May 16, SEC Crowdfunding Law, what does it mean for RE investing?

[Mike Hoherchak]

So I came across this article today. Starting May 16th, unaccredited investors can now take part in equity crowdfunding. 

Here's the full article from Entrepreneur.com: https://www.entrepreneur.com/article/275215

Of course, I could see potential downside for uneducated investors but I can also see the tremendous upside for new businesses looking for funding in order to get started. This particularly excites me about funding a real estate investing business. 

Here it is on the SEC.gov website: https://www.sec.gov/oiea/investor-alerts-bulletins...

What are your thoughts on this? What strategies come to mind to make this work for real estate investing?

[Brandon Romano]

It's an exciting development, albeit an imperfect one. Although some crowdfunding platforms are registering under the new rules, many are passing up on it because of the limitations on how much capital can be raised (only $1 million over twelve months), the strict limitations on how much an investor can invest, and other concerns. Right now, many platforms have greater incentive to keep funding projects through accredited investors or with only a limited amount of non-accredited. But the new crowdfunding rules can evolve toward a larger impact once regulators learn more about its effects on crowd investing. We'll just have to wait and see. 

Here's another interesting blog blog article that discusses the potential impact of Title III: https://brelion.com/blog/article/Title_III__What_I...

[Bryan Hancock]

For small real estate projects it will probably work okay.  You're limited to $1M in any trailing 12-month period if you use Title III.  You also have to market the projects through licensed portals to raise the funds.  

[Jay Hinrichs]

@Bryan Hancock  when you say licensed portals... what particular license is required?

[Bryan Hancock]

I'm not sure what the license is called, but here is the FINRA application process

Title III Application Process

You have to go through a pretty involved process. Our platform is standing up a separate legal entity called RealStarter Access, LLC to apply. Title III projects will be linked from our Title II platform when things are ready. We have been working on the laws and memo for compliance for all of this for over 18 months now. I am convinced that most of the industry is not compliant and it will end up biting them in some fashion in the long run. Fortunately we're real estate investors and have a vested interest in doing it correctly for the long haul and not just slapping something together and hoping for the best as things go along.

Be very careful who you select to do business with.  I have seen a lot of commentary on BP of late saying that it's "just a website" and that anyone can do it.  If you care about things being done correctly in a manner compliant with all of the laws it takes time to do things correctly or people should partner with others that have already gone through all of the brain damage needed.  

Title III is likely to make a bigger splash in the venture financing market given the $1M constraint for 4(a)(6) securities.  $1M doesn't get you very far for most real estate projects that can support the overhead of a securities offering.  If you add the overhead cost from the Portal to that the subset of projects that will work is likely to be even smaller.  

Unfortunately the securities regulators have pushed non-accredited investors to the riskiest projects around.  Venture deals for early-stage startups and small real estate projects from unproven promoters with shorter track records will be what is available to the people least able to sustain the losses.  

Ain't government grand?

[Ivan Vargas]

Its not a license, its a registration. A new entity created by the SEC called a funding portal. There's a few applications yes FINRA, and the SEC the process should take about 90 days. 

Once the funding portal is registered it can display Title 3 offerings, but they are only the intermediary just like a registered Broker/Dealer (who can also display Title 3 offerings on its "website").  The "portal" cannot handle money, it needs to go through an escrow agent, directly to the issuer, and the portals need to take extra measures to prevent fraud (similar to 506c taking extra steps to confirm accreditation).

Most existing "funding platform" is now running on 506c exemptions, maybe a few 504 or Reg A+. Those are from Title 2 & 4 of the JOBS Act. These are all Wordpress websites running fancy plugins. They have a great team of software geeks to make their systems functional and polished from the project widgets to the investor dashboard and registration process. With a few million in VC money they can make really nice "websites" and market the hell out of them. 

They are mostly offering single family rehab projects under $1M each. These projects are clearly 506c because they are using general solicitation. The rules state clearly if you use general solicitation NO non-accredited investors allowed. But they don't need non-accredited investors because when they send an email blast (general solicitation), the projects get funded within hours. 

So far the SEC has received 33 applications for funding portals. When these portals open up, they open to non-accredited investors with the same single family rehab projects under $1M and they CAN advertise to non-accredited investors. However these new inexperienced investors with under $1M in assets and less than $100k yearly income are only allowed to invest 10% of their income or net worth whichever is greater, and a maximum of $100k in a year. Funding portals need not verify the investors income or net worth just don't sell them more securities than they are legally allowed to buy. 

