Raising Capital Online: An Introduction For Real Estate Developers

If you’re a real estate developer accustomed to raising capital through traditional channels, you’re probably wondering about Crowdfunding. In this post, I’m going to provide some basic information, then try to answer the questions I hear most.

Basics of Crowdfunding

  • It’s Not Kickstarter. On Kickstarter, people make gifts, often to strangers. You’re not going to ask for gifts. Instead, you’re looking for investors, and in exchange for their money you’re going to give them the same kinds of legal instruments you’d give an investor in the offline world: an interest in an LLC, a convertible note, or something else.
  • It’s Just the Internet. For better or worse, a certain mystique has developed around Crowdfunding, if only because it’s so new. But Crowdfunding is just the Internet, finally come to the capital formation industry. We buy airline tickets online, we call a cab online, we search for significant others online, now we can search for capital online. If you’re comfortable buying socks on Amazon, you’ll be comfortable raising money using Crowdfunding.
  • Why Crowdfunding? How many investors do you know? Twelve? Seventy-two? With Crowdfunding, you can put your project in front of every investor in the world. And you’ll probably get better terms.
  • The Market Is Small But Growing Quickly. Title II Crowdfunding became legal in September 2013, Title IV in June 2015, and Title III in May 2016. The amounts being raised are in the billions of dollars per year, small in terms of the overall U.S. capital markets but growing quickly.
  • There Are Three Flavors of Crowdfunding. Crowdfunding was created by the JOBS Act of 2012. The three flavors of Crowdfunding are named for three of the sections, or “Titles,” of the JOBS Act:
    • Title II, which allows only accredited investors (in general, those with $200,000 of income or $1 million of net worth, not counting a principal residence) but is otherwise largely unregulated.
    • Title III, which allows issuers to raise up to $1 million per year, through a highly-regulated online process.
    • Title IV, which allows issuers to raise up to $50 million per year in what amounts to a mini-public offering.

For more information, take a look at this chart. But first, read the next bullet point.

  • You Don’t Have to Learn the Legal Rules. You’re a real estate developer, not a lawyer. You don’t have to become a lawyer to raise money using Crowdfunding, and in terms of lifestyle I wouldn’t recommend it.
  • You Don’t Have to Write Computer Code. You’re a real estate developer, not an IT professional. You don’t have to know or learn anything about technology to raise money through Crowdfunding.
  • Crowdfunding is About Marketing. It’s not a technology business, it’s not even a real estate business. Crowdfunding is all about marketing. You create a product that investors will want, and you market both the product and your track record. Just as you rely on your lawyer for legal advice and your IT folks for technology, you rely on marketing professionals to sell yourself and the product.

