do you do as a vc? Let's say you're looking at a cap table for Acme Inc. And you see Uncle Joe's an investor and he did not self attest whether he's accredited or not. And then you later find out he isn't. What happens then? Do you no longer invest in the deal?

Really depends. There are certain exemptions and so forth, but I don't know, sometimes those are the kinds of things that result in very messy cap tables, as we call them in the industry where you've got a whole bunch of very small investors and sitting on the cap table.

And the rule of VCP is if your deal has hair on it, there's another deal without hair.

Yeah, there's always another deal with less hair on it. That's more interesting. Right.

What do you do in those scenarios with those founders? Let's say there aren't. Do you just tell them, go work it through, talk to legal?

I mean it really depends. Like some funds will come in and they will buy out prior shareholders just to clean things up. Some funds will just say, yeah, you go figure it out. We're not going to clean up your messes. Right. So it really just depends on how much conviction the venture fund has around the investment opportunity.

My personal opinion is again, not some.

People, they just let it ride too. And they're just like, well, you know.

If it happens, just to know a risk.

Just a risk. Yep. That's why you do a lot of legal due diligence and you hire a really good law firm to go through and review all of the docs and so forth to make sure everything is in order before you invest. And that's also why it's really important as a founder to get good legal counsel early on. And the reality is like so many top firms will basically provide almost free legal service for the first few years to make sure everything's set up right because they know it will save a ton of headache and cost later on. So in my opinion, there's really no good excuse for not working with a good attorney very early on in the process.

I think I look at legal, one of the things my dad taught me early on is that legal is there ultimately to protect friendships and it's to properly document what happens. And one of my personal mentors, Jared Richards, back before he was an attorney and he became a founder, his point was, is that do not, if you get an investor, the deal is never final until you have both the cash in the bank and the contract signed. And if the cash comes and the contracts hasn't been signed, do not touch that money.

Yeah, I think that's right.

And so I think there's just general rules with accredited investors you should follow. Also, I think if someone's not accredited, there are hidden costs that come from taking 20 or 50,000 from Uncle Joe. I think as a, as a founder and a first time founder, you're trying to do anything you can to succeed. But anyone who has, if their investment represents a significant portion of their net worth and they put it into you, that's going to be a lot of stress that you personally have to deal with. And considering most startups go under, I know several founders that have lifelong burdens where they feel like their family no longer loves them or appreciates them because they've lost the family nest egg.

Yep, yep.

And it was while they're in their early 20s, early 30s.

Yeah. And generally, like my advice to people is don't invest. I mean, these are illiquid assets, whether you're investing in a company or a venture fund. Or whatever. Like, you should never really invest cash into high risk investments that you can't afford to lose. You shouldn't. You also shouldn't like put all of your eggs into one basket, right. That nest egg, right. Because you never know. Things, life happens, things happen, it can wipe you out really quick. I like the strategy of what's called the barbell strategy, where it's just an interesting intellectual exercise where basically you put 90% of your capital, your nest egg, into something like gold that just never loses value. Right. Or you put it under your mattress or what have you, and then you put the other 10% into the like craziest, riskiest, but highest yield potential investments you can. Because if you lose 10% of your net worth, it's not going to like ruin your life, but if that 10% suddenly became like a thou generated like a thousand X return, that would meaningfully change your life. Right. So it's just being smart about how much you're risking and to a certain extent, to your point, right, like, you shouldn't take money from investors. Like, you should be, in my opinion, you should be very clear with them about like what the risk profile is of the investment. And you shouldn't take, you know, 50 grand of Uncle Joe, 75k of retirement savings for your startup. You just shouldn't. Right. It's irresponsible in my opinion. And so I think it's important, you know, partially because, like, yeah, you don't want the risk. You don't want to have awkward Thanksgiving dinners. Right.

Or no Thanksgiving dinners.

Like, no Thanksgiving dinners you could get canceled. But also like it, you know, you shouldn't be, you shouldn't be, you shouldn't be putting Uncle Joe in that position to begin with. Right?

So, but what if you want to win, Peter, you want to win?

Well, then go find, you know, go hit up Uncle Joe for five grand and go find, you know, uncle and aunts and friends and cousins and intro, you know, to other people and raise the money from, from those people.

Yep. And then to conclude my point is, again, as a final reminder, no matter who you're taking money from, no matter what deal you're doing in the business world, make sure it's always properly documented through legal and or financial advisors.

Yep, I agree.

All right, go to Venture Capital fm. Leave questions below if you want to know more about accredited investor topics. And we will be going on to our next episode. Go to Venture Capital FM. Subscribe Like Comment Follow us on Instagram LinkedIn. We want to be connected to you and help you guys out.

Thanks.