WRITE YOUR REGULATION A OFFERING CIRCULAR WITH ADVERTISING IN MIND

WRITE YOUR REGULATION A OFFERING CIRCULAR WITH ADVERTISING IN MIND

Too many issuers think of the Regulation A Offering Circular as just a dry legal document between the SEC and the lawyers. It should be more than that.

As I’ve said once or twice before, Crowdfunding is a marketing business. Creating a great company with a great product isn’t enough. “Build it and they will come” worked for Kevin Costner but it doesn’t work for most companies trying to raise capital.

Here are some examples of things you’d like to say to attract investors:

  • We have a terrific track record in this industry going back 15 years.
  • Our performance during the last five years has doubled industry averages.
  • Our Founder has had successful exits from her last three companies.
  • Experts forecast that our market will triple over the next seven years.

Those can be very powerful messages for prospective investors. But here’s the thing:  you’re not allowed to say them in your Facebook ads unless you’ve already said them in your Offering Circular.

You spend all the time and money to have your Regulation A offering qualified by the SEC, only to learn that you’re not allowed to say what you’d like to say to attract investors. 

Write your Offering Circular with advertising in mind. Make your lawyer speak with your marketing team and vice versa, even though they speak different languages. Create your marketing materials — your website, your Facebook ads, your email campaigns — in conjunction with your Offering Circular, so all the pieces are working together rather than pulling in opposite directions.

COVID-19 DISCLOSURES IN CROWDFUNDING OFFERINGS

The COVID-19 pandemic illustrates why we include a list of “risk factors” when we sell securities. Suppose a company issued stock on January 1, 2020 without disclosing that its major supplier was located in Wuhan, China and that Wuhan was experiencing an outbreak of a new virus. Investors who bought the stock likely would be entitled to their money back and have personal claims against the founders, officers, and directors.

If the company issued stock on October 1, 2019, before the pandemic began, its duty to tell investors about the pandemic would depend on which version of Crowdfunding it used:

  • If it used Title II Crowdfunding (Rule 506(c)) the company would have no duty to tell investors about the pandemic.
  • If it used Title III Crowdfunding (Regulation CF) the company would be required to tell investors about the pandemic in its next annual report.
  • If it used Title IV Crowdfunding (Regulation A) the company would be required to tell investors about the pandemic in its next semiannual or annual report, whichever comes first.

CAUTION:  That assumes the Company was finished selling stock on October 1, 2019. If it was continuing to sell stock when it learned of the pandemic, then the Company would be required to tell new investors. And if a Title III offering hadn’t yet closed, all existing investors would have the right to change their minds.

CAUTION:  A company – even a publicly-reporting company – generally is not required to tell investors about COVID-19 if it is not selling securities currently, because pandemics are not on the list of disclosure items found in Form 1-U (for Regulation A issuers) or Form 8-K (for publicly-reporting companies). But be careful. For example, if a Regulation A issuer redeems stock without disclosing the effect of COVID-19, it could be liable under Rule 10b-5 and otherwise.

Assume that we’re required to tell investors about COVID-19 today, whether because we’re selling stock or are filing an annual or semiannual report. What do we say?

If this were January, we might say something simple:  “Wuhan, China is experiencing an outbreak of a highly-contagious virus, which is disrupting economic activity. If this virus should spread to the United States, as epidemiologists predict, it could have an adverse effect on our business.”

But this isn’t January. We have much more information today and are therefore required to say more. Exactly how much information we share is as much an art as a science. Our goal is always to give investors enough information to make an informed decision without making the disclosure so dense as to be useless.

Here are two examples, one for multi-family housing projects and the other for a technology company.

Multi-Family Housing

With unemployment reaching levels not seen since the Great Depression, by some estimates already 20% and rising, we are already experiencing a number of negative effects from the COVID-19 pandemic:

  • We are experiencing a decrease in the number of phone calls and visits from potential new tenants. Year-to-year compared to 2019, we experienced a decrease in traffic of approximately ____% in March and ____% in April.
  • We are experiencing an increase in rent delinquency. Year-to-year compared to 2019, the rate of delinquencies greater than 30 days rose from ____% to ____% during March and ____% to ____% during April.
  • We are spending more time and resources on collections and marketing.