Common Questions

  • Will I Have More Liability? Here’s a long and technical blog post, listing all the ways that an issuer of securities in Crowdfunding can be liable. By all means share this with your regular lawyer and ask for his or her opinion. But the bottom line is that if you do it right, raising money through Crowdfunding creates no more liability than raising money through traditional channels. It’s just the Internet.
  • Will Banks Lend Money for Crowdfunded Deals? In the earliest stages of Crowdfunding, some lenders balked at deals that involved a bunch of passive investors. But we crossed that bridge long ago. Today, banks and other institutional lenders routinely finance Crowdfunding deals.
  • Isn’t It a Hassle Dealing with All Those Investors? It can be, but doesn’t have to be. For one thing, investors in the Crowdfunding world get no voting or management rights. If you’re used to the private equity guys looking over your shoulder, you’ll be thrilled with Crowdfunding. For another thing, if you use one of the existing Crowdfunding portals (see below), you can outsource a large part of the initial investor relations.
  • I’ve Heard That Investors Must Be Verified – How Does That Work? In Title II Crowdfunding, the issuer – you – must verify that every investor is accredited. In theoretical terms that could mean asking for tax returns, brokerage statements, and other confidential information. But in practical terms it just means engaging a third party like VerifyInvestor. Most verification is done with a simple letter from the investor’s lawyer or accountant.
  • How Much Money Can I Raise? In a typical Title II offering, developers typically raise $1M to $3M of equity.
  • If Crowdfunding is Still Small, Why Start Now? One, you can raise capital for smaller deals. Two, it’s about building a brand in the online market. In a few years, when developers are raising $30M rather than $3M, the developer who built his brand early is more likely to be funded.
  • Is Crowdfunding All or Nothing? No, not at all. You can raise part of the capital stack through Crowdfunding and the balance through traditional channels.
  • Will I Need a PPM? You’ll generally provide the same information to prospective investors in the online world as you’re accustomed to providing in the offline world.
  • Why Am I Seeing All These REITs in Crowdfunding? Three reasons:
    • Most retail investors have neither the skill nor the desire to select individual real estate projects. Just as retail investors prefer mutual funds to picking individual stocks, retail investors will prefer to invest in pools of assets that have been chosen by a professional.
    • Theoretically, thousands of retail investors could invest in a traditional limited liability company. But when you own equity in an LLC you receive a K-1 each year. For someone who’s invested $1,000, the cost of adding a K-1 to her tax return at H&R Block could be prohibitive. In a REIT you receive a 1099, not a K-1.
    • Privately-traded REITs have a very bad reputation, plagued by high fees and sales commissions. But if light is the best disinfectant, the Internet is like a spotlight, relentlessly driving down costs and providing investors with instantly-accessible information.
  • What Kind of Yields Do Investors Expect? That’s a tough question, obviously. But here are two data points. For an equity investment in a high-quality, cash-flowing garden apartment complex, investors might expect a 7% preferred return and 70% on the back end (e., a 30% promote for you). For a debt investment in a single-family fix-and-flip, with a 65% LTV, they might expect a 9% interest rate on a one-year investment.
  • Should I Use Rule 506(b) or Rule 506(c)? If you’re asking that question, you probably shouldn’t be reading this blog post. Try this one.
  • Do I Need a Broker-Dealer? Two answers:
    • As a general rule, you are not legally required to be registered as a broker-dealer, or to be affiliated with a broker-dealer, if you’re offering your own deals. For a more technical legal answer, you can read this blog post.
    • To sell your deal, you might want to use a broker-dealer, or a broker-dealer network.
  • How Can I Get Started? You have two choices:
    • You can establish your own website and list your own deals. But there are millions of websites in the world, many featuring photographs of naked people. Against that competition you might find it difficult to attract eyeballs.
    • You can get your feet wet by listing projects on an existing real estate Crowdfunding portal, one with a good reputation and a large pool of registered investors. If that goes well, you can think about establishing your own website later. The portal will take the mystery out of the online process, making it look and feel like any other offering from your perspective.

Questions? Let me know.

What’s the Difference Between Rule 506(c) and Rule 506(b) in Crowdfunding?

Three and a half years into Title II Crowdfunding, I am asked this question a lot, sometimes by portals, sometimes by issuers.

A Chart, of Course

Three Important Differences

Verification

In a Rule 506(b) offering, the issuer may take the investor’s word that he, she, or it is accredited, unless the issuer has reason to believe the investor is lying.

In a Rule 506(c) offering, on the other hand, the issuer must take reasonable steps to verify that every investor is accredited. The SEC regulations allow an issuer to rely on primary documents from an investor like tax returns, brokerage statements, or W-2s, but they also allow the issuer to rely on a letter from the investor’s lawyer or accountant. In practice, that’s how verification is typically handled.

I strongly recommend that issuers do not verify investors themselves. Instead, they should use a third party like VerifyInvestor. If an issuer handles verification itself and makes a mistake, it’s possible that the entire offering could be disqualified. Conversely, once an issuer hands the task to VerifyInvestor, the issuer has, by definition, taken the “reasonable step” required by the SEC, and can sleep well at night.

Information

If all the investors are accredited, there is no difference between Rule 506(b) and Rule 506(c).

If there is even one non-accredited investor in a Rule 506(b) offering, on the other hand, the issuer must provide a lot more information, specifically most of the information that would be included in a Regulation A offering.

The technicalities are important to the lawyer, but to the issuer or the portal, the bottom line is that if non-accredited investors are included the offering will cost $5,000 – $7,500 more, and take a little longer to prepare.

Advertising

In a Rule 506(b) offering you can advertise only the brand. In a Rule 506(c) offering you can advertise the deal.

