How Does Investing in Venture Work?

By: Gridline Team | Published: 04/28/2022
Est. Reading Time:
3 minutes

The world of venture investing can be confusing and filled with jargon and acronyms. Regulations around who can invest and how much they can invest can seem daunting, but understanding how venture investing works is critical for anyone looking to get involved in the space.

At a basic level, venture investing is investing money in a company in exchange for equity in that company. The hope is that the company will be successful and grow, ultimately leading to a return on investment for the venture capitalists.

Why Are There Accredited Investor Rules?

To invest in a venture-backed company, an individual must meet the criteria to be considered an accredited investor. The reasoning behind this is twofold.

First, the Securities and Exchange Commission (SEC) wants to make sure that investors are financially savvy and capable of understanding the risks associated with venture investing. They don't want people investing in startups blindly and losing all their money.

Second, the SEC wants to protect investors from fraud. By only allowing accredited investors to invest in venture-backed companies, the SEC can reduce the chances of unscrupulous entrepreneurs taking advantage of people.

So, what exactly qualifies someone as an accredited investor? The criteria vary depending on whether the investor is an individual or an entity, but there are generally three main requirements.

There are a few different ways to qualify, but the most common is having a net worth of at least $1 million, excluding your primary residence. Alternatively, you can qualify by having an annual income of at least $200,000 for the last two years (or $300,000 if you're married).

Note that these requirements are not set in stone and can change over time. The SEC periodically reviews and updates the criteria for accredited investors.

What Is the 99 Rule?

The SEC provides two exemptions to the requirement for private funds to be registered: 3(c)(1) and 3(c)(7). A 3(c)(1) fund must have 99 or fewer accredited investors, while a 3(c)(7) fund may have up to 1999 investors, but they must be Qualified Purchasers or those with an investment portfolio worth at least $5 million.

Originating from the Investment Company Act of 1940, signed by President Franklin Roosevelt, these statutes were "to protect investors." Just over a decade removed from the Wall Street Crash of 1929 and emerging from the throes of the Great Depression, lawmakers were looking to shield investors from high-risk investment vehicles.

Why Can't VCs Just Accept Anyone's Money?

Rule 506(c) of Regulation D of the Securities Act of 1933 states that an issuer seeking to raise capital through a private placement must take reasonable steps to verify that each purchaser of securities is an accredited investor.

To verify that an investor meets the requirements to be considered accredited, VC firms may require potential investors to provide documentation such as tax returns, bank statements, and proof of income.

This may seem onerous, but it's important to remember that VC firms invest other people's money. As such, they have a fiduciary responsibility to their investors to only invest in companies with a high likelihood of success.

By only allowing accredited investors to invest, VC firms can avoid putting their investors' money at unnecessary risk. Gridline is a 506(c) fund, which means we can only accept accredited investors. Through Gridline, accredited investors can gain exposure to a diversified portfolio of venture-backed companies with low capital minimums and transparent fees.

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