The High Return Real Estate Show Podcast: Crowdfunding For Real Estate Investors 

2019-10-22_10-03-37CLICK HERE TO LISTEN

Jack gets the day off, and Shecky gets to have a one-on-one conversation with Mark Roderick, the leading Crowdfunding and FinTech lawyer in the US.

In this episode, you’ll learn…

  • What is Crowdfunding?
  • The two different kinds of Crowdfunding
  • What and who to look for in a Crowdfunding company.
  • How does Crowdfunding apply to Real Estate Investing?
  • Who are the big players in the Crowdfunding space?
  • The three types of Equity Crowdfunding

This episode is a MUST listen to anyone wanting to understand how technology is changing our investing landscape!

Questions? Let me know.

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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.

Filing Financial Statements Under Reg A

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.