Ever watch the commercials for brokers and investment banks during a golf tournament? They feature an older guy and his very attractive wife, planning for a carefree and meaningful retirement. They message is:  we can help you achieve your dreams. But they don’t show any of the actual investments they recommend! They’re only advertising the brand.

That’s the model for a website offering investments under Rule 506(b). We can advertise the website – the brand – but we cannot show actual investments. The website attracts investors who sign up and go through a KYC (know your customer) process following SEC guidelines. We have the investor complete questionnaires, we speak with the investor on the phone a couple times, we learn about his or her experience and knowledge investing – we develop a relationship. Then, and only then, can we show the investor actual investments.

In contrast, a website offering investments under Rule 506(c) can show actual investments to everyone right away.

Which is Better?

If I own a jewelry store, I have two choices:

  • I can display jewelry in the front window where passersby can see it.
  • I can display a sign in the front window saying “Great jewelry inside. Must register to enter.”

That’s why I prefer Rule 506(c).

But I also acknowledge three benefits of Rule 506(b):

  • To include non-accredited investors, you must use Rule 506(b), or another kind of offering altogether.
  • If you use Rule 506(c), you might lose bona fide accredited investors who are unwilling to provide verification.
  • If you use Rule 506(b), which doesn’t require verification, you might get money from non-accredited investors who are willing to lie.

Switching Midstream

You can start an offering using Rule 506(b), then switch to Rule 506(c), as long as you haven’t accepted any non-accredited investors.

Conversely, once you’ve advertised a Rule 506(c) offering, you cannot go back and accept non-accredited investors, claiming you’re relying on Rule 506(b).

Questions? Let me know.

If I Raise Money Using Crowdfunding, Will I Be Able To Raise More Money Later?

 

I have rarely attended a Crowdfunding conference where this question wasn’t asked. Maybe those of us in the industry haven’t done a good enough job answering it.

Before getting into details, I’ll note that it is no longer a hypothetical question, as it was when the JOBS Act was signed into law in 2012. Today, many companies have indeed graduated from Crowdfunding to venture rounds, to angel rounds, to Regulation A offerings, and even to IPOs.

But judging from the look on the faces of the audience, that answer never seems completely satisfying. Isn’t there something about Crowdfunding that sophisticated investors don’t like?

The answer is “Only if the Crowdfunding round is done wrong!” So:

  • Institutional investors don’t want anyone else participating in their round. If you give your Crowdfunding investors preemptive rights, or the equivalent of preemptive rights, the institutional investors won’t like it. That’s why you don’t give your Crowdfunding investors preemptive rights.
  • Institutional investors don’t want anyone but you managing the company. That’s why you keep your Crowdfunding investors (and friends & family investors) out of management. Ideally, you issue non-voting stock (or its equivalent) to the Crowdfunding investors, and don’t permit representation on your Board.
  • Institutional investors want to know what they’re getting into. If you conduct your Crowdfunding round carefully, with clear legal documents, that’s not a problem.
  • Institutional investors don’t like surprises. They don’t want to learn afterward that your Crowdfunding investors, or anyone else, have rights they didn’t know about. That’s why you form your entity in Delaware, which gives the parties to a business transaction more or less unlimited freedom of contract.
  • Institutional investors don’t like a messy cap table. There’s no reason to have a messy cap table in Crowdfunding. Often, we bring in Crowdfunding investors through a special-purpose vehicle, or SPV. We can also issue to Crowdfunding investors a separate class of stock. One way or another, we keep the cap table clean.
  • Institutional investors worry about legal claims brought by Crowdfunding investors. Of course they do! That’s why we conduct the Crowdfunding offering correctly, just as we conduct the institutional round.
  • Institutional investors don’t like sharing information with all those investors. With today’s technology tools, communicating with investors isn’t difficult, and Delaware law allows us to limit who gets what. But it’s certainly true that the more investors you have, the more people get the information.
  • Institutional investors just don’t like hanging out with the riffraff. That’s never stated outright, but implied. If we address all the real issues, I have never found it to be true.

As Crowdfunding gains traction, I expect institutional investors to embrace it fully, as another facet of their own business models. In the meantime, be assured that if done right, raising money through Crowdfunding today will not keep you from raising more money in the future.

Questions? Let me know.

