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May 01, 2007

SEC Rules on "Accredited Investors"

While doing some research on angel investors, I came across an SEC rule that made me wonder how useful it actually was.  Rule 501 of Regulation D regulates who is able to be labeled an "accredited investor" so that a company raising private capital does not need to register with the SEC.  When looking through the requirements, I was surprised to find the income and asset limits the SEC places on companies that take capital on the private market.  Using these requirements, neither of my parents would be able to invest in a company I create without being first affiliated with the company as a director or employee.

Considering one of the best sources of capital can sometimes be friends and family initially, if you want to give equity to them instead of taking out a personal loan, I wonder how many people run into the problem of not knowing anyone rich enough to invest in them.  For example, if someone were to try to raise the money from a group of friends and family without naming all of them directors, they would have to register with the SEC.  With small investments such as this, the majority of the population is kept out of private equity investments in firms started by friends and family.

Not only is the average person barred from investing in their friends' business without a directorship or employment, but they are barred out of the another high-return asset class, hedge funds.  I agree with the comments in the article that just because you aren't a millionaire doesn't mean you should be disqualified from investing.  Having an asset threshold seems a bit arbitrary, more arbitrary than say one based-on IQ or education-level would be (not that I would advocate for one). 

Even with its intentions of protecting the average investor, the government isn't protecting the rest of the investing public though by having "accredited investor" rules.  It's merely ensuring that the average person will not have access to the asset creation vehicles that the rich have access to.  With so much debate over the rich-poor income/asset divide, you would think politicians would want equal access to investment products for every American.  If every American has access to all wealth generation products, then they should achieve the same returns on average, allowing the average person who is financially responsible to keep pace with their wealthier counterparts.

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Comments

Justin. Some thoughts on your recent blog entry. You bring up a good point when it comes to companies raising capital. You also brought up the point of Hedge Funds. In my opinion, the reason why hedge funds exist today and are allowed to have so little transparency is because there are large barriers to entry. If anyone could invest in hedge funds, they would be extremely regulated and would cease to be as successful as they are today, thereby defeating the point. Just my thought...

I understand that hedge funds are able to get the returns they do, because they do not have the disclosure requirements and are less regulated than say mutual funds. Although, why should the government arbitrarily keep middle America from investing in them just because of their wealth?

It would seem to be more just to allow all of America to invest in hedge funds, with the current regulatory regime (or lack thereof), and let each person decide how much risk they are willing to take. In many respects, small technology companies are much more risky than hedge funds, but anyone can buy one of their shares on the NASDAQ.

My take on it is that hedge funds are extremely risky when you don't know what you're doing; that is, what exactly you're putting money toward in the hopes of gaining a profit. Because the majority of people who call themselves investors are in fact simple traders--or worse, outright gamblers--the SEC seeks only to protect those that don't have the proper training to make it big in the sophisticated and unregulated investment world.

I'd say this is analogous to sky-diving certification requiring a certain number of tandem jumps before you can go solo. The fact is that plenty of people would read a book about sky-diving (or listen to a friend's crash course) and think they're plenty prepared to jump alone. The certification/training programs protect them from their own ignorance, just as the SEC requirements protect risky investors from being swindled.

As for your original point, I would agree that there is a rich/poor divide, which probably means that your first business would not be SEC-registered because you wouldn't be able to get proper (read: rich-person) funding. However, once it caught on and you started turning the right heads, I think registration could happen if your business met the income or net worth requirements that the SEC has in place.

I really like the sky-diving analogy. It helps to make the idea a bit more vivid, although I don't think it the best analogy for investing. I can see how a sky-diving certification could be a great thing to have, because you have a very real risk of dying when you jump out of an airplane. On the other hand when investing, you don't have a risk of dying, just losing a bunch of fiat money, which could be your life's worth, but that's the assumed risk when investing your money. There is a very real chance that you could lose everything. This systematic risk is why stocks yield a greater return than government bonds over the long-term.

Actually with regards to SEC registration, I would have to become SEC registered because I was not rich-person-certified, whereas another entrepreneur that was rich-person-certified would not need to register with them. This places an undo hardship on small/startup business owners that do not have the connections with the wealthier segments of society, i.e. probably the top .5% or .1%.

Your perspective on the stock market is an accurate one, but I don't believe that even 25% of the population holds the same perspective on why stocks do as well as they do. An embarrassingly large majority of people will take "insider tips" from their weekly e-mails and invest on the hope of getting rich quick, just like millions of people try a new fad diet every day, thinking it will bring them the effortless results they desire. People don't ask questions as to why the stock market can be so profitable; they only know that it can be profitable, and that it is a ticket to success for many people.

This propagation of misinformation is exactly what the SEC regulations protect against. Granted, there will be accredited investors who still don't have a clue what they're doing, but the assumption is that if you're able to maintain $1m net worth or $200k annual income, then you probably know a thing or two about money. It's a restriction based on what people have, not what they know, but I also think it's impossible to assess what people know without administering some sort of test. And then you have people who are bad test-takers, but great investors, and the need to score the tests, create new questions every year, prevent cheating, etc. It's much more cost-efficient for the SEC to make the cutoff a simple one, even sacrificing accuracy to do so.

And I didn't know that about the SEC registration. That really sucks if your family was going to be willing to help you out. From what Kiyosaki talks about, though, small-cap businesses are the most profitable on the market, so I don't think you'll have any difficulty getting the funding you need once the project is off the ground.

This is just one more piece of evidence that the rich do in fact write the rules.

With all the variables listed as to why administering an actual test would not be practical, I'm still failing to see how the arbitrary rule benefits everyone. Why is there no such rule for people to gamble? Just because something carries a financial risk with it doesn't mean the government should determine who it believes should be allowed to invest.

When investing in a start-up company, I'd be surprised to see people think that they have a more than likely chance of making money. Everyone knows that entrepreneurship is one of the riskiest areas of business, and that's why people that make it are looked up to and respected for their skills. I wonder how many more businesses would potentially be launched in the United States without the rule? Allowing this class of people to invest would also give them the opportunity to practice further scrutinizing business opportunities and could improve their investing ability in the stock market.

On a parallel note, what if instead of having the rule of investing in businesses, what if the government created an arbitrary rule that said you could not start a company without a $200k annual salary or $1m net worth? I'm pretty sure the American entrepreneurial machine would slow down immensely with such a rule, considering 18-24 year-olds in the United States are more entrepreneurial than
35-44 year-olds.

http://www.nytimes.com/2007/06/14/business/14scene.html

That's not say they bring about disproportionately more innovations or capital gains at that age. But with the experience they gained in their youth, I bet it leads to a disproportionate amount of gains later, whether they start more companies or go corporate.

And deliberate practice is what leads to success at the work you do (whether it be investing, entrepreneurship, or dancing).

http://money.cnn.com/magazines/fortune/fortune_archive/2006/10/30/8391794/index.htm

I found an article I was looking for for the last comment. :-)

At the page is a synopsis of an interview with Gates and Buffett.

http://www.smallbusinesshub.com/blog/tabid/6307/bid/41/Learning-From-The-Legends-Quick-Insights-From-Buffett-and-Gates.aspx

"Buffett on predicting success: He quoted an interesting study he had seen that tried to correlate "things" (i.e. business school, grades, athletics, etc.) with future business success. The study found that the thing that most closely correlated with future success was the inverse of the age at which you started your first business (i.e. paper route, lemonade stand, painting co, other)."

Getting more people to start early could spur greater business success in our country. :-)

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