The funding portal needs to vet the sponsor more than the existing platforms do (they are not regulated on that department), and the funding portals have a whole section just for that in the 686 pages of rules. Also, Title 3 issuers have to register with the SEC 21 days before they can sell the first security, whereas 506c issuer just files a simple Form D, 15 days after they sell the first security. 

Is there still a chance for fraud? Maybe, but they took great measures to prevent it. There is still a chance for fraud with any Regulation D offering as well.

Will the sponsors be inexperienced or incapable of completing a single family rehab? That's up to the funding portal to be selective and perform due diligence just like the existing platforms. But just think how many investors here on BP can raise the capital to fund their first or next flip.

Will the current platforms bother to run Title 3 offerings? I doubt it, actually I think its not allowed but I'm not 100% on that. They may have to open a separate "website" for that and register it as a funding portal. They can do fine with their top 1% accredited investors and leave the millions of newly available non-accredited investors to the newly created funding portals.

[William Morrison]

@Ivan Vargas great recap.  Do you know if on the marketing side those project descriptions will have the same restrictions.  What I have received on the accredited side (not Crowdfunded) is more like the stock market side which has pretty strict pump and dump or hype rules on what can be said about the project and expectations.
Much of what I see here and on other sites marketed to investors in threads and emails would not cut it.
Inflated ARVs, haphazard repair estimates, estimated rents, quick sate (one month) estimates, experience resumes, etc are just few areas where there does not seem to be any accuracy accountability now.

[Bryan Hancock]

@Ivan Vargas

I hate to nit-pick given how excellent your thread post is, but Title III Portals do get licenses.  You can check out Mark Roderick's blog post here:

How To Operate A Title II Portal And A Title III Portal On The Same Platform

describing the process of operating a Title II platform and a Title III portal at the same time.  Note that he references the license.  If you have better information than this feel free to educate us because I am not claiming to be an authority on this.  I have heard many people in the industry referring to the licenses as well so it would be surprising to me if this wasn't the case.  

RealStarter is planning to stand up a "separate site" for Title III that is wholly-owned by our parent entity.  We'll be working through the best way to do this in the coming several months so this philosophy may change some.  The blog post above is a good place to start and Mark Roderick is an authority on the subject for sure.  

[Ivan Vargas]

@William Morrison great point. That's another reason why most platforms prefer not to deal with non-accredited investors, the information disclosure requirements. Issuers need to provide much more information to non-accredited investors than they provide to accredited investors. According to what I've read, 506 offerings not only need to restrict sales to "sophisticated" non-accredited investors, but they also need to provide information equal to that of a registered [public] securities offering. The slightest mistake and the exemption is void and they have to refund all investor's monies. 

With Title 3 offerings, the focus is on welcoming non-accredited investors into the marketplace. All the same information, disclosure and reporting rules should apply and quite possibly more than those in 506 offerings. Whether the information is accurate is another story. Any materially false or misleading information is considered fraud and a criminal offense. An error as in over/under estimating projections is not illegal and the reason all investors should do some kind of due diligence before investing in any offering rather than relying on the platform to due it for them.

One more thing to look at is the relationship between portal and issuer in Title 3, and how it compares to that of the platform, issuer and sponsor in Reg. D offerings. 

The portal is NOT allowed to invest in or purchase securities from the issuer. They are however allowed to accept securities, up to 10% equity in the issuer, as compensation for their services.

There's plenty of talk about how platforms prefund projects and have skin in the game... This is a totally different structure. What they do is they give a loan to or buy an equity stake in the developer, then form a new LLC which becomes the issuer offering securities/ownership, and they remain the managing member of that new LLC. As an investor you're buying securities in what is basically a shell company that in turn invests in the real estate company. If they offer/sell all the securities in that LLC, that is 100% ownership, then they no longer have any "skin in the game", unless they retain some equity in that newly formed entity. Yes they prefunded the project, but if they sold all securities in that entity, they recouped their investment from the crowd, and continue to charge fees based on the performance of that project. If the project fails or doesn't perform as projected they don't exactly lose, only the investors lose.

The portal on the other hand, is not allowed to do this. The portal cannot even advertise any of the specific offerings listed on the portal. The issuers themselves have to advertise their offerings and in their advertising provide the name of and a link to their offering on the portal. If the portal decides to accept an equity stake in the issuer as compensation for their services, then their interests are truly aligned with investors and, if the project does not succeed, they will not be compensated for their services. The more successful the project, the greater the compensation. 

