If you’re a entrepreneur, you’re probably looking for some way to raise capital. You probably have heard of crowdfunding, but you may not have heard of the Jobs Act of 2012 and how it relates to crowdfunding – which is significant because its potential is enormous. Besides Regulation A+, Reg. CF, and Title II crowdfunding options to name a few, now investors and issuers can take advantage of the “tokenization” of assets via Security Token Offerings based on blockchain technology. However, there are complicated rules associated with all aspects of crowdfunding, which is why it’s so important to have legal representation throughout all phases of the process.
In this podcast episode, we interviewed crowdfunding attorney Mark Roderick from Flaster Greenberg PC who gave us many insights on crowdfunding in general, plus his take on tokenization and what security tokens can actually do for issuers and investors alike. Forget what everyone says about raising money. As stated on the podcast, crowdfunding is a marketing business, but it’s smart to have legal counsel at all times too – which is why anyone thinking of getting involved with crowdfunding on any level would be wise to contact Mr. Roderick and read his crowdfunding blog where you can find hundreds of posts with excellent information dedicated to legal crowdfunding success. See that? Sometimes lawyers can be your friend!
And speaking of crowdfunding, according to Mark, about 90% of the Reg.A+ crowdfunding deals he’s seen is regarding real estate. You know what most of the Reg.CF deals are? (here’s a hint).
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.
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.
“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.
A couple weeks ago, Howard Marks of StartEngine and I presented a webinar about Regulation A. Listeners asked far more questions than we were able to answer in the time given, and I promised to post their questions and answers on the blog. Here goes.
What’s the difference between Regulation A and Regulation A+?
There is no difference. Regulation A has been around for a long time, but was rarely used primarily because issuers could raise only $5 million and were required to register with every state where they offered securities. Title IV of the JOBS Act required the SEC to create a new and improved version of Regulation A, and the new and improved version is sometimes referred to colloquially as Regulation A+. But it’s the same thing legally as Regulation A.
Can I use Regulation A to raise money from non-U.S. investors?
Definitely. Non-U.S. investors may participate in all three flavors of Crowdfunding: Title II, Title III, and Title IV (Regulation A).
But don’t forget, the U.S. isn’t the only country with securities laws. If you raise money from a German citizen, Germany wants you to comply with its laws.
Can non-U.S. companies use Regulation A?
Only companies organized in the U.S. or Canada and having their principal place of business in the U.S. or Canada may use Regulation A.
What about a company with headquarters in the U.S. but manufacturing facilities elsewhere?
That’s fine. What matters is that the issuer’s officers, partners, or managers primarily direct, control and coordinate the issuer’s activities from the U.S (or Canada).
Is Regulation A applicable to use for equity or debt for a real estate development project?
I believe that real estate will play the same dominant role in Regulation A that it plays in Title II. I also believe that real estate development will be more difficult to sell than stable, cash-flowing projects simply because of the different risk profile.
Is there any limit on the amount an accredited investor can invest?
No. An accredited investor may invest an unlimited amount in both Tier 1 and Tier 2 offerings under Regulation A. A non-accredited investor may invest an unlimited amount in Tier 1 offerings, but may invest no more than 10% of her income or 10% of her net worth, whichever is greater, in each Tier 2 offering.
What kinds of securities can be sold using Regulation A?
All kinds: equity, debt, convertible debt, common stock, preferred stock, etc.
But you cannot sell “asset-backed securities” using Regulation A, as that term is defined in SEC Regulation AB. The classic “asset-backed security” is where a hedge fund purchases $1 billion of credit card debt from the credit card issuer, breaks the debt into “tranches” based on credit rating and other factors, and securitizes the tranches to investors. However, the SEC views the term more broadly.
Can I combine a Regulation A offering with other offerings?
In general yes. For example, there’s no problem if an issuer raises money using Rule 506 (Rule 506(b) or Rule 506(c)) while it prepares its Regulation A offering. The legal issues become more cloudy if an issuer wants to combine multiple types of offerings simultaneously. Theoretically just about anything is possible.