Although we are working from incomplete information, we expect these trends to continue and perhaps accelerate, depending on the trajectory of the virus and the ability to re-open the economy. Among possible outcomes:

  • Occupancy levels might decrease, although they have not decreased yet as compared to the same periods in 2019.
  • We do not intend to raise rents until the pandemic eases. Depending on circumstances we could be forced to decrease rents.
  • We expect some tenants to re-locate for economic reasons, from Class A projects to Class B projects and from Class B projects to Class C projects. In some cases tenants might leave the market altogether, by moving in with relatives, for example. Because we operate primarily Class B properties, we are uncertain whether the net effect for our properties will be positive or negative.
  • Conversely, we expect that economic uncertainty will cause some families to postpone buying a house and rent instead, increasing the pool of potential tenants.
  • The pandemic has caused significant uncertainly in the value of many assets, including real estate. Until the uncertainty is resolved it might be difficult for us to borrow money or raise capital by selling equity.
  • If occupancy rates and rents decrease while delinquencies increase, we could be unable to meet our obligations as they become due. A reduction in cash flows and/or asset values could also cause us to be in default under the loan covenants under our senior debt. Either scenario could lead to foreclosure and the loss of one or more properties.

At least in the short run we expect the pandemic to cause our revenue to decrease, perhaps significantly. As a result, we are taking steps to conserve cash. Among other things we have decided not to make any cash distributions until the economic outlook stabilizes and have reduced our staff. We have also begun to contact lenders to request a deferral of our mortgage loan obligations.

We do not know how long the pandemic will last or how its effects will ripple through the American economy. In a best-case scenario we would experience a short-term drop in cash flow and a dip in asset values as the economy adjusts to a new reality. In a worst-case scenario, where occupancy and rent levels drop significantly over an extended period of time, we would be unable to make mortgage payments and possibly lose assets, risking or even forfeiting investor equity if asset values drop far enough. Based on the information currently available to us we expect an outcome closer to the former scenario than to the latter and are marshalling all our experience and assets toward that end.

Technology

Our software provides a virtual connection between internet-based office telephone systems and cellular phones, allowing incoming calls to the office number to be re-directed to the cellular phone and outgoing calls made from the cellular phone to appear to the recipient as if they were made from the office number. Will tens of millions of people working remotely due the COVID-19 pandemic, the demand for our software has grown substantially. On January 1, 2020 our software had been installed on ________ cellular devices worldwide. On May 1, 2020 it was installed on ________ devices.

As a result, we expect both our revenue and our net income for 2020 to increase substantially. However, with many workers now returning to their offices on a full-time or part-time basis it is unclear whether the high demand for our software will continue. Consequently, we are unable to provide a reliable forecast for revenue or net income at this time.

With more than ________ new users, even if temporary, we are accelerating developing of our new consumer-based communications tools. We expected to launch these tools in Q1 2021 but are now aiming for Q3 2020.

Even before the pandemic many of our employees worked remotely at least part of the time. Therefore, our operations have not been affected significantly by the pandemic. Tragically, however, David Newsome, the leader of our marketing team, contracted COVID-19 and died on March 27th in Brooklyn, NY. We have not yet found a replacement for David, who was with the company from its founding in 2013.

We were considering purchasing a commercial building in Palo Alto as the headquarters for our engineering team. Given our successful experience working remotely we have decided to put those plans on hold at least for the time being.

SEC PROPOSES MAJOR UPGRADES TO CROWDFUNDING RULES

The SEC just proposed major changes to every kind of online offering:  Rule 504, Rule 506(b), Rule 506(c), Regulation A, and Regulation CF.

The proposals and the reasoning behind them take up 351 pages. An SEC summary is here, while the full text is here. The proposals are likely to become effective in more or less their existing form after a 60-day comment period.

I’ll touch on only a few highlights:

  • No Limits in Title III for Accredited Investors:  In what I believe is the most significant change, there will no longer be any limits on how much an accredited investor can invest in a Regulation CF offering. This change eliminates the need for side-by-side offerings and allows the funding portal to earn commissions on the accredited investor piece. The proposals also change the investment limits for non-accredited investor from a “lesser of net worth or income” standard to a “greater of net worth or income” standard, but that’s much less significant, in my opinion.
  • Title III Limit Raised to $5M:  Today the limit is $1.07M per year; it will soon be $5M per year, opening the door to larger small companies.

