What is a pre-existing substantive relationship?

Here we break down the meaning of a pre-existing substantive relationship and why it’s so important to investor relations.

Involvement in a real estate syndication requires a certain caliber of relationships between everyone involved. Not only is it best practice to trust each person in the group and to know everyone’s financial health and history; it’s a requirement by the US Securities and Exchange Commission (SEC).

Let’s go back to several decades ago, before the internet. General solicitation, or the public marketing of raising capital, was (and still is) prohibited. That meant that you couldn’t post an ad for your investment opportunity in the daily newspaper and get applications from whoever read it. Those investors needed to be people you already knew and trusted.

Today we have the potential to make connections with almost anyone in the world. This opens up investment opportunities that can benefit individuals and communities everywhere—but reaching out to strangers on message boards online is kind of like posting a newspaper ad. So how can we take advantage of the internet without using general solicitation?

To allow appropriate online networking, the SEC requires what they call a pre-existing substantive relationship between the sponsor and any potential investor. To understand this more clearly, let’s break down the terms.

Substantive relationships in real estate

A “substantive” relationship implies that the sponsor or the company itself has enough information on the potential investor’s financial history to feel confident in the partnership. This means that they have sufficient knowledge of the investor’s financial circumstances, their sophistication, and established accreditation.

Financial Circumstances

To confirm an investor’s capability to contribute, sponsors should understand the investor’s financial situation. They may request income statements, tax information, and other records to verify your information, especially if you are an accredited investor.

Sophistication

From an investment standpoint, sophistication refers to the experience and reliability of a potential partner or investor. A sophisticated investor can demonstrate decision-making in past investment choices and knowledge of best practices related to their investments.

Established Accreditation

There’s no official accreditation process for investors. Instead, an accredited investor falls into categories defined by the SEC. They must have earned over $200,000 (or over $300,000 together with a spouse) in gross income over the past two years or have a net worth of $1 million or more (not including the value of their primary residence).

If you don’t qualify, you can still be considered a sophisticated investor depending on your experience, although there may be fewer investment opportunities available to you. Establishing a substantive relationship requires more than just checking a box, and sponsors must do their due diligence in determining an investor’s eligibility to invest.

What is a “pre-existing” relationship?

In addition to being substantive, relationships between broker and potential investor must also be “pre-existing,” meaning that the relationship was in place before the commencement of the sponsor’s offering or deal. The SEC does not specify the length of time that it should have existed, but they stress that the quality of the relationship is important.

As we mentioned, the SEC wants to prohibit general solicitation, which would look something like placing an ad on Facebook encouraging anyone who saw it to invest in your portfolio or project. This means that even contact and interest between investors over the internet must have a relational aspect beyond the minimal questionnaire or box-checking.

Relationship Guidelines

So we’ve established the groundwork for why a pre-existing, substantive relationship is so important. How do we go about developing one?

In 2015, the SEC approved a set of guidelines proposed by the networking platform Citizen VC on how to appropriately form relationships with investors in an online setting. These guidelines act as a framework for sponsors to learn about potential investors and partners and to gain trust. Here they are as they appeared in Citizen VC’s letter:

1. Contacting the prospective investor offline by telephone to introduce representatives of the company and to discuss the prospective investor’s investing experience and sophistication, investment goals and strategies, financial suitability, risk awareness, and other topics designed to assist the company in understanding the investor’s sophistication;

2. Sending an introductory email to the prospective investor;

3. Contacting the prospective investor online to answer questions they may have about the company, the company’s website, and potential investments;

4. Utilizing third-party credit reporting services to confirm the prospective investor’s identity and to gather additional financial information and credit history information to support the prospective investor’s suitability;

5. Encouraging the prospective investor to explore the company’s website and ask questions about the company’s investment strategy, philosophy, and objectives, and;

6. Generally fostering interactions both online and offline between the prospective investor and the company.

7. Additionally, prospective investors will be advised that every special purpose vehicle offering will have a significant minimum capital investment requirement for each investor, which will be not less than $50,000 per individual investment, and in some offerings significantly higher.

(sourced from the original letter and response from the SEC, which you can read here).

In a nutshell, these guidelines make an effort to simulate the depth of the relationship between sponsor and investor that occurs in offline investment communities.

Think about the requirement of a pre-existing substantive relationship not as a limiting set of restrictions meant to prohibit growth opportunities but as a framework that allows sponsors and investors to get to know and trust each other’s interests and demonstrated success.

Developing Relationships

Gaining trust and common ground is crucial. That’s why these guidelines help us make reliable connections with investors from all across the world. If you’re interested in investing with me, reach out as soon as possible to hear more about my background and share your own experience. Developing a strategy based on a shared vision and common understanding is the best start to progress.