Targeted IRRs in Crowdfunding

Targeted internal rate of return, or IRR, is used widely to advertise deals on Crowdfunding sites, real estate and otherwise. While target IRR means something to sophisticated sponsors and investors, its widespread and uncritical use makes me a little uneasy, for the following reasons:

  • If pressed, many people don’t know what IRR really means. Investors assume that a higher IRR is better than a lower IRR, but many couldn’t explain exactly why or how.
  • IRR can be misleading. For example, a bond purchased for $100 that pays interest of $10 at the end of each of the first four years and $110 at the end of the fifth year has an IRR of 10%. A bond purchased for $68.30 that pays nothing for four years and $110 at the end of the fifth year also has an IRR of 10%. But those two investments are very different. The IRR calculation assumes that the $10 interest payments on the first bond can be reinvested at 10%, which is probably not true.
  • The IRR of a real estate deal (or any deal) increases when the asset is refinanced and the proceeds distributed to investors. But refinancing the asset doesn’t necessarily make for a better investment.
  • There being no such thing as a free lunch in capitalism, a higher IRR generally coincides with higher risk. For example, I can usually increase my IRR by borrowing more money. That relationship is not typically highlighted.
  • For a typical startup outside the real estate industry, IRR has no meaning. Or to put it differently, a 28% target IRR for a startup plus $2.75 gets you on the New York subway.
  • The term “target IRR” tends to mask what’s really important:  the factual assumptions concerning sales and asset appreciation. To say “We expect a target IRR of 18%” is somehow easier to sell than “We expect the property to appreciate at 6% per year.”
  • Under FINRA Rule 2210, offerings conducted through a broker-dealer may not advertise target IRRs. FINRA also prohibits Title III Funding Portals from advertising target IRRs, and the SEC prohibits new issuers from advertising a target IRR in Regulation A offerings, even for sponsors with extensive track records. Hence, target IRR cannot be used to compare offerings across all platforms and all deal types.

What can we do better as an industry? Here are a few ideas:

  • We can explain internal rate of return better, maybe with examples and a standardized presentation and graphics.
  • We can develop other apples-to-apples metrics for comparing deals.
  • We can make clear that higher IRRs generally come with higher risks.
  • In Regulation A offerings, and even in Rule 506(b) offerings where non-accredited investors are involved, the issuer is required to provide extensive information about the sponsor’s track record. Some version of that concept, applied consistently and allowing for side-by-side comparison, might be the most valuable information for investors.

Questions? Let me know.

SEC Makes Intrastate Crowdfunding A Little Easier

Source: NASAA Intrastate Crowdfunding Update – October 17, 2016

The SEC just adopted rules that should make intrastate Crowdfunding easier, at least if State legislatures do their part.

To understand how the new rules help and how they don’t, start with section 3(a)(11) of the Securities Act of 1933, which has been, until now, the basis for all intrastate Crowdfunding laws. While section 5 of the Securities Act generally provides that all sales of securities must be registered with the SEC, section 3(a)(11) provides for an exemption for:

Any security which is a part of an issue offered and sold only to persons resident within a single State or Territory, where the issuer of such security is a person resident and doing business within or, if a corporation, incorporated by and doing business within, such State or Territory.

In 1974 the SEC adopted Rule 147, implementing section 3(a)(11). That was long before the Internet, and as state legislatures have enthusiastically adopted intrastate Crowdfunding laws since the JOBS Act of 2012, some aspects of Rule 147 have proven problematic. The rules just adopted by the SEC fix some of the problems of Rule 147:

  • In its original form, Rule 147 required that offers could be made only to residents of the state in question. The revised Rule 147 says it’s okay as long as the issuer has a “reasonable belief” that offers are made only to residents.
  • In its original form, Rule 147 required issuers to satisfy a multi-part test to show they were “doing business” in the state. Under the revised Rule 147, an issuer will be treated as “doing business” if it satisfies any one of several alternative tests.
  • The revised Rule 147 provides safe harbors to ensure that the intrastate offering is not “integrated” with other offerings.
  • In its original form, Rule 147 provided that securities purchased in the intrastate offering could not be sold except in the state where they were purchased for nine months following the end of the offering. The revised Rule 147 provides, instead, that securities purchased in the intrastate offering may not be sold except in the state where they were purchased, for a period of six months (not six months from the end of the offering).

