Why Accredited Investor Rules Widen Wealth Gaps

6 reasons why accredited investor rules for venture capital make no sense

Billionaire hedge fund manager Ray Dalio makes a compelling case for why empires rise and fall in his new book, The Changing World Order.

He cites several factors for why the Dutch and British fell from their perch, and how the United States faces a similar downwards trajectory today.

  • Economic downturns — largely a result of overspending.
  • The currency devaluations that follow.
  • Declining productivity and innovation.
  • External conflicts and threats.
  • And internal conflicts — owing to large wealth gaps.

And if growing wealth gaps that sow internal dissent, conflict, and ultimately, set the stage for civil war, are a key contributor to such downfalls, shouldn’t the United States and other western countries do what they can to address wealth gaps, instead of systemically widening them?

The Accredited Investor Rule in Venture Capital

This systemic widening shows up in myriad ways, but as someone who has worked in the early-stage startup ecosystem since 2013, the one addressable way I wish to highlight is the accredited investor rule as it applies to investing in a venture capital fund.

Let’s break that down.

  • A venture capital fund typically invests in early-stage companies that demonstrate high growth potential.
  • An investor in a venture capital fund is typically referred to as a ‘limited partner’.
  • To become a limited partner in most jurisdictions, such as in the United States, Great Britain, or Australia, requires that you are accredited.

While the rules vary across jurisdictions, to become accredited in the United States you need to demonstrate:

  • an income of more than US$200,000 in each of the past two years, or
  • an individual (or joint with a spouse) net worth of US$1 million or more, excluding primary residence.

Given that almost 60% of Americans don’t have more than US$1,000 in savings, or that the average American makes just US$52,000 a year, this rule excludes the vast majority of Americans from getting exposure to high-growth early-stage startup investing opportunities.

Protecting the Poor?

So why was the accredited investor rule established, to begin with? At its core, it was introduced to protect less-knowledgeable, individual investors from devastating losses.

This seems noble enough, but when you dig a little deeper for all of its nobility, it makes little sense and is actually counterproductive.

And here’s why.

6 Reasons Why The Rule Makes No Sense

1. Limited Partners Don’t Actually Make Investment Decisions

Limited partners typically don’t decide which startups a venture capital fund invests in. They simply invest in the fund itself and leave the decision-making to the alleged sophisticates running the fund (the general partners). The general partners are tasked with deploying their vast experience, performing due diligence, and acting in the best interests of limited partners.

It is one thing to prevent everyday mom and pop investors doing their own research and dropping $20K into their next-door neighbor’s teenage son’s video game on the back of a napkin idea, but it’s another to prevent them from investing their hard-earned it into a venture fund where they’d get exposure to a diversified portfolio of startup investments vetted by professionals.

2. Venture Capital Returns Beat Property and the Stockmarket

While returns vary wildly across funds, they target an annual return (excluding external factors such as inflation) of between 20–30%. And according to Pitchbook, average annual venture fund return, or IRR, for Q1 of 2021 was 19.8%. Zooming out, the average annual return for VC funds in the ten years to 2021 was 20.09%. This is based on an index of data from over 1,500 venture capital funds.

Meanwhile, the average S&P500 return for the ten years to 2021 was 9.2%, and the average annual return on residential real estate investments is typically between 7 to 10% — both investments that unaccredited mom and pop investors can freely make.

3. No Rules Against Credit Cards, BNPL, Penny Stocks, or the Casino

If the regulator really was so hell-bent on protecting everyday people, then they clearly haven’t spent enough time thinking about a) high-interest credit cards with large limits, b) buy-now-pay-later services such as AfterPay that help people buy what they don’t need with money they don’t have, c) roulette and blackjack tables, or d) penny stocks.

Heck, forget penny stocks — you could have legally purchased a blue-chip such as NFLX two weeks ago and today your investment would be worth 50% less.

4. Investing in the Future Should Be Encouraged

The reason why most Americans have less than US$1,000 is attributable to myriad factors, however, one factor that plagues human beings, in general, is a tendency to optimize for the present over the future.

But it was our species’ learned ability to delay gratification, to invest in the future, to plant seeds and reap the harvest tomorrow, that was fundamental to our evolution and growth.

In life, the person who saves more than they earn, and chooses to invest it instead of blowing every paycheck on material possessions and experiences is far more likely to succeed. If an unaccredited investor wants to take a bet on early-stage innovation instead of rack up a larger credit card bill, or buy some emotion-laden trinket, shouldn’t we be encouraging that?

5. Diversification Beats Direct Investment

Venture capital funds typically invest in a portfolio of startups. A US$10 million fund, for example, might make 50 investments. The reason for this is two-fold. First, early-stage startup investing is inherently risky. No matter the quality of the management team or the idea, there are so many known unknowns, and unknown unknowns, that can knock a startup off course.

The odds are stacked against them, and for every 10 investments that a fund makes, 1 or at most 2 will turn out to be home runs, 3 or 4 might be base hits, and the rest will go to zero. It is the home runs that bear the brunt of covering the losses and deliver what is, on average, a 20–30% annual rate of return for the entire fund.

Giving everyday investors an opportunity to get exposure to a diverse portfolio of startup investments, as opposed to investing in one or two directly — which is legal via equity crowdfunding sites, is actually a much safer bet.

6. Fueling Productivity, Innovation, and Competitiveness

Finally, if we want to support productivity and innovation, and avoid the economic demise that inevitably comes with flagging innovation, then the more capital that we can welcome into early-stage startups and innovation, the better off we will all be in the long run.

The world is going through tumultuous and rapidly evolving times, both on an economic, geopolitical, and technological level.

Jurisdictions that make it easier for the general population to invest in a diversified portfolio of early-stage innovation will have a better chance of closing wealth gaps, boosting innovation, keeping a lid on internal conflict, and ultimately, thriving as free and open societies.

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