Small businesses, such as startup companies, may choose to raise capital through a nonpublic offering, also called a private placement, when their capital needs exceed what might be available through other channels (such as bank loans, personal credit cards, or loans from friends and family). Public companies also may raise capital using private placements to benefit from lowered transaction costs and raise funds more quickly than in the public market. Private placements generally involve issuers, placement agents or finders, qualifying accredited investors, and regulators. Issuers. Issuers include private and public companies, and pooled investment vehicles such as hedge, venture capital, or private equity funds. Placement agent or finders. Issuers may employ placement agents (who are registered with SEC, the Financial Industry Regulatory Authority, or states) and finders (who are unregistered with regulators) to access accredited or other qualified investors. Qualifying accredited investors. Qualifying accredited investors can be individuals or institutions. Some individual accredited investors, called angel investors, invest in early-stage start-up companies with high growth potential. Other qualifying accredited investors, such as venture capital funds that invest in start-ups at later stages of development, are institutional accredited investors. Regulators. SEC and state regulators have some oversight over the offering and sale of private placement securities. SEC generally limits its enforcement activity to fraud and does not conduct reviews of offering materials or verify accredited investor status. State regulators play a role in investigating potential fraud in private placements and enforcement after the securities have been sold in their state for certain exempted securities. Regulation D defines accredited investors and describes certain terms and conditions of offers and sales of private placements securities. Under Regulation D, accredited investors consist of institutional entities and individuals. Institutions that qualify as accredited investors include certain regulated financial institutions and certain entities with total assets of $5 million or more. Individuals who qualify as accredited investors are directors, executive officers, and general partners of the securities issuers, or persons who have a minimum annual income in excess of $200,000 ($300,000 with spouse) or net worth in excess of $1 million excluding primary residence (see fig. 1). The focus of this report is on individual accredited investors. Regulation D establishes registration exemptions, with the exemptions differing in the size of offerings, the number and type of investors, or both. These exemptions are described in Rules 504, 505, 506. Under Rule 504, the maximum dollar amount of the offering is $1 million in any 12-month period and no limit is set on the number of investors. Under Rule 505, the maximum offering is $5 million in any 12-month period and unlimited number of accredited investors and up to 35 nonaccredited investors may invest. Under Rule 506, there are no offering dollar limits and an unlimited number of accredited investors and up to 35 nonaccredited sophisticated investors may invest. Offerings made in reliance on the rules cannot solicit investors through any form of general solicitation or general advertising. SEC staff has indicated that an issuer would not contravene the prohibition against general solicitation if the issuer had a preexisting and substantive relationship with the investor. Of the three rules, Rule 506 is the most widely used exemption because there is no limit on the size of the offering or the number of accredited investors. Further, according to a GAO report, complying with state securities registration requirements for other exemptions may play a role as to why issuers rely more on Regulation D. SEC data show that businesses make more Regulation D offerings than registered public offerings (see table 1). Regulation D is designed to (1) eliminate any unnecessary restrictions SEC rules place on small business issuers, and (2) achieve uniformity between state and federal exemptions to facilitate capital formation consistent with investor protection. The accredited investor standard, which is used to adjust exemptive conditions under Regulation D, has undergone several changes since its adoption in 1982. As shown in figure 2, the qualifications for investment in private placements securities went through several interpretations and changes. For example, in 1953 the Supreme Court ruled that the applicability of registration exemptions depended on whether the purchasers of securities could “fend for themselves.” In 1974, SEC adopted Rule 146, a predecessor to Rule 506, which stated that investors were financially sophisticated enough to be offered or purchase private placement securities based on their knowledge and experience, capability of evaluating the risk and merits, and ability to bear the economic risk of investment. In 1982, Regulation D—the goals of which included facilitating capital formation and promoting investor protection—replaced previous rules, including Rule 146. The income and net worth thresholds established in Regulation D were intended to serve as proxies for financial experience, sophistication, and adequate bargaining power. Since 1982, SEC twice revised the individual accredited investor standard: it added the $300,000 threshold for joint income in 1988, and excluded the value of primary residence as part of the net worth calculation in 2011 as required by the Dodd-Frank Act. In recent