Can the same platform list securities under both Regulation A and Title II?
Yes. In fact, the same platform can list securities under all three flavors of Crowdfunding: Title II, Title III, and Title IV. But on that platform, only licensed “Funding Portals” can offer Title III securities.
Does a platform offering securing under Regulation A have to be a broker-dealer?
The simple answer is No. But a platform that crosses the line into acting like a broker-dealer, or is compensated with commissions or other “transaction based compensation,” would have to register as a broker-dealer or become affiliated with a broker-dealer.
Can a non-profit organization use Regulation A?
Regulation A is one exception to the general rule that all offerings of securities must be registered with the SEC under section 5 of the Securities Act of 1933. Non-profit organizations are allowed to sell securities without registration under a different exception. So the answer is that non-profits don’t have to use Regulation A.
With that said, I represent non-profit organizations that have created for-profit subsidiaries that plan to engage in Regulation A offerings. For example, a non-profit in the business of urban development might create a subsidiary to develop an urban in-fill project, raising money partly from grants and partly from Regulation A.
Can I use Regulation A to create a fund?
If by “fund” you mean a pool of assets, like a pool of 30 multi-family apartment communities, then Yes. You can either buy the apartment communities first and then raise the money, or raise the money first and then deploy it in your discretion. If you want to own each apartment community in a separate limited liability company subsidiary, that’s okay also.
If by “fund” you mean a pool of investments, like a pool of 30 minority interests in limited liability companies that themselves own multi-family apartment communities, then No. Your “fund” would be treated as an “investment company” under the Investment Company Act of 1940, and Regulation A may not be used to raise money for investment companies.
Can a fund be established for craft beverages?
Same idea. You could use Regulation A to raise money for a brewery that will develop multiple craft beverages. You cannot use Regulation A to buy minority interests in multiple craft beverage companies.
For a brand new company, can the audited financial statements required by Tier 2 be dated as of the date of formation, and just show zeroes?
Yes, as long as the date of formation is within nine months before the date of filing or qualification and the date of filing or qualification is not more than three months after the entity reached its first annual balance sheet date.
How does the $50 million annual limit apply if I have more than one project?
The $20 million annual limit under Tier 1, and the $50 million limit under Tier 2, are per-issuer limits. A developer with, say, three office building projects, each requiring $50 million of equity, can use Regulation A for all three at the same time.
NOTE: This is different than Title III, where the $1 million annual limit applies to all issuers under common control.
What does “testing the waters” mean?
It means that before your Regulation A offering is approved (“qualified”) by the SEC, and even before you start preparing all the legal documents, you can advertise the offering and accept non-binding commitments from prospective investors. If you don’t find enough interest, you can save yourself the trouble and cost of going through with the offering.
NOTE: Any materials you use for “testing the waters” must be submitted to the SEC, if the offering proceeds.
Where can Regulation A securities be traded?
Theoretically, Regulation A securities could be registered with the SEC under the Exchange Act and traded on a national market. But I’m sure that’s not what the listener meant. Without being registered under the Exchange Act, a Regulation A security may be traded on the over-the-counter market, sponsored by a broker-dealer.
This sounds expensive! Can you give us an estimate?
On October 16th, I’m going to be talking about Regulation A at the5th Annual Global Crowdfunding Convention in Las Vegas, with Miss Nevada as my co-presenter (of course). I prepared this summary-of-a-summary for the event. For more in-depth information, here’s my Regulation A+ Primer. – MARK
The JOBS Act created three flavors of Crowdfunding:
Title II Crowdfunding, which allows issuers to raise an unlimited amount of money from an unlimited number of investors using unlimited advertising – but is limited to accredited investors.
Title III Crowdfunding, which allows issuers to raise up to $1 million per year from anyone, including non-accredited investors.
Title IV Crowdfunding, which modified the old Regulation A and is sometimes referred to as Regulation A+.
