Crowdfunding for Accredited and Non-accredited Investors
By: Mark Roderick, attorney, Flaster/Greenberg PC
What’s the difference, and why does it matter?
CROWDFUNDING IS giving commercial real estate developers access to trillions of dollars of capital that was previously unavailable, while allowing individual investors to participate in institutional-quality transactions for the first time. It’s a very big deal for the real estate industry.
The term “crowdfunding” can mean several different things. The most useful definition is also the broadest: raising money via the Internet. How can a real estate developer or crowdfunding platform raise money from accredited and non-accredited investors, and how does raising funds from accredited investors differ from raising money from unaccredited ones?
It’s always easier to raise money from accredited investors. That’s not only because accredited investors have more money, but also because the law assumes that accredited investors — individuals with an annual income of at least $200,000 ($300,000 with a spouse) or a net worth of at least $1 million (excluding primary residence) — are smart and sophisticated enough to protect themselves, while non-accredited investors need the paternalistic arm of the government. With non-accredited investors come additional legal rules and requirements.
There are three kinds of crowdfunding offerings today:
Offerings under Securities and Exchange Commission (SEC) Rule 506(b).
Offerings under SEC Rule 506(c).
Offerings under SEC Regulation A.
Rule 506(b) Offerings
Rule 506(b) offerings are simply old-fashioned private placements. This is how developers have been raising money for the last 30 years. But now you can conduct a Rule 506(b) offering online.
Using Rule 506(b), a developer can raise an unlimited amount of money from an unlimited number of accredited investors and up to 35 non-accredited investors. If an offering includes only accredited investors, the issuer is not required to provide any particular information, although issuers typically provide at least basic information, including a list of the risks of investing, to avoid being sued for fraud. If even a single non-accredited investor participates, the issuer must provide a great deal of information, including financial statements and an opinion of counsel.
A developer raising money in a Rule 506(b) offering is not allowed to show the deal to just anybody browsing the Internet. Only those who are already “customers” are allowed to see the deal. In 2013, however, the SEC gave its blessing to an arrangement that allows developers to turn almost anyone into a customer. On an Internet site, you can advertise that great projects are available, as long as you don’t talk about any specific project. Once a visitor registers at the site and waits 30 days (a “cooling off period”), he or she becomes a customer, can view deals and can start to invest.
Rule 506(c) Offerings
Rule 506(c) allows developers to raise an unlimited amount of money from an unlimited number of investors. In fact, Rule 506(c) offerings are very similar to Rule 506(b) offerings, but with two critical differences:
Only accredited investors can participate.
Advertising — in newspapers, on the radio or the Internet, anywhere you can think of — is permitted.
In a Rule 506(c) offering, the developer can’t just take the investor’s word that he or she is accredited. Instead, the developer is required to take “reasonable steps” to ensure that the investor is telling the truth. This can involve checking the investor’s tax returns and/or financial statements or, more likely, hiring one of the third-party companies that have sprung up to handle verification, like VerifyInvestor or Crowdentials.
Regulation A Offerings
Regulation A allows a developer to raise up to $50 million per year from an unlimited number of investors, and to advertise deals on the Internet — and everywhere else. Unlike Rule 506(c), Regulation A allows both accredited and non-accredited investors to participate. Not only does this allow the developer to cast a wider net for investors, it also means the developer can market a project to residents of the community in which the project is going to be built.
These are the main downsides:
To raise money under Regulation A, the developer must file a lengthy registration statement with the SEC, a process that could take up to six months and result in significant legal fees.
Depending on the specifics of the deal, the registration statement might have to include audited financial statements.
- After the project is funded, the developer could be required to file periodic reports (including audited financial statements) with the SEC.
A developer probably wouldn’t use Regulation A for a small deal or one he could fund solely through accredited investors. But there will be lots of deals for which Regulation A will be the perfect choice.
By the end of 2015, the SEC is expected to issue regulations under Title III of the Jumpstart Our Business Startups (JOBS) Act, allowing yet another form of crowdfunding. Meanwhile, Congress is already at work trying to improve the crowdfunding laws, and more and more states are adopting their own versions of crowdfunding regulations. All of the state laws allow non-accredited investors to participate, subject to strict limitations.
Crowdfunding is nothing more or less than the coming of the Internet to the capital formation industry. When the Internet comes to any industry — whether it’s the bookselling industry (Amazon), the travel industry (Expedia), the hotel industry (Airbnb) or the taxi industry (Uber) — it connects buyers and sellers directly, bypassing middlemen and leaving the industry looking nothing like it did before. That’s what’s starting to happen in the capital formation industry today. Three years from now, crowdfunding could be the primary way that developers access the capital markets, selling to accredited and non-accredited investors alike.
Perspectives of a Small-time Crowdfunding Investor
Since late 2013, when former Development magazine contributing editor Ellen Rand first brought the phenomenon of crowdfunding for commercial real estate to the rest of the editorial staff’s attention, they’ve been surprised by the pace and degree of interest in the topic among real estate practitioners. The magazine has provided regular updates for readers. (See “Crowdfunding: A Game-Changer in Finance?” and “Crowdfunding Scales Up.”)
In addition, Managing Editor Julie Stern “took the plunge” in March 2014 and invested $100 (the minimum allowed) in a “boutique retail rehab” project in Washington, D.C., with crowdfunding pioneer Fundrise. The total project cost was estimated at $1.7 million, with a projected annual return of 8 percent. Investment in this Regulation A offering, which was open to unaccredited investors, was limited to residents of the District of Columbia and Virginia.
The investor’s first email from developer WestMill Capital Partners arrived, via Fundrise, shortly after she selected the project and clicked on “Invest.” It welcomed her to the portfolio, announced, “you now own a piece of a unique property in the heart of DC’s fastest growing neighborhood, Shaw,” and included several photographs of the property, a two-story building that once housed a barbershop. “In your portfolio,” the message continued, “you will find all your relevant deal documents. In addition, you can expect to receive regular updates about the status of the project, as well as track distributions.” Indeed, the “My Portfolio” section of the Fundrise website contained all offering agreements as well as a “Confirmation of Issuance of Certain Class C Membership Units in Fundrise 1539 7th Street NW LLC, a Delaware limited liability company.”
Future messages followed, including one in June noting that the $350,000 offering had been fully funded by a total of 378 investors. An August message announced that the developer had received a matching grant from the local government’s Great Streets initiative to renovate the building facade and included the plans for that renovation, as well as information about new businesses opening on the block and the news that “investors will be receiving their first distribution from the 8 percent preferred return at the end of September.” That distribution was deposited into the investor’s designated bank account in late September.
More news arrived in January 2015: WestMill had purchased a perpetual easement behind the property from an adjacent building that would enable it to add a back stairway, something required by code to convert the second floor to restaurant or retail space. A “facade update” arrived in February, with photographs of the recently completed $35,000+ exterior upgrade. And, of course, a link to the investor’s Schedule K-1, “Partner’s Share of Income, Deductions, Credits, etc.,” reporting the $100 investment (0.00971 percent of the project capital) and $4.43 distribution in 2014. Second and third distributions of $2.01 each were deposited into the investor’s bank account on December 31, 2014, and April 2, 2015.
Unlike many investment communications, all messages from WestMill and Fundrise have been clear and easy to understand—and have provided an informative education in the real estate investment and development processes.
By Margarita Foster, editor-in-chief, Development