There's a huge difference and I believe the way the SEC set up the relationship in Title 3 is safer than what the current platforms are doing with Reg D offerings. There is so much more but there's 686 pages to read and they must be read more than once to fully understand them.

[Ivan Vargas]

@Bryan Hancock it seems they are using the terms interchangeably. Even in his article he quotes the definition of a platform as an excerpt from the Title 3 rules where they clearly mention "registered" funding portal, then further down he refers to it as a Title 3 License. 

Either way the funding portal is a new entity that must register with the SEC see below copy and paste from the rules: 

Crowdfunding Platforms. One of the key investor protections of Title III of the JOBS Act is the requirement that Regulation Crowdfunding transactions take place through an SEC registered intermediary, either a broker-dealer or a funding portal. Under Regulation Crowdfunding, offerings must be conducted exclusively through a platform operated by a registered broker or a funding portal, which is a new type of SEC registrant.

Since they refer to a portal as an SEC "registrant", I say it is not a license but I am no attorney, and I haven't read all 685 pages either. 

He also mentions how he would rather create a separate legal entity to hold the Title 3 "license" to keep the Title 2 & 4 offerings separate because the rules are different. I'd love to see RealStarter up and running and or a demo of the SaaS you will provide. 

[William Morrison]

Thanks @Ivan Vargas very informative.  My experience as an accredited investor has been on the commercial/light industrial side.  A 10 year or more horizon and a maximum number of shares or partners is pretty standard (say 10 or 12).  They are more of an asset growth or preservation strategy with little beyond cash neutral positions, thus low to no tax event early on.

[Amy Wan]

I don't think Title III will have a large impact in the real estate arena. Am actually writing an article about this that's supposed to come out soon (ping me if you'd like the link), but in short, with the expensive transactional costs (including GAAP financials), ongoing reporting requirements (which will be at least 2-3K a year), and inability to use SPVs, Title III as written is largely unworkable for RECF. It's not impossible, but it just doesn't make a whole lot of sense why any real estate issuer would use it, except for bragging rights to say that they did. All is not lost though--there is a bill that would amend Title III to make it more workable by increasing the funding cap to 5M and allowing for SPVs. But that is a bit far off and still needs to go through the regulatory process.

[Bryan Hancock]

Raises under $500k only need reviewed financial statements.  I think the costs could be contained there.  Asking for a full audit for raises over $500k will make it unworkable for real estate crowdfunding most likely unless there are accountants willing to sign up for a lot of risk for very little money.  

[Bryan Hancock]

Yup....we're keeping them separate and will reference the Title III projects from our platform.  Since we're generally not keen on being pioneers we'll probably be in the 2nd batch of registered (licensed?) platforms for Title III too.  We're not big on burning through a ton of venture capital to do what can be done a bit slower with a small dedicated team working on things part time.  Taking your time to do things right also generally yields a better work product and more well-thought-out underwriting processes.  We have two former Goldman analysts on our screening committee and we're about to roll out a loan committee with some gray beard bankers, lawyers, and CPAs to provide a nice, diverse set of perspectives on risk and other matters.

Our marketing team is working on a SaaS one-pager and standing up a webpage to describe the offering.  The legal is pretty close to being done, but there are some Anti Can Spam Act issues to sort through.  Hopefully we'll have something we can share on BP in June sometime.  

[Ivan Vargas]

As Scott Purcell said in his most recent blog post: "it costs money to raise money."

The costs may be somewhat of an issue but I think they'll do fine. The real issue is that those costs will come at the expense of investor returns in the long run.

Title 3 may not have much of an impact in the current Real Estate Crowdfunding space, but it should open the doors for new projects/sponsors seeking $300k for a single family flip. Any offerings over $1M shouldn't be looking at Title 3 anyway. 

I'm not sure what it costs to have your financials reviewed or audited, but for a startup, a newly formed single purpose LLC, with $0 revenue and $100 in a bank account, I can't imagine it being much.

Ongoing reporting is yearly unless the LLC is dissolved. A typical fix and flip should be completed and sold or refinanced within a year at which point investors can receive their final distributions and the LLC dissolved. Form a new LLC for each project just like the big names do.

[Amy Wan]

I think my main dismay is that, at least under my reading of the SPV/integration rules, a developer could do max only a couple properties per year. Serious developers are going to want to do a lot more than that, so it seems like a bit of a waste time and effort. But I'm hopeful that they'll fix the regs to be more flexible.