Simultaneous Offerings Under Rule 506(c) And Regulation S

Co-Authored By: Bernard Devieux & Mark Roderick

If you ask one of my partners whether he wants beer or hard liquor, he says “Yes.” That’s the same answer most entrepreneurs give when asked whether they want to raise money from U.S. investors or investors who live somewhere else. Fortunately, if you’re reasonably careful, you can raise money from U.S. investors under Rule 506(c) – otherwise known as Title II Crowdfunding – while simultaneously raising money from non-U.S. investors under Regulation S.

You don’t have to use Regulation S to raise money from non-U.S. investors. You can use Rule 506(c) instead, as long as you take reasonable steps to verify that they’re accredited, just as with U.S. investors. But verification can be difficult with non-U.S. investors. You use Regulation S either because you want to include non-U.S. investors who are non-accredited or because you just don’t want the hassle of verification.

The concept behind Regulation S is simple:  the U.S. government doesn’t care about protecting non-U.S. people. That sounds harsh but think about it this way. If an American citizen is taken hostage in Albania, boom, the U.S. military comes to the rescue. But if a Russian citizen is taken hostage in Albania. . . .well, maybe that’s a bad example these days, but you get the picture.

To implement this concept, Regulation S provides that:

For purposes of section 5 of the Securities Act of 1933 [the law that usually requires the registration of securities offerings], the terms offer, offer to sell, sell, sale, and offer to buy shall be deemed . . . not to include offers and sales that occur outside the United States.

An offer or sale by an issuer of securities will be treated as occurring “outside the United States” only if all of the following requirements are satisfied:

  • The buyer is a non-U.S. person.
  • The issuer follows designated guidelines with legends on the securities, restrictions on resales, etc.
  • The offer is not made to a person in the United States.
  • No “directed selling efforts” are made in the United States.

The first two are relatively easy:  you make sure the investor isn’t a U.S. resident and you put the right words on stock certificates, promissory notes, and other legal documents.

The second two become tricky in Crowdfunding, where everything is done on the Internet.

For example, suppose an issuer maintains a single website advertising its offering of common stock, equally accessible to prospective investors in Iowa and in Spain. The website undoubtedly constitutes an “offer” to investors in Iowa, and is undoubtedly part of a “directed selling effort” in Iowa, no less than if the offering had been advertised in the Des Moines Gazette. Does this ruin the Regulation S offering?

The SEC’s definition of “directed selling efforts,” written in the early 1990s, doesn’t address this situation. And other than confirming that issuers are legally permitted to conduct simultaneous offerings under Rule 506(c) (to U.S. investors) and Regulation S (to non-U.S. persons) so long as each offering complies with its applicable rules, the SEC has not provided specific guidance on how to avoid the “cross-contamination” issue involving websites.

Fortunately, the SEC addressed a very similar issue with intrastate Crowdfunding just last year. Technically, an intrastate offering is allowed only if “offers” are limited to the citizens of one state. Does posting an offering on a website violate that rule, given that the website is visible to everyone? The SEC chose the position more favorable to Crowdfunding (as it almost always does), announcing that an intrastate offering could be advertised on a website as long as the issuer accepts investments only from residents of the state in question.

The SEC’s position on intrastate offerings suggests that it would take a similar position on Regulation S, finding that the use of a single website would not violate either (1) the requirement that no “offers” be made in the U.S., and (2) the requirement that “no directed selling efforts” be made in the U.S. But we don’t know for sure.

To be on the safe(er) side, an issuer would create separate websites, one for the Rule 506(c) offering and the other for the Regulation S offering, and use IP addresses to ensure that the Regulation S website is not visible within the United States. On the Regulation S website, you would also:

  • Have each visitor (and potential investor) verify his, her, or its legal residence before being permitted to see the details of the offering; and
  • Feature prominent disclaimers that U.S. persons are not welcome.

Finally, bear in mind that Regulation S is an exemption from U.S. securities laws. If you’re offering and selling securities to the citizens of another country, you should think about the laws of that country, too.

 

 

 

 

REALCROWD Webinar: An Attorney’s Take on Real Estate Crowdfunding

Listen as Adam Hooper and Mark Roderick discuss crowdfunding for real estate and the legal documents investors sign when investing in a real estate deal.

Mark Roderick is one of the leading attorneys in the Crowdfunding/Fintech industry and speaks at conferences and other events all over the world. If you’re interested in having Mark speak at an event, please contact Molly Grimm,Communications Manager at Flaster Greenberg PC, at 856.382.2211 or via email: molly.grimm@flastergreenberg.com.