Quick Summary of Regulation A
Raise up to $50 million per year for each issuer
Raise money from both accredited and non-accredited investors
Register with the SEC
Takes about five months, start to finish
No State-level registration
Shares freely tradeable from day one
Sales by existing shareholders
Regulation A shareholders not counted toward Exchange Act limits for full reporting
Mini-IPO, but with much lower cost
Two Tiers
Theoretically, there are two “tiers” under Regulation A:
Tier One
Tier Two
Amount Per Year
$20 million
$50 million
Non-Accredited Allowed
Yes
Yes
Limits on Investment
None
For non-accrediteds, 10% of income or net worth, whichever is greater, per offering.
Audited Financials
No
Yes
Registration with SEC
Yes
Yes
Registration with State
Yes
No
Excluded from Exchange Act Limits
Yes
Yes
Shares Freely Tradeable
Yes
Yes
Post-Offering Reporting
No
Yes
Testing the Waters
Yes
Yes
Online Distribution Allowed
Yes
Yes
Bad Actor Limits
Yes
Yes
Because of the exemption from State registration, most companies will choose Tier Two.
Companies That Cannot Use Regulation A
Investment Companies
Companies that own stock or other securities in other companies.
Foreign Companies
Issuers must be organized and have their principal place of business in the U.S. or Canada.
Oil and Gas Companies
Can’t sell fractional undivided interests in oil and gas rights, or a similar interest in other mineral rights.
Public Companies
Can’t be a publicly-reporting company.
Companies Selling Asset-Backed Securities
For example, interests in a pool of credit card debt.
Where Regulation A Makes the Most Sense
Pools of high-quality real estate assets, especially REITs
High quality assets in inefficient markets
Sexy companies (companies with high social-media followers or potential)
“How long will it take?” That’s one of the two questions I’m asked most often about Regulation A.
The answer is that if everything goes smoothly, it should take about 20 – 24 weeks from the day an issuer decides to raise money using Regulation A until it begins selling securities. Every company is different, of course, and lots of things can delay the process, but 20 – 24 weeks is a good rule of thumb.
With this Regulation A Timeline, I hope to provide issuers and their advisors with a framework for conducting a Regulation A offering, with tasks and milestones. Three notes:
Don’t try to view this on your phone! There’s a lot to cover.
As you’ll see, there’s a lot to do in the first few weeks. The more thorough the attention given to the earliest tasks, the more smoothly the process will roll out.
By definition, this Timeline is from the perspective of the lawyer. Each member of the team – the accountant, the escrow agent, etc. – will have a separate timeline, all within the same 20 – 24 week framework.
What is the other question I’m asked most often about Regulation A? You guessed it. I’ll cover assembling the team and the cost of Regulation A in another post.
On March 4th I had the pleasure of co-presenting a workshop on Regulation A (Title IV Crowdfunding) in Mountain View, California, at an event organized by Crowdfund Beat. My co-presenter, Jillian Sidoti of SyndicationLawyers.com, is a terrific person, an engaging speaker, and one of the country’s leading authorities on Regulation A.
I hope you enjoy our conversation and get a sense of the real-life practicalities of preparing and filing a Regulation A offering.
CrowdFund Beat Media International is an online source of news, information, events and resources for the crowdfunding industry. Currently we cover the USA, Canada, the UK, Italy, Germany, France, and Holland, and soon we’ll be expanding to Spain, Australia, Japan and China. We think of our work as an educational and informative service to the crowdfunding community, and appreciate your suggestions.
Last Thursday I joined Jack Miller, the host of “Down to Business” on 880 AM The Biz in Miami, for a discussion about Crowdfunding and what it means for entrepreneurs and investors. Jack is a terrific interviewer and an entrepreneur himself, and brings a great perspective to the subject.
We had a lot of fun and might have even shed some light on this brave new world for Jack’s listeners.
I really appreciate the time you spend on my blog. To make the blog more useful, I’ve added a Legal Links button, up there to the right. To start, you’ll find links to:
Real Estate Investment Trusts, or REITs, are the shiny new object in Regulation A. What is a REIT and what good are they?
