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Who Should Be Deemed 'Sophisticated' Enough to Be an Investor? Regulators argue that the income requirements for accredited investors -- which were set in 1982 -- are in desperate need of an adjustment. Entrepreneurs and investors, meanwhile, don't want to see access to capital limited.

By Catherine Clifford

Opinions expressed by Entrepreneur contributors are their own.

Determining whether an individual ought to be able to make equity investments in startups and other private companies is a regulator's nightmare. But if and when the government jiggers with the definition of an accredited investor, it will almost certainly make for a smaller, more exclusive group who are allowed to do so. And that has a lot of investors and entrepreneurs on edge.

The elite group of individuals known as accredited investors, whom the government deems capable of making private equity, venture capital and other high-risk investments, must have individual income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years, according to the current rules.

Alternatively, an individual can be considered an accredited investor if he or she has more than $1 million in assets, excluding the value of a primary residence.

Those income level thresholds were adopted on March 8, 1982, though some important developments over the last few years have paved the way for significant change. The caveat that excludes the value of a person's primary home in the estimation of net worth was implemented in 2011 as a result of the Dodd-Frank Act passed in 2010. The Dodd-Frank law also mandated that, in 2014 and every four years thereafter, the Securities and Exchange Commission must reconsider the definition of what determines an accredited investor.

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The conversations over how best to define an accredited investor have started and so far there has only been one true consensus: This is a formidable task.

If the current levels of income thresholds are adjusted for inflation, which they haven't been in more than three decades, then an accredited investor would be a person who makes about $500,000 in annual income or a couple who makes more than $700,000, according to an estimate made by Barbara Roper during a meeting of the SEC's Investor Advisory Committee last week. Roper leads a subcommittee of the Investor Advisory Committee, which was established as part of the Dodd Frank Act to provide the SEC with regulatory priorities and guidelines.

Similarly adjusted for inflation, an accredited investor would have to have between $2.5 and $3 million in assets, Roper estimates.

The SEC declined to comment on Roper's estimates.

The 2011 change that excluded the value of a primary residence from the net worth calculation was a big change, said Roper, especially for those individuals living in New York, San Francisco or Washington, D.C., where real-estate values are substantially higher than the rest of the country. Still, the 1982 levels are desperately out of whack with today's market, she said. "Even with that change, the threshold has been eroded by inflation in the intervening years."

Related: Why Fraudsters Won't Sink Equity Crowdfunding

Accredited investors are granted special privileges, which is why coming up with a reasonable definition is so important. They are eligible to make investments in private companies. For a company to accept investments from anyone other than accredited investor, it must file appropriate documents with the SEC associated with being a "public" company. If an individual is investing in a private company, the assumption is that he or she can manage the economic risk of investing -- and potentially losing -- a portion of his or her wealth.

For an individual to make reasonable financial investment decisions, Roper says that they need three things: access to information, sophistication to access the real risks of the investment and the financial safety net to be able to handle potential losses.

Raising the income thresholds for the definition of an accredited investor would shrink the pool of eligible investors able to participate in private markets. For startups, that could be a tough blow.

"It would be a shame to see the definition of an accredited investor become even more onerous," said Jilliene Helman, CEO of Realty Mogul, an investment platform connects accredited investors with real estate investments. "What we've found is that the majority of our investors are highly sophisticated. I'd hate to see those investors lose out on the opportunity to invest in private markets if income requirements are increased by the SEC."

Related: Best Advice from Billionaire Investors for Entrepreneurs (Infographic)

Angel List, a popular platform for investors to meet startups seeking capital, says a raised income threshold would eliminate 23 percent of its investor base. "The main impact would be on the startups. Try cutting a quarter of the capital out of any industry and see what happens to it," said chief operating officer Kevin Laws. "This group of accredited investors that wouldn't qualify under the new standard are sophisticated, desirable investors in the startup community."

Crowdfunding platform Circle Up and angel investor trade group Angel Capital Association expressed similar concerns.

Even if regulators could agree on a financial threshold, there's the thornier issue of sophistication. "It's not just that the asset number is wrong, it's that the approach is wrong," said Damon Silvers, associate general counsel for the American Federation of Labor and Congress of Industrial Organizations (AFL-CIO), at the same meeting with Roper last week.

The Angel Capital Association wants the SEC to add another category of certification for those potential investors who are sophisticated enough to make their own reasonable financial decisions, even if they don't meet the income thresholds. "But it is important that these sophisticated measures help increase the pool of accredited investors," said Marianne Hudson, the executive director of the ACA. "The SEC could develop a questionnaire that easily allows individuals to include relevant information about their sophistication, from experience as an entrepreneur or executive with profit and loss responsibility, an MBA or a degree in finance or accounting, services on a board of directors of a for-profit entity, or membership in an established angel group, among others."

Regulating sophistication, though, is like weaving with dry spaghetti. "The way we got to the current definition is it's easy. It's easy to administer. The only problem is it doesn't work," said Roper. "You can't let simplicity override the need to actually perform the function that it is intending to regulate as a matter."

Related: The JOBS Act Two Years Later: Where We Are and What's Next for Crowdfunding (Infographic)

Catherine Clifford

Senior Entrepreneurship Writer at CNBC

Catherine Clifford is senior entrepreneurship writer at CNBC. She was formerly a senior writer at Entrepreneur.com, the small business reporter at CNNMoney and an assistant in the New York bureau for CNN. Clifford attended Columbia University where she earned a bachelor's degree. She lives in Brooklyn, N.Y. You can follow her on Twitter at @CatClifford.

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