- SEC Rule 506
- Real Estate Crowdfunding
Companies raise capital to start or expand operations by selling equity or debt securities. Offerings are regulated by Federal and state securities laws which require registration. Since registration is costly and time-consuming, most offerings are made pursuant to exemptions to registrations, using private placements.
Use of 506
Real estate investors and developers commonly rely on the exemption found in Rule 506 of Regulation D under the federal Securities Act of 1933, and on corresponding exemptions under state securities laws, for a “safe harbor” from registration. The new Rule 506 (c allows you to make general solicitations of private sales of securities for the first time in 80 years. And Rule 506(c puts no limit on the amount of funds you can raise from friends, family, and strangers.
The SEC added provisions to restrict those with a history of regulatory issues. The “bad actor” provisions preclude general partners, managing members, executive officers, promoters or other representatives participating in a 506 offering (as well as anyone who owns 20% of the company) who have been convicted of any felony or misdemeanor involving securities or who is guilty of certain SEC regulatory matters.
Under Rule 506 (c, you can now advertise an offering using general solicitation, including websites and online advertising; electronic mail; social media, such as Facebook and Twitter; all other online activities; plus press releases; television; radio; direct mail marketing; and other media including craigslist.org.
You should have a process in place to communicate with possible investors. It may be helpful to say in your initial response that an intermediary will be engaged to assist with distributing and collecting investor questionnaires and determining whether potential investors are qualified.
Who May Be an Investor?
If you are offering securities pursuant to a general solicitation, you can sell them to “accredited investors.” Individual investors are accredited investors if they have either: net worth of at least $1 million, excluding the value of primary residence, or income of at least $200,000 in each of the last two years (or $300,000 with a spouse) and have the expectation to earn at least the same amount in the current year.
Other, less common types of accredited investors include: a corporation, business trust, trust or partnership, not formed for the specific purpose of purchasing your company’s stock or other securities, with total assets in excess of $5,000,000; an investment company registered under, or a business development company as defined in, the U.S.Investment Company Act of 1940; a Small Business Investment Company licensed by the U.S. Small Business Administration under Section 301(c) or (d) of the U.S. Small Business Investment Act of 1958; a private business development company as defined in the U.S. Investment Advisers Act of 1940; an entity in which all of the equity owners are accredited investors; an ERISA employee benefit plan if the plan has total assets in excess of $5,000,000 or if the investment decision is made by a plan fiduciary that is a bank, savings and loan, insurance company or registered investment advisor; or self-directed employee-benefit plans that are controlled by an accredited investor.
Selling securities to non-accredited investors in a 506(c offering can result in an automatic right of rescission, a permanent future status as a “bad actor,” and other penalties. You must take reasonable steps to verify that each purchaser is an accredited investor. Issuers should initially respond to inquiries with a form letter that identifies the various categories of accredited investor and suggests a time and opportunity for a telephone conversation. A subsequent letter should describe the services of the verification and intermediary service you have chosen.
Which verification tests should you select?
The certifications required by the SEC depend on the status of each investor. An investor often qualifies under more than one test. The verification tests below appear in order of ease of effort under most circumstances. Many investors qualify under more than one test; always choose the least intrusive and most expeditious test(s) whether or not you use a verification service.
Individual earns more than $200,000 a year or $300,000 with spouse
Net Worth Verification
Investor is an individual with more than $1 million in net worth, excluding residence
Investor is an entity with more than $5 million in good will or assets
Investor> is a member of an entity all of whose members are accredited investors
Investor is a member of a special type of qualifying regulated entity
Investor is a director, executive officer or general partner of a qualified issuer
Whichever certification services you select, you should have policies in place to protect confidential information of potential investors and ensure compliance with all applicable privacy laws and regulations. Alternatively, you can use an accredited investor verification service that has these policies in place, such as Private Placement Advisors, LLC.
You should use professionally prepared offering documents that describe: the type of security your company is offering (limited partnership interests, limited liability company interests, promissory notes,common stock, or preferred debt); the price of the security; terms and economic rights such as dividends or interest payments, anti-dilution protections, and grounds for exemption from registration; and representations about the investors’ accredited investors status.
You must provide investors with annual reports or financial statements (or reasons not to have such documents) as well as a private placement memorandum, describing your company and its business operations and setting forth risk factors such as your limited operating history; risks related to the real estate industry; risks specific to your company’s products, technologies or services; and, finally, state that investors may lose their entire investment. You also need to make sure to tell investors that because the securities were sold under the exemption in SEC Rule 506(c, they are “restricted securities” and therefore re-sales are not permitted for six months.
Completing the sale
The closing will occur when the investor delivers the purchase price and you issue the securities to the investor pursuant to the terms of the subscription agreement. You may decide to hold one closing or you may hold multiple closings throughout a pre-determined period of time.
You will need to make informational filings with the SEC and also with one or more state regulators shortly after the closing (usually 15 days). Although the securities sold under Rule 506(c may be “covered securities” — meaning state securities registration requirements are preempted by federal laws – you will need to make periodical, informational filings with each state’s regulatory authority in all states where investors have a primary residence. Since each state has different filing requirements and some states have pre-filing requirements, it is advisable to know where each investor resides before any securities are sold.
