Want to Invest in Startups? Regulatory Changes May Help Make That Happen
Many private equity opportunities, from investing in startups to private hedge funds, are reserved for “accredited investors” — investors who meet specific income or net worth requirements. But regulatory changes could increase the number of accredited investors, and a recent Wall Street Journal article offers insight into why the US Securities and Exchange Commission wants to expand access to investing in startups and private placements.
To be considered an accredited investor, you need a net worth of $1 million, excluding the value of your primary residence, or annual income of more than $200,000 as an individual or $300,000 for joint filing for the past two years with an expectation that you have the same or more earnings in the current year. Currently, according to the Journal, roughly 16 million US households meet that criteria. That is up from 1.5 million when the rules went into effect in 1982.
Besides updating the rules to exclude the value of your primary residence from the calculation of net worth, the criteria to qualify as an accredited investor has not been overhauled since going into effect in 1982.
In that time, the Journal reports that the number of public companies has shrunk while private markets are growing. Sales of private equity investments and private placements are expanding as investors seek access to hot startups, like Uber or Airbnb, and look to diversify their portfolios beyond stocks and bonds.
This is a trend we are familiar with at PENSCO. For nearly 30 years, we have worked with retirement investors who hold alternative assets, such as private equity and real estate, in their self-directed IRAs. Interest in alternative assets is growing as investors hunt for consistent, risk-adjusted returns that are uncorrelated to the market. They are also looking for ways to add income or inflation protection in their retirement accounts.
Last year, $710 billion of private placements were sold through brokers, according to the Journal, representing a nearly threefold rise from 2009. This year through August, at least $500 billion has been sold.
With demand for private placements growing, the Journal said the SEC is expected to seek public comment in coming months on expanding the definition of accredited investor. An earlier report in the Journal noted that the SEC will look for ways to streamline the process for investors to be approved as accredited, and potentially allow investors who don’t meet income or wealth thresholds but have professional licenses or advanced education to be considered accredited.
Investing in Startups: The Story of Rewards and the Risks
For investors considering investing in startups or private placements, it’s important to be aware not only of the potential rewards but also the risks.
Investors should not expect overnight success, and it’s not likely that profits, if there are any, will come quickly. The average private equity holding period for US-based companies is 6.17 years, according to PitchBook data. However, that timing could work well for investors who own these private company stakes in their self-directed IRAs, because retirement investments tend to have a longer time horizon.
In addition, there are few secondary markets for trading shares of early startup companies. If extenuating circumstances arise after you make an investment in a startup, no clear means exist for you to sell that investment before the company pursues its exit — like an IPO.
There is no doubt that investing in startups has the potential to reap substantial returns for investors, especially when these investments are held in a tax-advantaged self-directed IRA. But we strongly encourage investors to work with tax, legal or financial professionals before making any investment decision and understand the potential risks.
This Blog does not provide investment, tax, or legal advice nor does it evaluate, recommend or endorse any advisory firm or investment vehicle. Investments are not FDIC insured and are subject to risk, including the loss of principal.
PENSCO Trust Company performs the duties of an independent custodian of assets for self-directed individual and business retirement accounts and does not provide investment advice, sell investments or offer any tax or legal advice. Clients or potential clients are advised to perform their own due diligence in choosing any investment opportunity as well as selecting any professional to assist them with an investment opportunity. Alternative investments are not FDIC insured and are subject to risk, including loss of principal. PENSCO is indirectly affiliated with a registered broker dealer and with a licensed small business investment company through Opus Bank (“Opus Affiliates”). Other than the Opus Affiliates, PENSCO is not affiliated with any financial professional, investment, investment sponsor, or investment, tax or legal advisor.