Real estate professionals have always needed to raise capital from friends and family, investors, family offices, pensions, and institutional LPs. Unfortunately, there are a lot of myths surrounding the legalities of raising capital. This article will provide a clear explanation as to why sponsors must consider securities laws.
The most common strategies to raise capital in real estate have been to offer and sell LLC or LP interests, debt instruments, warrants, or equity/income participation contracts. In most contexts, all these investments are securities. Thus, the issuer of said securities must either register the offer and sale of these securities with the state the investors reside in or the Securities & Exchange Commission OR find an exemption from registration. This article will focus on the commonly relied upon exemptions for real estate professionals, including Regulation D, Regulation A, and other options.
Many sponsors have argued that securities regulations do not apply to “friends & family” capital raises. This could not be furthest from the truth. Both the Howie Test and Reves Test tell us that the conclusion on whether an investment is a security lies in a multi-pronged analysis that focuses on the investor’s relationship and expectations along with the nature of the investment itself.
The simplest way to drive this question home is the following: if the investors are all business partners that will equally participate in the operations and efforts for return on investment, this is less likely to be a security. Any instance to the contrary has a higher likelihood of being a security. If it is assumed that the investment is a security, how does a sponsor ensure that the securities are being offered and sold in conformity with state or federal law?
Which Exemption Should I Choose?
The key questions sponsors should answer are:
Do they seek to raise capital from NON-ACCREDITED INVESTORS?
Do they wish to ADVERTISE the investment opportunity to the public?
Absent a crowdfunding strategy, most sponsors in real estate seek to raise capital from high-net-worth investors. They are more yield driven, likely to invest larger sums of capital, and less likely to be activist.
For these reasons, the most relied upon exemption in real estate is Regulation D Rule 506. This rule allows sponsors to raise an unlimited amount of capital throughout the United States. There are two versions of Rule 506 offerings: Rule 506(B) and Rule 506(C). Rule 506(B) allows Funds to raise an unlimited amount of capital throughout the United States as long as the Fund
- Only sells securities that are restricted from transfer for at least one year (“restricted securities”),
- Limits the total number of unaccredited investors to thirty-five investors (each of whom are financially sophisticated), and
- Refrains from general solicitation and/or advertising to gather investors. 506(B) places no restrictions on the total number of accredited investors. This restriction is significant because in today’s competitive market, advertising and general solicitation has become a necessity to be successful. The most complex and least understood restriction is 506(B)’s prohibition on general solicitation. This restriction prohibits the offer and sale of securities to any investor that does NOT have a pre-existing business relationship with the sponsor.
Rule 506(C) allows advertising and general solicitation but restricts Funds to accept verified accredited investors only. Verification can be done by the sponsor via reasonable means, such as bank statements, tax returns, or other financial documents. This verification process does have a safe harbor – by obtaining a verification letter from 1 of 4 professionals: CPAs, Attorneys, Broker Dealers, or Registered Investment Advisers.
Under both Rule 506(B) or 506(C), the sponsor is required to file an annual notice filing with the Securities and Exchange Commission (“SEC”) known as Form D. The Fund is also required to file a copy of Form D with the most state jurisdiction in which a Fund’s investors reside. Recent changes to the definition of an “accredited investor” by the Securities & Exchange Commission makes Regulation D Rule 506(B) or 506(C) a much more attractive option.
Another key question we must ask is: Where do your investors reside? Some sponsors elect to raise capital in a single state, which is perfectly acceptable. In these instances, sponsors can rely on the securities laws of the state. Every state in the union has different securities regulations and exemptions, so it is important to consult with an attorney familiar with these regulations.
For sponsors seeking to raise capital from a larger contingent of non-accredited investors or looking to pursue a crowdfunding strategy, we typically recommend Regulation A as the best option. Generally, Regulation A is no different than a public offering in that it requires SEC approval and frequent reporting. It permits full advertising and general solicitation and permits a larger contingent of non-accredited investors. There are specific caps on the total capital that can be raised. A commonly overlooked issue for Regulation A is state compliance. Tier 1 requires registration in every state in which the securities are sold. Tier 2 does preempt state law, but it does require additional compliance.
Do I need a Prospectus / Private Placement Memorandum?
YES! Regardless of whether you are selling securities using Rule 506(B), 506(C), state law, or Regulation A, it is considered standard and best practice to offer and sell securities using an offering memorandum like a prospectus. The primary reason is because these documents disclose the key features of the investment, risks associated with the investment, and outlines the investor qualifications.
COMMONLY RELIED UPON FEDERAL SECURITIES EXEMPTIONS
| Reg D 506(B) | Reg D 506(C) | Reg A Tier I | Reg A Tier II | |
| Limits on Total Capital | None | None | $20MM/12 months | $75MM/12months |
| State Law Preemption | Yes | Yes | No | Yes |
| Transfer Restrictions | Yes | Yes | Limited | Limited |
| Accredited Investor Verification Required | No | Yes | No | No |
| General Solicitation/Advertising | No | Yes | Yes | Yes |
| Offering Approval | No | No | Yes | Yes |
| Investor Limit | 2000 Max 35 Non-Accredited Investors | 2000 | 2000 Accredited Investors 500 Non-Accredited Investors | None – but if offering equity may subject to ’34 Act reporting requirements after a certain point |
| Ongoing Reporting | Form D | Form D | Exit Report and Annual approval required | Annual / Semi-Annual / Current Event Reporting: Audited Financials |
Whether you are a developer, family office, mortgage lender, or investor, it is important to consider these fundamental securities considerations. Please contact us if you would like to learn more!
