Knowledgeable Employee — Impactful or Nominal Addition to the Accredited Investor Definition?
I hope you find this article helpful, but please remember this is shared as a helpful analysis for educational purposes and is not legal advice — always consult your attorney before making any investments!
TL;DR
- Unfortunately, Knowledgeable Employees can only invest in their employer’s fund, not just any startup or private offering
- If you qualify as a member of the investment team (analyst or associate), you have to wait until you’ve been at the fund for 12 months
- This addition probably won’t be a big impact; how much extra cash do analysts/associates have lying around to invest?
- Still, it aligns the interests of all employees — net positive impact and step in the right direction
The SEC finally announced a change to the Accredited Investor definition (as I summarize here). The new definition expands on the income and net worth standard to include certifications (Series 7, 65, and 82); certain governmental, foreign, and other organizations; and “Knowledgeable Employees” of an investment fund.
There is some confusion around the Knowledgeable Employee clause, as this is the most common question I’ve seen on the rule change. So, I thought I would break down this prong of the rule and discuss whether it will truly be impactful.
Who are Knowledgeable Employees under the rule?
The third prong identifying Knowledgeable Employees as accredited investors generates a lot of interest due to some initial ambiguity in the SEC Fact Sheet. The new definition states: “…as accredited investors, with respect to investments in a private fund, natural persons who are “knowledgeable employees” of the fund[.]”
Numerous people have reached out asking if Knowledgeable Employees of a fund are accredited investors such that they may purchase any private security. Unfortunately for all of the VC associates like myself, this is not an accurate interpretation.
Under the rule change, Knowledgeable Employees of a fund can invest in the fund, e.g. their employer. For example, if Sarah works at Venture Fund I, she can invest in Venture Fund I as an accredited investor. This does not mean she can invest in any startup, investment fund, or other private placement as an accredited investor just because she is a VC associate at Venture Fund I.
At least we can invest in our own funds now, right?
Well, before we get that far, we still have to figure out what it means to be a Knowledgeable Employee.
Thankfully, Section 3c-5 offers a fairly clear distinction. First, executive officer and policy-making employees are knowledgeable under the rule. This includes an “Executive Officer, director, trustee, general partner, advisory board member, or person serving in a similar capacity” of a covered fund. Second, employees who participate in the investment activities (like all of us investment associates) are considered accredited investors under the new rule if:
such employee has been performing such functions and duties for or on behalf of the Covered Fund or the Affiliated Management Person of the Covered Fund, or substantially similar functions or duties for or on behalf of another company for at least 12 months (emphasis added) (“Participating Employee”).¹
So, the core impact of the Knowledgeable Employee provision allows investment analysts and associates to invest in the private fund they work for after their 1st anniversary.
Is this change impactful or impractical?
This analysis is much more theoretical and varies depending on the venture firm, more specifically differing between funds that have limited-term associate programs and funds that bring on associates to work towards becoming a General Partner (if helpful, check my article Behind the Scenes in Venture Capital to learn more about GPs and fund structure).
The ultimate question is whether this rule change better aligns interests.
On its face, sure! Associates and analysts could try to scrape together a few thousand dollars to add to their fund and have some skin in the game. Better fund performance means better returns for the associate, so they will no longer source deals “like they’re investing their money” because they actually will be investing their money.
There is the notion that, in some firms, associates are seemingly rewarded for sourcing high profile investments and pushing them through the pipeline to close the deal, even if they don’t truly think the company offers strong long-term returns. Associates putting money into the fund may take care of this problem.
However, is this really practical?
Many funds have 2 year analyst and associate roles where new classes of lower-level employees constantly cycle through. An associate knowing their tenure with the fund ends in 2 years may cause a chilling effect on employee interest in investing in the fund. The overarching question is whether an associate would lock up a few thousand dollars for a 10 year period, remaining illiquid until 8 years after their associate role ends.
Moreover, are analysts and associates willing to put such a small amount of money into a fund? Depending on the level of business school (or in my case law school) debt, a modest salary only goes so far. That $2–10K may be better spent on loans, rent, or maybe just some nice dinners now that school is over and you are finally a working adult (I obviously did not eat well during law school 😅).
The shortened timeline of analyst and associate programs paired with the inability to invest a meaningful check size causes many to believe the Knowledgeable Employee provision is not very practical.
My conclusion — overall net benefit and a step in the right direction.
Regardless of whether some or even a majority of associates want to invest a small amount of money in a fund, this gives more people access to invest as an accredited investor and align interests with their employer. The accredited investor definition is an outdated rule and should continue to be further refined. While the Knowledgeable Employee rule doesn’t give venture associate free rein to invest in any private company, it is nonetheless a great update to the rule and creates much-needed movement in an outdated area of securities law.
Agree, disagree, or just want to talk more? Leave a comment or reach out on LinkedIn or Twitter and I’d be happy to talk further.
[1] More specifically, 3c-5(a)(4)(ii) breaks down the knowledgeable employee definition pertaining to investment analysts and associates. One important note is an employee can invest in a number of funds managed by the management company. If the associate works for a firm with 5 funds run by a management company, the associate could potentially invest in all 5 funds. Further, the associate may not have to wait until their 1st anniversary with the fund if they have worked in a similar role at a different company or firm as noted by the “substantially similar functions or duties for or on behalf of another company” language towards the end of the definition.