CROWDFUNDING AND CRYPTOCURRENCIES

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Cryptocurrencies are hot. And often the sale of cryptocurrencies is referred to as Crowdfunding. Unfortunately, the use of “cryptocurrencies” and “Crowdfunding” together creates confusion about both, along with some pretty serious legal risks.

We use “Crowdfunding” to mean raising money for a business or other venture online. We say “donation-based Crowdfunding” when we’re talking about Kickstarter, where people ask for donations. We say “equity-based Crowdfunding” when we’re talking about raising money from investors, who receive a stock certificate or some other security.

A cryptocurrency is, well, hard to pin down. It’s a transaction registered in a distributed, secure database. Because it exists in limited quantities and is secure, it has value. Like anything of value, it can be used as a currency. For purposes of this post, the key feature of a true cryptocurrency is that is has value of itself, like a nugget of gold.

You use Crowdfunding to sell shares of stock. Obviously, the paper certificates representing the shares of stock have no value by themselves, they have value only to evidence ownership in the business that issued the certificates or, more exactly, in the cash flow the business is expected to generate. So it wouldn’t make sense to say “I’m selling nuggets of gold using Crowdfunding.” The nuggets of gold have an intrinsic value without reference to the cash flow of anything else, or at least you hope they do. I can go shopping with a cryptocurrency like Bitcoin or Ethereum, just as I can shop with US dollars or, historically, with gold.

This is where things get tricky and words matter. The blockchain – the technology underlying all cryptocurrencies – can be used for a lot of things other than cryptocurrencies. As it happens, one of the things the blockchain can be used for is to keep track of stock certificates. In fact, the blockchain works so well keeping track of stock certificates that it will undoubtedly be used by (or replace) all public stock transfer agents within the next five years.

What’s happening today is that companies are selling what they call “cryptocurrencies” that are really just interests in the future operations of a business, i.e., really just hi-tech stock certificates. Cool, they’re using blockchain technology to keep track of who owns the company! But that doesn’t mean what you’re buying is really a cryptocurrency and that you’re going to get rich like the early buyers of Ethereum.

Words are powerful, and the confusion around cryptocurrencies is deepened by the nomenclature. Sales of cryptocurrencies are often referred to as “initial coin offerings,” or ICOs, which implies a similarity to “initial public offerings,” or IPOs. Yet if we’re being careful, the two have nothing in common. In an IPO a company sells its own securities, which have value only based on the success of the company. In an ICO somebody sells a product that has intrinsic value of itself.

Ignoring the difference is going to land someone in hot water, probably sooner rather than later. A company that sells something it calls a cryptocurrency but is really just a share of stock is selling a security, even if that company has an address near Palo Alto. And a company that sells a security is subject to all those pesky laws from the 1930s. If you sell a cryptocurrency that is really just a hi-tech stock certificate, then not only do you risk penalties from the SEC and state securities regulators, you’ll also face lawsuits from your investors if things don’t go as planned.

How to know whether you’re selling a true cryptocurrency or a hi-tech stock certificate? Here are some tips:

  • If the value of the cryptocurrency depends on the success of the business, it’s a security.
  • If the value of the cryptocurrency depends on, or is backed by, real estate or other property, it’s a security.
  • If the cryptocurrency is marketed as an investment, it’s probably a security.
  • If the value of the cryptocurrency depends what the buyer does with it, rather than the success of the business, it’s probably not a security.
  • If the cryptocurrency merely gives the holder the right to participate in a group effort (g., the development of software), it’s probably not a security.
  • If you’re selling the cryptocurrency in lieu of issuing stock, it’s probably a security.

What is a REIT, Anyway?

Real Estate Investment Trusts, or REITs, are the shiny new object in Regulation A. What is a REIT and what good are they?

A REIT is just a tax concept. A REIT is an entity that is treated as a corporation for Federal income tax purposes and satisfies a long list of requirements listed in section 856 of the Internal Revenue Code. These requirements include:

  • The kinds of assets it owns
  • The kind of income it generates
  • Who owns it
  • How much of its income it distributes to its owners

Conversely a REIT is not a function of securities laws, contrary to what many people believe. Thus, many REITs have “gone public” by offering their securities in offerings that are registered under the Securities Act of 1933, while many other REITs are still private. Some “public” REITs have registered their shares on a national securities exchange, allowing the shares to be publicly traded, while the shares of other “public” REITs are traded privately. There are very large REITs and very small REITs, and everything in between. Some REITs invest in one class of real estate assets, others invest in completely different classes of real estate assets (e.g., only mortgages), and still others invest in multiple classes of real estate assets. The only thing all these companies have in common, being REITs, is that they all satisfy the requirement in section 856 of the Code.