NOTE:  Those two changes, taken together, mean that funding portals can make more money. The impact on the Crowdfunding industry could be profound, leading to greater compliance, sounder business practices, and fewer gimmicks (e.g., $10,000 minimums).

  • No Verification for Subsequent Rule 506(c) Offerings:  In what could have been a very important change but apparently isn’t, if an issuer has verified that Investor Smith is accredited in a Rule 506(c) offering and conducts a second (and third, and so on) Rule 506(c) offering, the issuer does not have to re-verify that Investor Smith is accredited, as long as Investor Smith self-certifies. But apparently the proposal applies only to the same issuer, not to an affiliate of the issuer. Thus, if Investor Smith invested in real estate offering #1, she must still be verified for real estate offering #2, even if the two offerings are by the same sponsor.
  • Regulation A Limit Raised to $75M:  Today the limit is $50M per year; it will soon be $75M per year. The effect of this change will be to make Regulation A more useful for smaller large companies.
  • Allow Testing the Waters for Regulation CF:  Today, a company thinking about Title III can’t advertise the offering until it’s live on a funding portal. Under the new rules, the company will be able to “test the waters” like a Regulation A issuer.

NOTE:  Taken as a whole, the proposals narrow the gap between Rule 506(c) and Title III. Look for (i) Title III funding portals to broaden their marketing efforts to include issuers who were otherwise considering only Rule 506(c), and (ii) websites that were previously focused only on Rule 506(c) to consider becoming funding portals, allowing them to legally receive commissions on transactions up to $5M.

  • Allow SPVs for Regulation CF:  Today, you can’t form a special-purpose-vehicle to invest using Title III. Under the SEC proposals, you can.

NOTE:  Oddly, this means you can use SPVs in a Title III offering, but not in a Title II offering (Rule 506(c)) or Title IV offering (Regulation A) where there are more than 100 investors.

  • Financial Information in Rule 506(b):  The proposal relaxes the information that must be provided to non-accredited investors in a Rule 506(b) offering. Thus, if the offering is for no more than $20M one set of information will be required, while if it is for more than $20 another (more extensive) set of information will be required.
  • No More SAFEs in Regulation CF:  Nope.

NOTE:  The rules says the securities must be “. . . . equity securities, debt securities, or securities convertible or exchangeable to equity interests. . . .” A perceptive readers asks “What about revenue-sharing notes?” Right now I don’t know, but I’m sure this will be asked and addressed during the comment period.

  • Demo Days:  Provided they are conducted by certain groups and in certain ways, so-called “demo days” would not be considered “general solicitation.”
  • Integration Rules:  Securities lawyers worry whether two offerings will be “integrated” and treated as one, thereby spoiling both. The SEC’s proposals relax those rules.

These proposals are great for the Crowdfunding industry and for American capitalism. They’re not about Wall Street. They’re about small companies and ordinary American investors, where jobs and ideas come from.

No, the proposals don’t fix every problem. Compliance for Title III issuers is still way too hard, for example. But the SEC deserves (another) round of applause.

Please reach out if you’d like to discuss.

Regulation A: What Country Do You See When You Wake Up?

sara palin

A company may use Regulation A (Tier 1 or Tier 2) only if the company:

  • Is organized in the U.S. or Canada, and
  • Has its principal place of business in the U.S. or Canada.

I’m often asked what it means for a company to have its principal place of business in the U.S. or Canada. The first step is to identify the people who make the important decisions for the company. The next step is to ask what country those people see when they wake up in the morning. If they see the U.S. or Canada, they’re okay. If they see some other country, even a beautiful country like Norway or Italy, they’re not okay, or at least they can’t use Regulation A.

Seeing the U.S. or Canada via Facetime doesn’t count.

