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What is a qualified investor in simple terms?
What are the essential elements you should know!
In this article, I will break down the meaning of Qualified Investor so you know all there is to know about it!
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What Is A Qualified Investor
A qualified investor is a person or legal entity that, due to the investor’s net worth and income level, is qualified to purchase securities that ordinary investors will not have the ability to purchase.
For a person or entity to be considered a qualified investor, there are qualified investor rules and requirements that must be satisfied.
The main advantage for companies to sell securities to qualified investors is that they are not required to register the securities with the SEC.
Since qualified investors are more sophisticated investors, they are permitted to make riskier investments and have a reduced need for legal protection.
Securities And Exchange Commission
In the United States, the Securities and Exchange Commission (or the SEC), Rule 501 of Regulation D sets out the qualified investor criteria to be met.
Since qualified investors are considered to be “sophisticated” investors, the SEC allows them to make riskier investments without having to offer them the same level of protection as the general public who may have little to no investment knowledge.
When selling securities to qualified investors, the SEC’s role is to establish the rules as to who meets the financial test and has sufficient investment knowledge and experience to be able to buy unregistered securities.
When companies sell securities that are not registered with the SEC, they can only sell them to qualified investors.
Qualified investors are a class of investors that are considered to be financially stable, experienced, and knowledgeable to assume a higher level of risk.
When companies offer nonregistered securities to qualified investors, the offering is considered to be a private placement.
A private placement is a type of investment that is not accessible to the general public as the shares are bought and sold are not registered with the SEC.
Be sure to keep reading as I will break down the qualified investor requirements so you know exactly who is eligible as such.
Qualified Investor Definition
How do you define qualified investor?
In essence, the formal definition of a qualified investor is given by the SEC under Rule 501 of Regulation D.
For most, the definition of qualified investor can be broken down as:
- An individual having a gross income over $200,000 a year for the past two years and expecting the same or higher income in the future
- An individual and spouse having a joint income of $300,000 a year for the past two years and expecting the same or higher income in the future
- A person whose net worth, individually or with a spouse, is over $1,000,000 excluding the primary residence
- A person showing professional knowledge or having sufficient relevant education in understanding unregistered securities
Qualified investors are individuals who have a high level of income, high net worth, or sufficient knowledge and experience in dealing with unregistered securities.
Since qualified investors are financially more stable and have more investment knowledge, the SEC is comfortable in letting them make riskier investments without having to provide them the same level of protection as the general public.
Why Have An SEC Qualified Investor
The SEC has defined an investor calls called the “qualified investor” separating them from the general public.
In essence, the SEC has two fundamental roles:
- Protect the public and safeguard investors in general
- Promoting investments and entrepreneurial activities
Protecting the public means that the SEC must adopt stricter rules relating to the securities offered to the general public.
Promoting investments means that the SEC must relax some of its rules allowing investors to take on more investment risk.
To balance these apparently conflicting objectives, the SEC has created a “qualified investor” class where individuals who are financially well-off or have a high level of investment knowledge are permitted to purchase unregistered securities.
This means that companies are exempt from registering the securities with the SEC when they intend to sell to sophisticated investors.
In this fashion, the general public is protected as they are not able to invest in unregistered securities and the more sophisticated investors are given the freedom to invest in riskier stocks encouraging entrepreneurs and early-stage companies to raise the capital they need to grow their business.
Pros And Cons of Being A Qualified Investor
Just like most things in life, there are advantages and disadvantages to being considered a qualified investor.
For the investors, the main advantage of being legally considered a qualified investor is that you can purchase unregistered securities that are not available to the general public.
For the companies issuing securities, the main advantage of selling shares to a qualified investor is that they are not required to provide the legally required disclosures and go through a costly process of registering the securities with the SEC.
Qualified investors therefore benefit by having a wider range of investment options allowing them to tap into opportunities before the general public can access them.
On the flip side, being a qualified investor also has disadvantages.
For the investor, the main disadvantage is that purchasing unregistered securities are inherently riskier as the issuer is not required to make all the legally required disclosures to the investor.
For the companies, it’s important to ensure that they are effectively selling shares to a person or entity that is legally considered a qualified investor to avoid triggering the fines and penalties for violating the SEC rules.