A REIT may raise capital the same way any other company may raise capital. It may raise capital from accredited investors under Rule 506(c), or from accredited and non-accredited investors under Rule 506(b), or in a quasi-public offering under Regulation A, or in a fully-registered public offering, or in an intrastate offering, or in an offering under Rule 504.

A REIT may offer any kind of financial instrument to its investors:  common stock, preferred stock, straight debt, convertible debt, etc.

So if a REIT is just a tax label, rather than a securities label, why bother to use a REIT for real estate Crowdfunding? The answer is, again, just taxes.

If we’re going to create a fund of real estate assets, we have three choices:  a REIT; a corporation that is not a REIT; and a regular limited liability company or limited partnership. Here’s the logic:

  • If we use a corporation that does not qualify as a REIT, it will be subject to tax on its income at the corporate level, and investors would then be subject to tax again when the corporation distributes its income, resulting in two levels of tax on the same income. Forget that.
  • If we use a regular limited liability company or limited partnership, it will send each equity investor an IRS Form K-1 each year, reporting all of its categories of income, gains, deductions, and distributions.
  • If we use a REIT, it will send each equity investor a simple IRS Form 1099.

Now, if all your investors are wealthy, sophisticated Republicans, they don’t care about receiving another K-1. But if you’re trying to market your fund to simple Democrats, it’s a different story. Say your typical simple Democrat can afford only a $1,000 investment, and a tax filing service charges $49.95 to add the K-1 to her Form 1040 (assuming she files a Form 1040). That’s a 5% annual cost of investing in your fund! A 1099, in contrast, is free.

That’s why we never saw REITs in Title II Crowdfunding, which allows only accredited investors to participate, while we’re seeing a lot of them in Title IV, which allows everyone. The REIT has to spend money complying with Code section 856, but has an easier time attracting non-accredited investors simply as a matter of tax reporting.

Finally, perceptive readers might ask “If REITs are corporations, why do I see REITs on the market with ‘LLC’ after their names?” The answer is that REITs don’t have to be corporations, they have to be taxed as corporations for Federal income tax purposes. A limited liability company that elects to be taxed as a corporation (yep, that’s possible) can qualify as a REIT.

Questions? Let me know.

Filing Financial Statements and Other Reports Under Regulation A

“I know I have to include financial statements when I file an Offering Statement under Regulation A. When should these statements be dated and what periods should they cover?”

“What ongoing reports do I have to file with the SEC after my Regulation A offering is qualified, and when do I have to file them?”

We hope to answer these questions below.

Types of Financial Statements in the Offering Statement

A Regulation A Offering Statement can require four kinds of financial statement:

  • A balance sheet as of the end of a fiscal year
  • An interim balance sheet
  • A statement of income, cash flows, and changes in stockholders’ equity
  • Interim statements of income, cash flows, and changes in stockholders’ equity

Requirements for Financial Statements

In general, the financial statements must be audited in a Tier 2 offering, but not in a Tier 1 offering. However, interim financial statements – balance sheets and statements of income and cash flows – never have to be audited, even in Tier 2.

Audits in Regulation A may be performed using U.S. Generally Accepted Audited Standards or the standards of the Public Company Accounting Oversight Board. The accounting firm that prepares the audit does not have to be registered with the PCAOB.

When Should the Financial Statements in the Offering Statement Be Dated?

This is tricky, because there are not one, but two important dates:  the date the Offering Statement is filed with the SEC, and the date it is qualified by the SEC. By definition, the date of qualification is always after the date of filing, by a month in the best of circumstances and often by many months. That means that a financial statement that was timely when the Offering Statement was filed might be “stale” by the time it’s qualified. In that case, you’ll need to submit updated financial statements before qualification.

Thus, read the term “Reference Date” in the chart below to mean the date of filing, when you’re preparing your Offering Statement. But bear in mind that eventually the “Reference Date” will mean the date of qualification. So if you’re close, you might as well use a later date.

Click here to view the printable chart.

Ongoing Reporting under Regulation A

Click here to view the printable chart.

 

Questions? Let me know.

A Summary of the Investment Company Act for Crowdfunding

Hardly a day goes by without someone asking a question that involves the Investment Company Act of 1940. Although the Act is hugely long and complicated, I’m going to try to summarize in a single blog post the parts that are most important to Crowdfunding.

Why the Fuss?

If you’re in the Crowdfunding space, you don’t want to be an “investment company” within the meaning of the Act:

  • As an investment company, you’re not allowed to raise money using either Title III (Regulation Crowdfunding) or Title IV (Regulation A).
  • Investment companies are subject to huge levels of cost and regulation.