A company called Longfin Corp. ignored this rule and suffered the consequences. The people who made the important decisions for the company saw India when they woke up in the morning. The only person who saw the U.S. was a 23-year-old, low-level employee who worked by himself in a WeWork space. In its offering materials the company claimed to be managed in the U.S., but a Federal court found this was untrue and ordered rescission of the offering, $3.5 million in disgorgement, and $3.2 million in penalties.

Harder questions arise if, for example, three of the directors and the CFO see the U.S. when they wake up, but two directors and the CEO see Ireland.

On the plus side, a U.S. mining company with headquarters in Wyoming definitely can use Regulation A even if all its mines are in South America. The “principal place of business” means the location where the company is managed, not where it operates.

Questions? Let me know.

The Biggest Challenge With Title III Crowdfunding

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The biggest challenge with Title III Crowdfunding isn’t the $1,070,000 maximum or the per-investor limits. The biggest challenge is how a small company complies with the disclosure requirements on a tight budget.

The disclosures required by Title III — I’m talking specifically about the long list of disclosures required by 17 CFR 227.201 — are fundamentally the same as those required by Title IV (aka Regulation A), which is itself only a slightly scaled-down version of a full-blown public offering.

There are easy questions, like naming the directors and officers, but the most important disclosures make sense only to securities lawyers. Ask the owner of a small business to list the “risks of investing” and you get mostly a blank stare, not the careful list the regulations anticipate. And when you get through everything else, you’re told to disclose “Any material information necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading.”

To a securities lawyer that’s just a restatement of SEC Rule 10b-5. To the founder of a small business it means nothing.

The result is what we see in the Title III market today, a mishmash. Some sites and companies manage to do it well, but many don’t. The widespread failure of compliance has led some to question whether Title III should be expanded before the Title III industry gets its house in order.

How does the industry get its house in order?

Before trying to answer that question, let’s think about how small companies raised money before Title III.

Before Title III, the typical small business was only vaguely aware of securities laws, if at all, and raised money however it could from whomever it could. Without knowing it, the microbrewery raising $250,000 from friends and family was eligible for the Federal exemption under Rule 504 and might have been eligible for state exemptions as well. But it probably wasn’t making the kind of disclosures required by Title III.

The same was true for would-be Silicon Valley unicorns. I’m pretty sure SoftBank didn’t ask Adam Neumann for a list captioned “Risks of Investing.”

The fact is that investing in a small business before 2016, big or small, generally was driven by relationships, not by legal disclosures. Because disclosure is the heart of the U.S. securities laws, it’s no surprise that the SEC turned to disclosure to protect widows and orphans in Title III. But the full-disclosure paradigm is new to this world. Ironically, the typical Title III issuer – even the issuer whose Form C falls short – is making far more disclosures than most small companies made before Title III, and far more than would-be unicorns are making to VCs today.

Does the paradigm used for large companies and institutional investors make sense for tiny companies and non-accredited investors? I’ll leave that for another day.

As an industry, we can take a few steps to improve:

  • Software and Templates – Better software and better templates can help. At the same time, no template or software can produce “Any material information necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading.” I translate that to “What would you tell your grandparents if they were investing?” But still, it’s hard.
  • Standardization – Depending on your point of view, standardization is either the price or the benefit of participating in a mass market. In either case, I’m convinced that Title III can’t function properly without far more standardization:
    • Standardized Corporate Structures – It would be great if every Title III issuer were a Delaware corporation or a Delaware limited liability company, using the same standardized Bylaws or Limited Liability Company Agreement.
    • Standardized Securities – Common stock, a simple preferred stock, a straight term loan, a simple revenue-sharing note, a SAFE, and their tokenized equivalents.
    • Standardized Disclosure Templates – An investor should be able to compare the disclosures between companies and portals apples-to-apples.
    • Standardized Legal Documents – Subscription Agreement, contract between portal and issuer, terms of the SAFE – everything should be standardized. Toward that end, within the next month I’m going to make a set of standardized documents available for issuers and portals.
  • No More $10,000 MinimumsC’mon, man! The Target Amount should reflect the minimum required for a viable business, or to get a necessary patent, or something. The widespread use of artificially-low Target Amounts has damaged the Title III market, driving away serious investors.