years, market participants and a regulator have proposed several changes to the accredited investor standard for individuals. The proposals were generally based on concerns for investor protection and capital formation, and consist of adjustments to income and net worth and alternative ways of measuring investor knowledge. For instance, two consumer advocacy groups, an investment company association, SEC, and North American Securities Administrators Association (NASAA) have expressed concerns that the number of those eligible to be accredited investors has grown significantly since the thresholds were established. According to SEC, when the standard was first created, 1.87 percent of households qualified as accredited investors. SEC staff estimate that 9.04 percent of households would have qualified as accredited investors under the net worth standard in 2007; we estimate that removing the primary residence from households’ net worth, as required in the Dodd-Frank Act, dropped the percentage to 7.2 percent (based on 2010 data). SEC and NASAA say that because private placement offerings are generally illiquid, complex, and not reviewed by state or federal regulators, the risks of investing in private placement offerings are high and a higher level of protection may be necessary to protect accredited investors. In contrast, the angel investor community has expressed concerns about how any proposed changes could affect capital formation for start-up companies. Noting concerns about investor protection, SEC proposed several changes to Regulation D during the 2000s. In December 2006, SEC proposed a new standard for individuals with the goal of providing additional protection to accredited investors investing in certain pooled investment funds, including hedge funds. An investor would have to meet either the existing income or net worth criteria and also own at least $2.5 million in investments at the time of the purchase of the securities. SEC stated that with this proposal, it sought to ascertain that an individual likely would have sufficient knowledge and experience to evaluate the merit and risk of certain private placement investments or be able to hire someone able to do so. In their comment letters on this proposal, some market participants suggested that SEC adjust the income and net worth standards for inflation, while others suggested these standards be lowered or eliminated. Some commentators suggested that SEC use a percentage of the net worth standard for certain investments. Others agreed with the proposal but made suggestions such as decreasing the required investments owned. This proposal was never finalized because, according to SEC officials, it received competing demands and mixed comments during the comment period. In July 2007, SEC proposed other changes to align its rules with modern market practices and communications technologies without compromising investor protection. First, SEC proposed to create a new exemption for offers and sales for a new category of investors to be designated as “large accredited investors.” Under this standard, individuals would have to own $2.5 million in investments or have an annual income of $400,000 (or $600,000 for married couples). Second, SEC proposed an alternative criterion for the accredited investor standard (to include $750,000 of investments owned) and adjusting the dollar-amount thresholds for investments owned, income, and net worth to reflect future inflation. According to SEC, it did not finalize its proposals due to, as stated before, competing demands and the mixed comments it received during the comment period. There are pending changes to Regulation D as a result of the passage of the Dodd-Frank Act and the Jumpstart Our Business Startups Act (JOBS Act). First, Section 926 of the Dodd-Frank Act directs SEC to adopt a rule that would make the Rule 506 exemption unavailable to securities offerings in which “felons or other bad actors” were involved. SEC proposed a rule in 2011 defining bad actors and prohibiting them from using the Rule 506 exemptions if they have been convicted of, or are subject to court or administrative sanctions for securities fraud or other violations of specific laws. The SEC commission adopted the final rule in July 2013 which prohibits bad actors, which include the issuer, certain issuer, officers, significant owners, general partners or managing members of the issuer, whose actions occurred after the rule’s effective date from using Rule 506. Actions which occurred before the effective date must be disclosed but do not act as a prohibition against using Rule 506. Second, the Dodd-Frank Act also requires SEC to review the “accredited investor” definition in its entirety beginning in 2014 and every 4 years thereafter and to conduct rulemaking as SEC deems appropriate after each review. As a result, criteria within the standard could change. According to SEC officials, they are conducting their review of the entire definition in 2014, after we publish our report on market participants’ views relating to existing and alternative criteria for qualifying as accredited. Third, the JOBS Act directs SEC to implement a rule that would permit companies to use general solicitation and advertising to offer securities under Rule 506 of Regulation D. In August 2012, SEC proposed a rule permitting companies to advertise and market such securities offerings provided that the issuer takes reasonable steps to verify the purchaser’s accredited investor status. Currently, Rule 506 does not specifically require that the issuer verify that accredited investors meet the requirements.