What is an Investment Company?

An investment company is company in the business of holding the securities of other companies. That statement raises many interesting and technical legal issues that have consumed many volumes of legal treatises and conferences at the Waldorf. But almost none of it matters to understand the basics.

All that matters from a practical perspective is that stock in corporations, interests in limited liability companies, and interests in limited partnerships are all generally “securities” within the meaning of the Act.

And that means, in turn, that if you hold stock in corporations, interests in limited liability companies, and/or interests in limited partnerships, then assume you’re an “investment company” within the meaning of the Act, unless you can identify and qualify for an exception.

How Much is Too Much?

Holding some securities doesn’t make you an investment company. Under one of the many technical rules in the Act, a company won’t be considered an investment company if:

  • No more than 45% of its assets are invested in securities, as of the end of the most recent fiscal quarter; and
  • No more than 45% of its income is derived from investment securities, as of the end of the most recent four fiscal quarters.

Does That Mean a Typical SPV is an Investment Company?

Unless the SPV can find an exception, yes.

Many Crowdfunded investments use a “special purpose vehicle,” typically a Delaware limited liability company. Investors acquire interests in the SPV, and the SPV invests – as a single investor – in the actual operating company. Because the only asset of the SPV is the interest in the operating company, which is a “security,” the SPV is indeed an investment company, unless it qualifies for one of the exceptions below.

Simple Exceptions

The definition of “investment company” is so broad, most of the action is in the exceptions. I’m not going to talk about all of them, only those that are most relevant to Crowdfunding.

  • No More Than 100 Investors – A company with no more than 100 investors (who do not have to be accredited) isn’t an investment company. That’s the exception used by SPVs in Crowdfunding. Which means that as the size of deals in Crowdfunding grows, SPVs will no longer be used.
  • All Qualified Investors – A company with only “qualified investors” isn’t an investment company. A “qualified investor” is generally a person with more than $5 million of investable assets. Many hedge funds rely on this exception, but it’s not going to be used widely in Crowdfunding.

NOTE:  A company that would be an investment company but for either of those two exceptions is still not allowed to use Title III or Title IV.

  • Companies That Invest In Mortgages – A company that invests in or originates mortgages is usually not an investment company.
  • Wholly-Owned Subsidiaries – A company that conducts its business through wholly-owned subsidiaries isn’t an investment company, as long as the subsidiaries are not investment companies. For these purposes, “wholly-owned” means the parent owns at least 95% of the voting power.
  • Majority-Owned Subsidiaries – A company that conducts its business through majority-owned subsidiaries usually isn’t an investment company, as long as the subsidiaries are not investment companies. For these purposes, “majority-owned” means the parent owns at least 50% of the voting power.

The 45% Exception

Some companies, including some REITs, own interests in subsidiaries that are not wholly-owned or even majority-owned. To avoid being treated as investment companies, those companies typically rely on an exception that requires more complicated calculations. Under this exception, a company is excluded from the definition of “investment company” if it satisfies both of the followings tests:

  • No more than 45% of the value of its assets (exclusive of government securities and cash items) consist of securities other than what I will refer to as “allowable securities.”
  • No more than 45% of its after-tax income is derived from securities other than those same “allowable securities.”

For these purposes, the securities I am calling “allowable securities” include a number of different kinds of securities, but the two most important to us are:

  • Securities issued by majority-owned subsidiaries of the parent; and
  • Securities issued by companies that are controlled primarily by the parent.

So think of those securities as being in the “good” basket and other kinds of securities as being in the “bad” basket.

In determining whether a security – such as an interest in a limited liability company – is an “allowable security,” and therefore in the “good” basket, the following definitions apply:

  • A subsidiary is a “majority-owned subsidiary” if the parent owns at least 50% of the voting securities of the subsidiary.
  • A parent is deemed to “control” a subsidiary if it has the power to exercise a controlling influence of the management or policies of the subsidiary.
  • A parent is deemed to “control primarily” a subsidiary if (1) it has the power to exercise a controlling influence of the management or policies of the subsidiary, and (2) this power is greater than the power of any other person.

Summary

If your business model involves investing in other companies and you plan to raise money from other people, the Investment Company Act of 1940 should be on your To Do List.

As a rule of thumb, you can feel comfortable investing in wholly-owned subsidiaries, majority-owned subsidiaries, and subsidiaries where you have exclusive or at least primary control. If you find other investments making up, say, more than 25% of your portfolio, measured by asset value or income, look harder.

Questions? Let me know.

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.

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