Those are all good changes. But the SEC didn’t stop there. In addition to changing Rule 147 for the better, the SEC has adopted a brand new Rule 147A. Rule 147A more or less begins where Rule 147 leaves off and adds the following helpful provisions:

  • Most significantly, offers under Rule 147A may be made to anyone. That means the issuer may use general soliciting and advertising – and the Internet in particular – to broadcast its offering to the whole world. Purchasers – the investors who buy the securities – must still be residents of the state, but offers may be made to anybody.
  • The issuer doesn’t have to be incorporated in the state, as long as it has its “principal place of business” there – defined as the state “in which the officers, partners or managers of the issuer primarily direct, control and coordinate the activities of the issuer.” Thus, a Delaware limited liability company could conduct an intrastate “offering in Indiana, as long as all the officers and managers live and work in Indiana.

Why did the SEC bother to create a whole new Rule 147A to add these provisions, rather than just adding them to Rule 147?

The answer is that Rule 147 is an implementation of section 3(a)(11) of the Securities Act, and if you look at section 3(a)(11) you’ll see that the additional provisions in Rule 147A – allowing offers to everybody, allowing a non-resident issuer – are prohibited by the statutory language. To add these provisions, the SEC had no choice but to create a new Rule 147A that is entirely independent of section 3(a)(11).

And there’s the rub. Many of the existing intrastate Crowdfunding laws require the issuer to comply with Rule 147 and section 3(a)(11). Texas, for example, says:

Securities offered in reliance on the exemption provided by this section [the Texas intrastate Crowdfunding rule] must also meet the requirements of the federal exemption for intrastate offerings in the Securities Act of 1933, §3(a)(11), 15 U.S.C. §77c(a)(11), and Securities and Exchange Commission Rule 147, 17 CFR §230.147.

This means that issuers in Texas will not be allowed to conduct an offering under the more liberal provisions of Rule 147A until the Texas State Securities Board changes that sentence to read:

Securities offered in reliance on the exemption provided by this section must also meet the requirements of the federal exemption for intrastate offerings in the Securities Act of 1933, §3(a)(11), 15 U.S.C. §77c(a)(11), and Securities and Exchange Commission Rule 147, 17 CFR §230.147, or, alternatively, the requirements of the federal exemption for intrastate offerings in Securities and Exchange Commission Rule 147A, 17 CFR §230.147A.

To those who have spent the last three years pushing intrastate Crowdfunding laws through state legislatures, it might look as if the boulder has rolled back down the hill. But there might also be a silver lining. Almost all the state rules were adopted before Title III became final, and almost all include very modest offering limits. Now that Title III is working as promised, Rule 147A might present an opportunity for legislatures not just to take advantage of the more liberal provisions, but also to raise offering limits and make other adjustments, seeking to make their state rules more competitive with the Federal Title III rules.

In the big picture, the SEC has once again proven itself a fan of Crowdfunding. And that’s good.

Questions? Let me know.

Two Upcoming Events

I’m delighted to participate in two important Crowdfunding events over the next few weeks:

  • The Regulation A Bootcamp in Manhattan this Thursday, November 10th. For more information and to register, click here.
  • The CrowdInvest Summit in Los Angeles on December 7th. For more information and to register, click here. (Use prom code “MARK30” for 30% off your conference pass).

Both these events are going to be terrific, with a roster that reads like a who’s-who in the industry.

(Miss Nevada had planned to attend also, but apparently had a last-minute scheduling conflict when she learned I would be participating.)

I look forward to seeing everyone else there!

MARK

Assembling the Team for a Regulation A Offering (and how much it costs)

The two most frequently asked questions about Regulation A are: How long does it take? and How much does it cost?

I tried to answer the first question with this Regulation A Timeline.

To answer the second question, I’ve created a chart called Assembling the Regulation A Team. The chart identifies the services required for a successful Regulation A offering (legal, accounting, etc.) and estimates how much each service will cost. At the end, I’ve included a pro forma chart for issuers to estimate the cost of their own offerings.

I find that many would-be Regulation A issuers find the process opaque and somewhat intimidating. I hope these two tools – the Regulation A Timeline and Assembling the Regulation A Team – can make it simpler, more transparent, and more predictable.

Questions? Let me know.

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