Notes from IMN Crowdfunding Forum for Real Estate Conference
Peter Goldthorp - September 2014
Crowdfunding sites like Kickstarter allow entrepreneurs to raise money to fund small projects. They are a popular vehicle for product based startups. Investors are typically offered a finished example in return for their investment. They do not receive equity in the company. This approach cannot be used for real estate transactions due to securities law. Anyone offering to collect money in return for a share of an investment opportunity is subject to securities law.
In the United States the SEC regulates securities law. US law prevents the solicitation of unregulated securities. The SEC requires most securities to be registered prior to offering. It also defines certain classes of investment as exempt from this requirement. In summary there are 3 types of security in the United States: “Registered”, “Exempt” and “Illegal”.
The JOBS Act - 506 (b) and (c)
Prior the JOBS Act this generally meant using 506 Reg “D” exemption rules. These allowed offerings to accredited investors with whom you have an existing relationship. Reg D defines an accredited investor as someone with over $1 million in investable assets and/or an annual income in excess of $200k for an individual or $300k for a couple.
The JOBS act retains the definition of an accredited investor but removed the requirement to establish a relationship prior to making the offering. It introduced 2 new exemptions: 506 (b) and 506 (c). 506 (b) mirrors Reg D and was designed to replace it. 506 (c) allows marketing to accredited investors. This means it is now legal to create a website with details of a deal you would like to fund. 506(c) also places an additional burden on the sponsor. They are responsible for insuring accredited investors meet the SEC accreditation definition. Reg D (and the new 506(b)) allow investors to self-certify.
506(c) places the burden of proof on the sponsor to insure they have taken reasonable steps to verify the status of the investor before allowing them to invest in the deal. There is no case law to identify what constitute reasonable steps. SEC guidance suggest the investor’s tax accountant or registered investment advisor would be able to make this determination. A deal can offered under 506 (b) or 506 (c) terms but not both. It is impossible to show that an investor heard about the deal privately if it is also advertised on a portal site.
Individuals can still get into trouble even if deal is exempt under 506 (c). The exemption belongs to the deal. Individuals can still be held accountable for their actions while marketing it. For example, it is legal to advertise the deal but not to advise on its suitability. A securities license is required for that. The JOBS act does not require the use of a broker dealer but it is considered best practice to do so.
SEC rules prohibit curation (assembling deals based on qualitative factors) from non-broker dealers. This could prohibited a site from including or excluding offerings based on the quality of management, valuation of the company, market size, need for additional capital, pending litigation, or other qualitative factors which increase the risk to an investor.
Most broker dealers and real estate firms do not have the technical expertise to setup the sort of website required to market a 506(c) offering. It needs to provide a combination of content management, secure payment, social media, e-commerce, account management and systems integration features.
Content management facilities allow a sponsor to create hypertext links and upload offering documents to support each deal. Account management facilities allow investors register their interest in a deal and ask questions about it. These questions could be directed to the sponsor other potential investors or using social media facilities. Secure payment facilities are required to accept payments and systems integration to direct these payments to escrow.
A number of “portal” sites are available today. These sites market the securities, collect commitments and place them in escrow. Funds are released to the sponsor when the investment target has been reached. They are returned to the investors if the offering does not meet its fundraising goal.
These portal sites typically work in one of 2 modes. The first acts as a broker between the sponsor and the investors. They publish details of the offering and act as an intermediary between the parties. Ultimately the investors invest directly in the deal and the sponsor is able to establish and ongoing relationship with them.
In the second mode the portal acts as a gatekeeper to the deal. They create an LLC to pool interests and the LLC becomes an LP in the transaction. The first approach is suitable for large commitments, the second a better fit for small ones. The first approach has an additional advantage. It can be used as a lead generation platform for future deals. Both platform approaches offer value add and admin services, for example most offer bookkeeping and investor accreditation services.
There are 9 million people in the United States who would qualify under the current definition of a high net worth accredited investor. These are the potential client pool for 506 (c). This leaves 100 million unaccredited investors. The JOBS act also created “Title III” as an investment vehicle for these people. It is intended to allow non-accredited to have an opportunity to invest in early stage Pre-IPO companies (the next Face Book or Google). The rules for Title III have not been finalized. They are likely to require the security to be registered prior to offering and place limits on the amount an investor may invest each year and in any given offering.
Title 3 offerings are less attractive for real estate deals due to the small sums involved and the assumption that small investors are more likely to cause trouble if the project loses money.