Professional, qualified, sophisticated investors: definitions

Originally the crowd investors had been divided into professional investors and retail investors, a distinction borrowed from the similar distinction that arose with traditional investment regulations. With the enactment of the EU Crowdfunding Regulation such labels will have to be replaced with those established to standardize regulations and nomenclatures throughout the European Union and facilitate cross-border capital raising. So today we find ourselves with many definitions that mean the same thing, or almost the same thing.

Let's try to clarify and understand who the professional, qualified, sophisticated investors. In parallel, we will also recall the opposite retail or unsophisticated investors.

In crowdfunding, the meaning of these labels has had important additional implications for access to certain types of investments, but even these implications have changed as regulations have changed. 

The goal of these distinctions, in each case, is to ensure adequate protection for investors by gauging each individual's financial skills and knowledge and providing the necessary assistance before allowing access to complex financial instruments and transactions.

Qualified and professional investors: differences

Let's start by clearing the air of a very common misconception: qualified investors and professional investors are not the same thing. The two concepts overlap but are not equivalent.

Specifically, qualified investors are a subset of professional investors, who fall into two macro categories:

• Institutional investors, i.e., private companies or specialized public agencies that make investments on a regular basis.
• Qualified investors, i.e., entities other than private companies or specialized public bodies, but with special qualifications due to such financial skills and knowledge as to fall into a professional level.

Let us now look at what is meant by "professional level" and the further distinctions within this definition.

Professional investor: requirements and categories

The definition of a "professional investor" established by Consob describes "a person who possesses the experience, knowledge and expertise necessary to make informed investment decisions and to properly assess the risks he or she takes."

A more colloquial definition is that of high net worth individual (high net worth individual).

The professional investors - whether they are institutional or qualified - are in turn divided into. two sub categories.

• By right: all entities authorized to operate in the financial markets, i.e., banks, insurance companies, investment funds, UCITS, stockbrokers, national governments, and all "institutional" investors, i.e., those who operate with financial instruments as their main business.

To these should be added large enterprises that meet at least two of the following size requirements: 

- At least 20 million euros in budget assets 

- At least 40 million in net sales

- At least 2 million in equity.

• Upon request: individuals who have substantial assets, a portfolio of high-value financial instruments, and significant financial experience. They must meet at least two of the following requirements:

- Average frequency of 10 market transactions per quarter of significant size in the previous four quarters

- Securities portfolio greater than 500,000 euros

- Professional position in finance held for at least one year involving knowledge of financial operations.

A decisive point of the Consob regulation for equity crowdfunding established the requirement for companies engaged in crowdfunding campaigns to have at least one professional investor covering at least 5 percent of the capital raised in order for the campaign to be considered valid. This was a not obvious condition, desired by the financial authority in order to have a third-party "validator" of the sustainability and potential of the proposed crowdfunding business project.

The new definition: sophisticated investor

After continuous delays and extensions, Italy too has finally transposed the ECSP Regulation, which was approved by the European Parliament back in October 2020 but did not officially become operational until November 2023.

The content of this regulation, which we have already analyzed in another article, also includes numerous provisions aimed at increasing protections for investors. Crowdfunding platforms will be required to carefully scrutinize users' financial skills and knowledge and the ability of their assets to withstand any losses from their investments.

The Regulations thus introduce the figure of the "sophisticated investor", or "an investor who is aware of the risks involved in investing in the capital markets and has adequate resources to assume those risks without exposing himself to excessive financial consequences."

I requirements to fall under this definition are different for legal entities and individuals.

Legal entities must meet at least one of the following conditions:

• Own funds of at least 100,000 euros.
• Net sales of at least 2 million.
• Budget of at least 1 million euros.

Individuals, on the other hand, must possess at least two of the following characteristics:

• Gross personal income of at least 60,000 euros per tax year, or a portfolio of financial instruments, including cash deposits and financial assets, worth more than 100,000 euros.
• Current or previous work in the financial sector for at least one year in a professional position requiring knowledge of the transactions or services involved, or executive position for at least 12 months within legal entities that are sophisticated investors.
• Significantly large transactions in capital markets with an average frequency of 10 transactions per quarter in the previous four quarters.

Also provided in the European Regulations is the status of sophisticated investor of law for certain individuals, defined as "professional clients" and listed in Annex II of the directive 2014/65/EU: in fact, these are the professional right investors listed in the dedicated paragraph above.

The substance, then, is very similar. Except for one extremely significant detail: the EU Regulation does not require at least one professional, or rather, sophisticated investor to cover at least 5% of the raising in an equity crowdfunding campaign in order for it to be considered valid.

Another novelty, albeit of lesser magnitude, is that the subscription to Bonds and Minibonds in crowdfunding will also be open to non-sophisticated investors (i.e., retail).

Who are the retail investors

Retail investors were originally defined by Consob as "ordinary savers-even businesses, companies, or other entities-that do not qualify as professional clients." This is a definition by negation, which does not add particularly useful information; in fact, the basic concepts are given by the definition of professional investor. 

The status of retail investor, before the ECSP Regulation came into force, prevented access to some particular crowdfunding investments such as underwriting of Bonds and Minibonds unless certain asset and portfolio requirements of financial instruments were met. Today, the label has become that of unsophisticated investor, which can access any crowdfunding financial instrument, subject to verification of knowledge and skills by the platform.

Retail or unsophisticated investors are the "small investors" who are key players in the phenomenon of "asset management," that is, entrusting savings to an intermediary who is to invest them and manage investments on behalf of the client. In recent years, with the multiplication of online investment apps and platforms, retail investors who seek to create a basic education on the subject and act independently have increased a great deal. "A great deal" in relation to the starting point, but in absolute terms, the need and habit of turning to brokers and financial advisors still prevails.

This conclusion should be kept in mind, because the retail investor is the subject of a major misconception in the crowdfunding arena: many of the small business owners who are interested in raising capital through crowdfunding have in mind the myth of the undistinguished crowd of nonprofessional investors who have some savings set aside and from their home computers invest modest amounts of money on projects on crowdfunding platforms, guided by instinct, sympathy, and the little information they understand about business plans.

Here, this almost never happens. While it is true that crowdfunding, with its generally very low minimum investment denominations, offers investment opportunities even to ordinary people, it is also true and confirmed by the data that there is no phenomenon of scrolling through crowdfunding platforms in search of some interesting project on which to bet 200 euros "at random." The Crowdinvesting Observatory 2024 report. of the Polytechnic University of Milan shows that there are no such phantom "serial investors," in fact most users invest on average only once. 

When retail investors invest in crowdfunding, they often do so through the mediation of a professional entity, or they invest in projects and companies that they know closely and with which they already have a relationship of some kind. This is why it is critical, among other things, to know how to turn customers (and potential customers) into investors and to look for investors in the broader category of stakeholders.