Forcing Small Investors Out of Big Opportunities: The SEC’s 99 Investor Limit
At TinySeed, we are in the process of raising the second fund for our SaaS accelerator, and we’re often asked why we have such a high minimum investment. If an accredited investor wants to put in $50,000, why would we turn them down?
It all comes down to SEC regulations, which limit funds like ours to a maximum of 99 accredited investors. In order to raise the amount of capital required to execute on our investment thesis, we must enforce a (relatively) high minimum investment.
We didn’t write this article to complain about our situation, as fundraising (even with this minimum in place) is going quite well. But for us, this process has brought to light an unintended consequence of this 99 investor limit.
Over time, successful venture firms raise larger and larger funds, quickly running into the 99 investor limit, and forcing their investment minimum higher. These high minimums concentrate this wealth creation opportunity to super high net worth individuals and institutional investors, excluding accredited investors who cannot afford to write such a large check.
The SEC enforces certain kinds of regulations to provide investor protections against fraud and abuse, which we salute. However, current regulations (and this 99 investor limit) prohibit the average accredited investor from accessing these markets in a meaningful way. This matters because the private markets are a significant driver of wealth creation.
We fully understand that the SEC needs to have some limit on the number of investors that can invest in a private fund. However, we believe that the current limit of 99 is the wrong approach.
We started TinySeed because we wanted to give founders more options for capital to grow their companies, and we feel that as a fund, we can and should also call for change in how sophisticated investors are able to invest their money.Specifically, we believe that successful tech founders and operators should be able to invest into the field they understand best — early stage technology — instead of being limited to real estate or the public markets.
We believe funds like ours should be able admit up to 1999 accredited investors, assuming they are required to make reasonable efforts to verify that investors are accredited.
As the current rules are enshrined in law, we’re exploring ways to bring this issue in front of Congress. If you are an emerging manager or stakeholder who would like to see the 99 investor limit raised, send us an email at hello@tinyseed.com.
Fund regulations and SEC rules are fairly complicated; read on for our breakdown of what everything means below:
Current SEC regulatory regime for private funds
3(c)(1) vs. 3(c)(7)
The SEC’s regulatory regime currently provides 2 exemptions to the (burdensome and expensive) requirement for a venture fund like ours to be registered with the SEC: 3(c)(1) and 3(c)(7).
A 3(c)(1) fund may have no more than 99 Accredited Investors, while a 3(c)(7) fund can have up to 1999 investors, but these must all be “Qualified Purchasers”. The qualified purchaser, or QP, definition is a significant increase in the required net worth compared to accredited investors.
Why can’t investors pool their money and create a single entity to invest?
The SEC stipulates that accredited investors cannot pool their money and create a single entity (for example through an SPV) to invest in the fund — the SEC will “look through” this entity and count the number of investors there as long as the entity was created for the purpose of making a specific investment.
Why can’t we create parallel funds?
Another often suggested option, to run several parallel funds that co-invest, is also forbidden, as the SEC will count as a single fund, any set of funds that a reasonable investor would deem to be identical.
One burdensome option: The “QP sleeve”
The only exception to the above is what’s sometimes referred to as a “QP sleeve”. A 3(c)(1) fund may operate in parallel with a separate 3(c)(7) fund. This does add significant overheads, but frees up some slots for accredited investors by moving the qualified purchasers into the 3(c)(7) (of which there can be 1999).
The recent JOBS act
A more recent change was introduced with the JOBS act, which expanded the ability of fund managers to promote their offerings publicly, with the trade-off that doing so would tighten the requirement to verify that all investors were in fact accredited investors (a 506c offering). We think these changes are laudable, as they increase awareness of specific offerings among accredited investors while also adding further, appropriate, protections.
Recent regulatory efforts to expand investment opportunities, harmonize regulations with other jurisdictions and further capital formation
The SEC very recently issued updated accredited investor definitions:
For the first time, individuals will be permitted to participate in our private capital markets not only based on their income or net worth, but also based on established, clear measures of financial sophistication.
(Emphasis ours.)
We salute this change, and even though we think the SEC has further to go in terms of widening the definition of accredited investors, it’s a great first step. This change is well inline with the SECs ongoing efforts to “simplify, harmonize, and improve the exempt offering framework, thereby expanding investment opportunities while maintaining appropriate investor protections and promoting capital formation.”
However, we believe that the current limit of 99 accredited investors per 3(c)(1) fund runs counter to these efforts.
The many downsides of the 99 accredited investor limit
The current limit of 99 accredited investors hurts capital formation, reduces investment opportunities, increases the risk to individual investors and decreases access to private capital markets for underrepresented groups.
- A fund manager can accept smaller checks from wealthier individuals, as the higher QP limit in the sleeve means that there is effectively no minimum amount required of those individuals.
- Conversely, and perversely, a fund manager looking to raise a more substantial fund is forced to ask for larger checks from the less wealthy investor, or keep that investor out of the fund entirely.
This is far from ideal and, in our experience, excludes sophisticated investors from being allowed to invest in funds like ours. In some cases these excluded investors have a deep understanding of the industry being invested into, and perhaps with atypical backgrounds as far as fund investors go. We do not believe those kinds of investors should be effectively excluded from making these kinds of investments.
Instead what happens is that as funds grow from very small (sub $10m) they are forced to seek capital from larger, institutional investors like Fund of Funds, Endowments and various Family Offices.
While these more institutional LPs are a fine source of capital, it’s undoubtedly true that they are more risk averse and in general prone to relying on a proven track record for the managers they back.
A great example of this is the University of Texas’ (laudable) Emerging Managers Program. This is a program setup explicitly to support new (aka emerging) managers, though the criteria for selection includes:
- Attributable track record within target strategy
- Investment teams with history of working together
- Principals known in the investment community and are positively referenceable
Clearly, such terms favor managers that “emerge” from existing funds. This means that the type of general partners that more easily get backing from these kinds of investors are of the same mold as GPs that already exist. New and diverse GPs with novel ways to invest are effectively locked into staying small or violating SEC rules.
Proposed solution: Allow as many Accredited Investors as Qualified Purchasers.
The oversight of private funds is light by definition, so we fully understand why the SEC imposes a limit on the number of investors. Without a limit, a fraudulent fund could become a significant issue if tens or hundreds of thousands of investors could invest.
However, we feel the unintended consequences of concentrating wealth creation to only super high net worth individuals or institutional investors with the 99 Accredited Investors limit is not the right trade-off in this regard. We propose that private funds relying on the 3(c)(1) exemption should be allowed to admit up to 1999 accredited investors, assuming they are required to make reasonable efforts to verify that investors are in fact accredited (something that is already a requirement for a 506c offering.)
If you are an emerging manager or stakeholder who would like to see the 99 investor limit raised, send us an email at hello@tinyseed.com.
Originally published at https://tinyseed.com on November 10, 2020.
