I remember back in 2004 when I was putting together my first private equity fund.
I owned a mortgage company at the time that specialized in brokering loans to real estate investors.
Closing a mortgage for an investment property is very different (and a hell of a lot more difficult) than closing a mortgage for a primary residence and we were good at finding loan programs that were a good fit for for our real estate investor clients.
The problem for us and our clients was that most lenders don’t like to make loans on vacant houses or houses that need a lot of repairs.
And when you’re an investor, that’s pretty much all you look for.
Our clients were increasingly turning to “hard money lenders” to purchase the houses and then coming to us when the work was finished to refinance the hard money loan into a more suitable long-term mortgage.
These hard money lenders were local guys who had cash of their own and cash from their investors to make high-cost, short-term, construction loans.
The hard money guys back in the day were charging 4 points and 15% interest for a 6 month loan!
What the What?!
On a loan of $100,000, 4 points is 4% of the loan amount or $4,000 and the monthly interest payment at 15% came out to $1,250 a month.
And that was business that I wasn’t getting.
So, I met with a local hard money lender, Ed, and asked him to teach me to make these hard money loans.
I created the loan program, the underwriting guidelines, and went out to raise money from my friends and family to fund the loans.
I lined up 15 people – friends, family, and acquaintances – who had varying amounts of capital willing to invest it in my loans for a return of 7.5%.
And as real estate investors came in to borrow money under our new hard money loan program, I would go to the next investor on my money list who had enough available cash to fund the loan.
Joe needs $170,000. Peggy has $170,000. Match made.
One borrower to one investor.
I did these “one to one” deals for a few years until I realized that I needed to attract more capital and get more efficient at deploying it.
So, as I mentioned earlier, in 2004 I decided to put together my first private equity fund.
It’s called a “private placement” and I had to work with an attorney to develop the private placement memorandum, and all of the other required disclosure documents for my fund.
I was excited because I was only putting together a $3.5 – $5 million fund and from my 15 investors, their referrals, and some institutional capital I had lined up I figured it was a no-brainer to be able to get my $5 million.
The attorney drew up the documents and walked me through them.
He told me that the rules stipulated I could solicit investments only from accredited investors.
I was like, “what the hell is an an accredited investor?”
And that is when I learned the hard way that only 2 of my 15 investors could actually invest in my new fund.
I was angry that day, and I’m still angry today that most of the best private investment opportunities are only available to accredited investors.
So, let’s explore that.
What Is An Accredited Investor?
In the United States, to be considered an accredited investor, you must have a net worth of at least $1,000,000, excluding the value of your primary residence, or have income at least $200,000 each year for the last two years (or $300,000 combined income if married) and have the expectation to make the same amount this year.
According to the Securities and Exchange Commission (SEC), only about 8.5% of the US population meets the accredited investor requirements.
The government basically uses this rule to “protect” ordinary people from investment scams.
But what it does instead is prevent ordinary people from investing in lucrative opportunities that only the rich historically have had access to.
These opportunities include hedge funds, private equity, and venture capital.
So, the guy who Jeff Bezos first pitched to invest in Amazon, just like my private equity fund, had to be accredited or he missed out.
You Don't Want to Be the Guy Who Missed Out on Investing in Amazon
Amazon was bootstrapped with about $300,000 in initial capital and the first investors were all family…
In One Click: Jeff Bezos and the Rise of Amazon.com, they detail the early fundraising that Amazon did after Bezos and his family's initial investments.
The first check was Nick Hanauer, who put in $40,000.
Then came checks from Tom Alberg for $100,000 and Eric Dillon (a Seattle area stockbroker for Smith Barney).
All in, Bezos raised $981,000 in 1995 from 20-23 angel investors, with the typical check being $30,000.
Now, imagine for a moment if Jeff was one of your friends back in the day and came to you with this amazing investment opportunity…
… and you were prohibited from investing because you didn’t meet the government’s ludicrous, arbitrary net worth or salary requirements.