As long as I’m at it, I’ll ask just one thing of the SEC. Ideally, figure out a way to eliminate the per-investor limits for accredited investors under Title III, which serve no purpose and are inconsistent with Regulation D. Or, if that’s not possible under the language of the JOBS Act, get to almost the same place by creating a regulatory safe harbor under the Exchange Act, which would allow funding portals to receive commissions from accredited investors in a side-by-side offering.

Everyone benefits, and the Title III market gets healthier.

Questions? Let me know.

Married Couples As Accredited Investors

When a married couple invests in an offering under Rule 506(b), Rule 506(c), or Tier 2 of Regulation A, we have to decide whether the couple is “accredited” within the meaning of 17 CFR §501(a). How can we conclude that a married couple is accredited?

A human being can be an accredited investor in only four ways:

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  • Method #1: If her net worth exceeds $1,000,000 (without taking into account her principal residence); or
  • Method #2: If her net worth with her spouse exceeds $1,000,000 (without taking into account their principal residence); or
  • Method #3: Her income exceeded $200,000 in each of the two most recent years and she has a reasonable expectation that her income will exceed $200,000 in the current year;
  • Method #4: Her joint income with her spouse exceeded $300,000 in each of the two most recent years and she has a reasonable expectation that their joint income will exceed $300,000 in the current year.

A few examples:

EXAMPLE 1: Husband’s net worth is $1,050,001 without a principal residence. Wife’s has a negative net worth of $50,000 (credit cards!). Their joint annual income is $150,000. Husband is accredited under Method #1 or Method #2. Wife is accredited under Method #2.

EXAMPLE 2: Husband’s net worth is $1,050,001 without a principal residence. Wife’s has a negative net worth of $500,000 (student loans!). Their joint annual income is $150,000. Husband is accredited under Method #1. Wife is not accredited.

EXAMPLE 3: Husband’s net worth is $850,000 and his income is $25,000. Wife’s has a negative net worth of $500,000 and income of $250,000. Husband is not accredited. Wife is accredited under Method #3.

Now, suppose Husband and Wife want to invest jointly in an offering under Rule 506(c), where all investors must be accredited.

They are allowed to invest jointly in Example 1, because both Husband and Wife are accredited. They are not allowed to invest jointly in Example 2 because Wife is not accredited, and they are not allowed to invest jointly in Example 3 because Husband is not accredited.

The point is that Husband and Wife may invest jointly only where both Husband and Wife are accredited individually. At the beginning, I asked “How can we conclude that a married couple is accredited?” The answer: There is no such thing as a married couple being accredited. Only individuals are accredited.

CAUTION: Suppose you are an issuer conducting a Rule 506(c) offering, relying on verification letters from accountants or other third parties. If a married couple wants to invest jointly, you should not rely on a letter saying the couple is accredited. Instead, the letter should say that Husband and Wife are both accredited individually.

Questions? Let me know.

Amendments and Supplements in a Regulation A Offering

Pigeon Point lighthouse USA, California, Big Sur

Your Offering Statement has been qualified by the SEC. Now something changes. Do you have to file something with the SEC? If so, what and how?

Changes Reported on Form 1-U

Some changes must be reported using Form 1-U:

  • If the issuer has entered into or terminated a material definitive agreement that has resulted in or would reasonably be expected to result in a fundamental change to the nature of its business or plan of operation.
  • The bankruptcy of the issuer or its parent company.
  • A material modification of either (i) the securities that were issued under Regulation A, or (ii) the documents (g., a Certificate of Incorporation) defining the rights of the securities that were issued under Regulation A.
  • A change in the issuer’s auditing firm.
  • A determination that any previous financial statements cannot be relied on.
  • A change in control of the issuer.
  • The departure or termination of the issuer’s principal executive officer, principal financial officer, or principal accounting officer, or a person performing any of those functions even if he or she doesn’t have a title.
  • The sale of securities in an unregistered offering (g., Rule 506(c)).

Form 1-U may be used, at the issuer’s discretion, to disclose any other events or information that the issuer deems of importance to the holders of its securities.

NOTE:  If an event has already been reported on an annual or semi-annual report, the same event does not have to be reported again on Form 1-U.

NOTE:  A report on Form 1-U must be filed even if the Regulation A offering has ended.