Once you have prepared an executive summary, a business plan and financial projections, you need offering documents. These include:
1) Private Placement Memorandum
A private placement memorandum is a document that discloses all relevant and material information that a reasonable investor would want to know before deciding whether or not to engage in a proposed transaction.
A PPM is different from a prospectus. The term “prospectus” is used when referring to an offering document for registered securities whereas the term “private placement memorandum” is used in reference to securities that are exempt from registration under Regulation D.
Checklist of what can be in a PPM:
- Securities Legends
- Suitability Standards for Investors
- Summary of the Securities Offering
- Risk Factors
- Capitalization of the Company
- Use of Proceeds from the Securities Offering
- Plan of Distribution of the Securities
- Selected Financial Data
- Analysis of Financial Condition and Results of Operation
- The Business of the Company
- Management and Compensation
- Certain Transactions (transactions between the Company and its shareholders, officers, directors or affiliates)
- Principal Shareholders
- Terms of the Securities Offered
- Description of Capital Stock of the Company
- Tax Matters
- Legal Matters
- Documents Available for Inspection
- Financial Statements
2) Investor Questionnaire
The Investor Questionnaire is crucial for private placement offerings. Each type of offering has its own requirements for investors. A company must have a reasonable belief that its potential investors meet those requirements. That determination should be made before the potential investor is given offering documents or specifics regarding the offering.
3) Subscription Agreement
The Subscription Agreement is the “investment contract” for purchasing the securities. Typically an investor will complete this document with a signed copy of the Investment Questionnaire before writing a check.
Doing either an equity or debt raise under Rule 506, you need to:
- Reduce to writing executive summary, business plan, and financial projections
- Form a limited liability company or other entity
- Prepare a private placement memorandum, investor questionnaire, operating agreement, subscription agreement, and pitch deck
- File exemption documents with the necessary regulators
- Identify and present your business to investors
- Prepare term sheet, or not
- Have an expert verify to the SEC that money is only coming from accredited investors
- Execute investor documents and receive funding
An equity offering occurs when a company sells partial ownership in a company, usually using corporate stock or LLC membership units.
A debt offering occurs when a company sells one or more promissory notes to investors. A debt offering is similar to a business loan; instead of a bank providing the financing, investors lend funds to the firm.
The first step in an offering is properly setting the structure. Structuring includes determining how much of the company to sell (in equity transactions), setting the maturity date and rate of return for the promissory notes (in debt offerings), electing which Reg D program to use, and establishing minimum and maximum offering amounts.
The private placement memorandum (PPM) is the document that discloses all required information to the investors about the company, proposed operations, the transaction structure and the terms of the investment offered.
The promissory note outlines the terms of the loan arrangement with the investor.
The note is the loan contract between the company and the investor.
A Form D is filed with the SEC in Washington, DC. It notifies the SEC that you are using the Regulation D exemption and provides them basic information about the company and the offering. This is not a document seeking approval or registration. This is a filing that notifies the SEC that you have a Regulation D offering underway.
“Blue Sky” laws require a specific form to be filed along with a copy of the SEC Form D. States charge a small fee. This filing form does not need to be filed until capital has been received from an investor in that state, typically within 15 days.
New laws and regulations following the JOBS Act of 2012 have led to a number of online platforms, both crowdfunding and peer-to-peer, that help investors find and evaluate private offerings, while providing unprecedented opportunities for real estate developers and brokers in search of funding for their projects.
A recent report by the research group Massolution opines that crowdfunding and P2P investors injected $1 billion into the U.S. real estate market in 2014 and that the number will double in 2015. New debt participation structures and an increased access to non-U.S. investors are cited as two reasons.
“It’s growing beyond expectations,” says Richard Swart, a research adviser on the report. “When the JOBS Act passed we didn’t think real estate would be a part of it, but it turns out to be a more efficient way for investors to find good deals across the spectrum. Real estate crowdfunding can be a good way for small investors to play big.”
For investors willing to throw in their money with strangers to purchase larger investments than they could afford on their own, real estate crowdfunding has become an attractive alternative investment asset class. According to the Massolution report, 2014 private placement real estate funding was 76% debt with only 18.5% equity.
“The excitement is giving everyone access to investing in commercial real estate,” according to Dan Miller, president of Fundrise, a leading real estate crowdfunding platform with over 42,000 users.
Real estate crowdfunding and other forms of syndication as a concept is not new. Since the 1970s publicly offered limited partnerships, often styled “syndications,” and real estate investment trusts (REITs), allowed investors to combine resources to access a diversified portfolio of larger properties.
The JOBS Act supercharged this concept.
There are roughly 100 real estate crowdfunding platforms in the U.S. and more are on the way. Finding the right ones can be intimidating and frustrating.
Through SEC Regulation S, foreign investors are now able to participate in U.S. deals. This will impact cities with heavy foreign investment, such as Miami and Seattle.
Crowdfunding platforms earn most of their revenue by charging each issuer a flat due diligence fee, which varies, plus a percentage of funds raised at closing, typically 2% or 2 1/2%. Also, there is usually an annual servicing fee from investors of up to 0.50%.
Look for platforms with at least partially-funded deals. Committing to a deal is seen as an expression of confidence in a platform’s deal-selection process.
Real estate crowdfunding and real estate P2P platforms have fundamentally changed real estate financing.