According to Bezos, the first few angel investors, who put in an average $30,000 each got a stake of a little less than 1% of the company at the time.
If those early investors had held on to their entire stakes, and those stakes had never been diluted by later investors, they would be worth $3.5 billion today.
A return of 70,000x.
I’d be pissed if I missed out on that.
And you would, too.
How the JOBS Act Changed the Rules
The Obama administration thought this was BS, too so the issue of opening up deal flow to non-accredited investors was addressed in Title III of the Jumpstart Our Business Startups (JOBS) Act.
The JOBS Act was designed to help small businesses raise capital by easing certain securities regulations, and although the legislation was signed in 2012, it required the SEC to write new rules.
And they are frigging slowpokes.
The equity crowdfunding portion of the act that applies to non-accredited investors—known as Title III (Regulation CF)—became effective May 16, 2016.
By opening up equity crowdfunding to non-accredited investors, Title III gives small businesses and early stage startups an alternative method of raising capital in addition to bootstrapping, friends and family, angel investors and small business loans.
It's called crowdfunding.
With as little as $10, but more often $100 to $500, investors can now put their money into a startup that they believe can be the next Amazon, Apple or Facebook.
But this still isn’t a free for all of non-accredited investors gone wild.
Although, that would be fun to see.
The SEC placed limits on non-accredited investors because they're the government and it's what they do:
- If a non-accredited investor has an annual income or net worth of less than $100,000, then the investor can invest the greater of $2,000 or 5 percent of the lesser of his or her annual income or net worth.
- If the investor has more than $100,000, then the investor can invest 10 percent of the lesser of his or her annual income or net worth.
Mark Cuban and I Are On to You, SEC
I closed my mortgage company and my private equity fund back in 2008, and now I'm a financial publisher.
My job is to seek out and research great investments and share them with my subscribers.
And I absolutely LOVE it but as I search for real estate specific investments for my passive real estate investing newsletter, Real Passive Profits, I still see a huge number of private investments that exclude non-accredited investors.
I wondered how many accredited investors subscribe to Real Passive Profits, so I surveyed my subscribers and here's what I discovered…
Only 19% of my Real Passive Profits subscribers are accredited! Which makes what I do even more valuable – finding great investments for them to consider whether they're accredited or not.
How to Become an Accredited Investor
There is no agency or institution who confirms the accreditation of an investor, and no certification is issued.
The SEC requires that anyone soliciting an investment from accredited investors must verify their status.
This is usually done with a formal investor questionnaire that includes financial statements, tax returns, or W2’s as proof.
Because I work with many entrepreneurs and small business owners, a question that comes up a lot is “does equity in my business count toward accreditation?”
And the answer is yes.
So, that may be one way to become an accredited investor.
And just this month, the US House of Representatives passed the JOBS and Investor Confidence Act of 2018, known as the JOBS Act 3.0.
This bill is comprised of 32 pieces of legislation that have passed the Financial Services Committee with broad support.
In fact, the bill passed with a vote of 406-4.
So, yeah. Broad support is an understatement.
From the press release…
“The JOBS and Investor Confidence Act of 2018 will help sustain 3% economic growth and ensure we are able to compete globally with countries like China. By helping entrepreneurs access the capital they need to launch their companies and to go and stay public, this bill ensures that America’s garages have fewer old cars and more new startups,” said Financial Services Committee Chairman Jeb Hensarling (R-TX).
“The small businesses of today become the Amazons, Googles and Microsofts of tomorrow. Thanks to the hard work of Members on both sides of the aisle – especially Ranking Member Maxine Waters who worked so strongly and fervently on a bipartisan, cooperative basis – this bill will make a difference for economic growth for all Americans.”
The Fair Investment Opportunities for Professional Experts Act included in the bill modernizes the definition of accredited investor so those who do not have a high income or high net worth but do have the education and job experience to evaluate investment risks and merits can invest in private companies.
So, if you’re not an accredited investor yet, you now know exactly what you have to do (and be) to qualify.
And if you are an accredited investor, log off and start looking for the next Amazon!