Amendments

After the offering is qualified by the SEC, the issuer must file an amendment of its Offering Statement “to reflect any facts or events arising after the qualification date. . . .which, individually or in the aggregate, represent a fundamental change in the information set forth in the offering statement.”

Examples of fundamental changes:

  • A change in the offering price of the security.
  • A change in the focus of the issuer’s business, g., we were going to focus on cryptocurrencies, but now we’re pivoting to blockchain-based financial services.
  • The bankruptcy of the issuer.
  • A change in the type of security offered, g., from preferred stock to common stock or vice versa.

An amendment of an Offering Statement must be approved by the SEC before it becomes effective, which means waiting.

Even more important, depending on the nature of the change, the issuer might be required to stop selling securities or even stop offering securities (i.e., shut down its website and all marketing activities) while the amendment is pending.

Supplements

After the offering is qualified by the SEC, the issuer must file a supplement of its Offering Circular to reflect “information. . . .that constitutes a substantive change from or addition to the information set forth” in the original offering circular.

Examples of substantive changes or additions:

  • A new Chief Marketing Officer joined the management team.
  • The issuer’s patent application, disclosed in the original Offering Circular, was approved.
  • The issuer moved its principal office.

Unlike amendments, supplements do not require SEC approval and do not require that that the issuer stop selling or issuing securities. Instead, the supplement must be filed with the SEC within five days after it is first used.

Real Estate Supplements

While its offering is live, an issuer in the real estate business — a REIT, for example — must file a supplement “[w]here a reasonable probability that a property will be acquired arises.” Not when the property is purchased, but when there is a “reasonably probability” that it will be purchased.

The SEC doesn’t specify what information to include in these supplements, except to disclose “all compensation and fees received by the General Partner(s) and its affiliates in connection with any such acquisition.” Including a statement of any significant risks associated with the property is a good idea, too.

Having filed a separate supplement for each property, the real estate issuer must then file an amendment at least once every quarter that consolidates the supplements and includes financial statements for the properties. Notwithstanding the general rule for amendments, however, the issuer doesn’t have to stop offering or selling securities pending SEC approval.

Supplement vs. Amendment

An amendment is required for “fundamental changes,” while only a supplement is required for “substantive changes.” Where to draw the line?

There’s a lot at stake. If an issuer uses a supplement where it should have used an amendment, it will be using an Offering Statement that has not been qualified by the SEC. Meaning, the whole offering will be illegal.

The SEC won’t say whether it believes a given change requires a supplement or an amendment, leaving the decision to the issuer and its lawyer. The SEC will, however, allow an issuer to file an amendment even for non-fundament changes, i.e., where a supplement would have done the trick. Filing an amendment takes a little longer, costs a little more, but eliminates the risk of guessing wrong.

Often, however, an issuer wants to make a change but doesn’t want to go through the amendment process. In those cases, the rule of thumb should be as follows:

Would an investor of ordinary prudence want to re-think his investment decision based on the new information?

If the answer to that question is Yes, the new information should be provided via amendment. If the answer is No, it can be provided supplement.

For example, an investor who liked the cryptocurrency space might not be interested in the financial services space, while the addition of a new CMO might be interesting and useful, but unlikely to affect the investment decision.

Contrary to popular belief, the main risk of this or any other violation of the securities laws is not that the SEC will bring your offering to a screeching halt or fine you. Those things are possible, but the SEC has more important things on its plate. The main risk is that an investor will lose money and hire a clever lawyer, who will then seize on your mistake (or your alleged mistake) as grounds to get the investor’s money back.

Supplement vs. Form 1-U

If a change falls within any of the specified categories of Form 1-U, then it should be reported on Form 1-U rather than via supplement.

If the offering has ended, then supplements are no longer relevant and changes should be reported on Form 1-U.

If the offering is still live and the change does not fall within any of the specified categories of Form 1-U, then it can be reported on either Form 1-U or via supplement, take your pick. However, supplements may not be accompanied by exhibits. So if you need to change or add an exhibit (e.g., you’ve modified your Subscription Agreement or entered into a material contract that doesn’t constitute a fundamental change), you should use form 1-U.

Questions? Let me know.

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.

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.