Qualified Investor Requirements
Some investors can be considered “qualified investors” under the SEC rules allowing them to purchase non-registered securities.
Now, what are the requirements to satisfy to be considered as an SEC qualified investor?
Type of Investor
To start with, let’s see who can be seen as a qualified investor SEC?
A qualified investor can be an individual, company, financial institution, trust, corporation, nonprofit business, insurance companies, brokers, investment advisors or any other type of company.
A business development company or entity with assets exceeding $5 million can be considered an accredited investor.
In addition, a general partner, executive officer, or director of the company issuing the unregistered securities can also be considered an accredited investor.
A person or entity can be considered a qualified investor if it has a high level of knowledge and enough assets to be able to understand the investment risk and financially assume the investment (this is considered the knowledge test).
Other factors can also be considered to determine that a person can trade unregistered securities, such as a person’s professional experience and education.
Alternatively, a person having an annual income over $200,000 individually or $300,000 of joint income with another during the past two years and having the expectation to be at the same or above this threshold going forward can qualify as a qualified investor (this is considered the income test).
When a person has gotten married during the income test period or has a net worth over $1,000,000 individually or jointly, the income test will no longer be necessary to satisfy.
Investor Net Worth
A person who has a net worth of over $1 million either individually or jointly with a spouse can be considered an accredited investor.
How To Be Considered A Qualified Investor
A person or entity does not have a specific process or formality to observe with the SEC to be considered a qualified investor.
Typically, the issuer or entity issuing the unregistered securities will verify that the investors participating in the private placement meet the SEC eligibility criteria.
In most cases, the issuer, their financial advisor, or attorneys will provide the investor with a questionnaire helping them determine if the person is eligible or not.
Investors will need to answer questions relating to their income, net worth, investment knowledge, and other related questions to validate their eligibility as qualified investors.
Companies can also ask for supporting documentation such as financial statements, copies of tax returns, credit reports, or other evidence demonstrating that the investor meeting the SEC requirements.
Qualified Investor vs Accredited Investor
What is the difference between a qualified investor and accredited investor?
Today, the terms qualified investor and accredited investor are used interchangeably both referring to a type of investor able to purchase unregistered securities.
Qualified or accredited investors are high net worth individuals or entities, high-income earners, or individuals having financial sophistication to understand the risks and rewards of purchasing unregistered securities.
In the past, there was a nuance that could have been made between qualified investors and accredited investors.
In fact, prior to the Dodd-Frank reform, to determine the accredited investor status, you could have used the value of the investor’s primary residence.
On the other hand, you could not use the value of primary residence to qualify an investor as a qualified investor.
However, today, the value of the investor’s primary residence is excluded in calculating net worth.
As a result, if you qualify as an accredited investor, you are also qualifying as a qualified investor.
Qualified Investor Example
Let’s look at an example of an investor and see if this person could be viewed as a qualified investor or not.
Imagine John with the following characteristics:
- John is not married
- Has an annual income of $175,000 for the past four years and expects the same income level for the future
- Has a primary residence having a net worth of $1,200,000
- Has investments of $900,000
This investor will not be considered a qualified investor as John does not pass the income test and has a net worth of $900,000 excluding the primary residence.
However, imagine Mary having the following characteristics:
- Mary is not married
- Has an annual income of $250,000 for the past three years and expects the same income level for the future
- Has a primary residence having a net worth of $750,00
- Has investments of $1,100,000
Mary will qualify as a “qualified investor” as she has a net worth over $1,000,000 excluding the primary residence.
She also qualifies based on the income test as she has an income over $200,000 for the past two years and expects the same income level going forward.
Qualified Investors Takeaway
So there you have it folks!
What Does Qualified Investor Mean
In essence, qualified investors are individuals or entities that are permitted to purchase securities that are not registered with the regulatory bodies.
The Securities and Exchange Commission sets out the rules relating to who can be considered a qualified investor.
There are several factors that must be satisfied by a person or entity to be viewed as a qualified investor such as having a high income, high net worth, experience, and other.
Now that you know what is a qualified investor, why the SEC has created this investor category, its requirements, and why it matters, good luck with your research or private placement!
Remember, if you are making investment decisions, you should consider consulting an investment advisor or securities lawyer for advice so you can adequately appreciate your investment option.
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