Real Estate Crowdfunding has gained traction and become more popular in the past few years. People who have lower annual income or are considered non-accredited investors are now allowed to invest in ways they normally haven’t over the internet due to a recent SEC change in 2015. These crowdfunding websites solicit small individual investments from a large number of people. The question which has come up is, “How does one enter this market of Equity or Debt Real Estate Crowdfunding without violating either 506(b) or 506(c)?” First, let us walk forward from the basics.
Securities are simply rights to ownership. More specifically, it’s a financial instrument which has financial value and can be traded. We can categorize securities into three groups.
- Derivatives Securities. Think gambling or hedging positions. Options contracts on stocks and future contracts are in this category.
- Debt Securities. Think fixed income. Bonds and debentures, which is a way a company can borrow money at a fixed interest rate.
- Equity Securities. Think stocks, not fixed income. If a company makes money, dividends are paid out.
This isn’t an exhaustive list by any means, as there are many types of securities which fall into these three categories. The categories at issue here are the debt and equity securities category. For debt, an investor would loan money to a deal sponsor. This loan would be secured by the property, and in return for the loan the investor would receive a fixed rate of return which is agreed upon by the parties involved. For equity securities, an investor would purchase securities for a percentage of the company, and if the real estate property bought makes money from sale or rent, profits would be distributed to the investor. Regardless of the type of security chosen, the party sponsor would need multiple investors to purchase his or her securities, thus enters the SEC.
When a private company wants to offer or sale a security, they can either offer the securities in a public or private placement. If they chose a public offering, they must register the offering with the SEC (U.S. Securities Exchange Commission). If private placement is chosen, they would not have to register with the SEC if they are able to meet exemption guidelines. Not having to register does prevent a lot of headaches, and is desirable for smaller companies. For a smaller venture such as real estate crowdfunding, being exempt is highly beneficial.
Regulation D governs private placement exemptions, which would allow private companies to offer debt or equity securities and not be required to register those securities with the SEC.
For our question at issue, crowdfunding targets non-accredited investors. To be considered an accredited investor, a natural person would need to have an annual income of $200,0000 (or $300,000 if married) for the prior 2 years or a net worth of over $1,000,000 which does not include the primary residence. Also, companies, banks, and other entities can be accredited investors. A non-accredited investor would be your typical middle-class individual.
There are two (actually three but one is absorbing another) exemptions from registering with the SEC in Regulation D. These are Rules 504 and 506. Rule 506 of Regulation D is the only rule which provides an exemption for non-accredited investors for private placement.
506(b) states a company can’t solicit or advertise to market securities, but the company may sell its securities to an unlimited number of accredited investors and up to 35 non-accredited. Therefore, 506(b) allows the private company to sell to non-accredited investors, but the restrictions on advertising and broad solicitation defeats the crowdfunding aspect. Since this won’t work, we look at our last option.
506(c) right out of the gate says a company can broadly solicit and advertise, but can only offer to accredited investors. This doesn’t work either, because non-accredited investors are the target audience for crowdfunding.
Therefore, how and why do we see this type of crowdfunding today being advertised and solicited broadly online? Enter surprise third exemption.
Crowdfunding Intermediary, found in 227.100. These companies are members of FINRA (Financial Industry Regulatory Authority). These companies are considered a broker-dealer or funding portals. Specifically, the private company seeking to sell securities in a crowdfunding offering must go through a crowdfunding intermediary. The private company is not allowed to advertise, market, or offer securities directly. Only the crowdfunding intermediaries are.
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