506(b) Exploration and Advice Needed

6 Replies

Hello, 

My business partner and I have just set up our LLC and are beginning to source properties for our first purchase under our LLC. We are purchasing our first property(s) by using a funding source from someone we know personally, with the commitment to pay that person back what they lent us, plus a 2.75% interest rate.

After having listened to episode 354 on the Bigger Pockets podcast, we feel like we may be very closely resembling a 506(b) approach. We do not plan on the 506(c) approach but would love to get to that after we get to a certain size and have demonstrated our ability to do this successfully. Before we make any purchase, we want to determine if we should explore a 506(b) more formally. 

We are eager to learn and do this the right way, so are seeking any advice or insight when it comes to 506(b) funding/investing and how to operate correctly and legally under this structure. Any advice, documents or web pages that can get us pointed in the right direction would be great. Some initial questions that come to mind are below: 

1) What do we have to do to operate formally/legally in a 506(b) structure? 
2) What are the downsides of a 506(b) structure? 
3) What are the upsides of a 506(b) structure?
4) Does a 506(b) replace an LLC or operate in-tandem to an LLC?
5) Can the initial 506(b) funding serve as a down payment for a property and the remainder of the property be financed through a bank?
 

      Many of these questions are addressed in free or low-cost books from syndication attorneys. Check out Mauricio Rauld's YouTube Channel and just watch a ton of those videos. He'll clear a lot up for you. 

      506(b) is an exemption in Regulation D that allows you to raise capital from passive investors under certain conditions. It is not a corporate structure like an LLC or a JV, that is separate.

      Generally speaking, the upsides are that you can have investors who are both accredited (unlimited number) and non-accredited/sophisticated (up to 35). The downside is that you cannot publicly solicit. More details are laid out in the link to the SEC's website I put above.

      Many syndicators use LLCs to hold properties. Common setup is investors get Class A shares, which have limited voting rights but own a majority of the equity. The syndicator gets Class B shares, which have the rights to control and operate the company and make important decisions. These days I'm seeing more and more types of passive investor shares, with different waterfall structures and minimum investments.

      It is very common to use bank financing with investors contributing most or all of the downpayment and capital expenditure money. The lender will want you to have money in the deal as well.

      Not a lawyer, just a guy who likes 506(b)s :)

      @Beau Brockway 

      1) What do we have to do to operate formally/legally in a 506(b) structure?  

      Consult a Securities Attorney. DM and I can recommend a few.

      2) What are the downsides of a 506(b) structure? 

      Limited to 35 non-accredited investors. Can not advertise publicly, ie. social media, media, physical advertisements, etc.

      3) What are the upsides of a 506(b) structure?

      Less restrictions for entry for an investor. Does not necessitate accreditation proof or third party verification of investor incomes/worth. Represents about 90% of all syndications, so the more common approach.

      4) Does a 506(b) replace an LLC or operate in-tandem to an LLC?

      Used in-tandem. Some attorneys will create the LLC in tandem and some will simply ask for an LLC name for the paperwork letting the investor create the LLC.

      5) Can the initial 506(b) funding serve as a down payment for a property and the remainder of the property be financed through a bank?

      Typically a down payment is going to a "closing attorney"/"Title Agency" (depending location) and not a "securities attorney", however there are attorney/company offices that do both. Still, when creating 506b exemption paperwork, you are paying for services rendered to an attorney and not anything to do with the property down payment.

      Look into books such as "It's a Whole New Business!" by Gene Trowbridge for more legal detail on the subject or  "The Best Ever Apartment Syndication Book" by Joe Fairless/Theo Hicks for more of an overall Syndication process. 

      @Beau Brockway

      I’m not an attorney and can’t give legal or tax advice.

      It seems as though your business structure would not even qualify under the 506(b) regulation. If you and your partner are actively working in the business and the passive investor is structured as real estate debt with an interest payment. This is just a simple business with a loan. Typically the 506(b) reg is used to take on investors into a company in which they are gaining some equity and in most cases less than 20% equity. This does not seem to be your case, so probably not something to spend a lot of effort on until you're ready to put out syndication offerings.

      Happy to talk debt and deal structuring more If you are interested. We partner with our brokers and investors on deals as debt and equity all the time creating a structure that you are describing. We also are offering syndications.

      Pending on the structure you want to reach out to syndication attorneys to get legal counsel prior to anything. Best way is to reach out to @Amy Wan or @Kim Lisa Taylor who can help you clarify anything you are unsure of. 

      Happy investing!

      Thanks @John Fortes

      1) What do we have to do to operate formally/legally in a 506(b) structure? You must have no more than 35 non-accredited investors, have a substantial pre-existing relationship with all of them, and have a PPM to the extent you have any non-accredited investors (though even if they're all accredited, a PPM is best practice). You also need to do federal and state filings.

      2) What are the downsides of a 506(b) structure? There isn't really such a thing as a 506b structure. 506bs can be LLCs, corporations, etc. They're just a type of exemption from registering a security. You have to follow certain limitations.

      3) What are the upsides of a 506(b) structure? 506b is the easiest way to raise capital. Over 95% of private placement dollars (a market larger than the public markets) raises under 506b.

      4) Does a 506(b) replace an LLC or operate in-tandem to an LLC? they're two different topics--one is a securities registration exemption, the other is an entity structure.

      5) Can the initial 506(b) funding serve as a down payment for a property and the remainder of the property be financed through a bank? yes, folks do that all the time.

      Happy to chat on the phone as well.

      Thanks @John Fortes

      If you are just doing a one-off loan, you don't need to be overly concerned about Rule 506(b); especially if your investor is accredited. With a single investor, you may also want to consider structuring this as a joint venture (where everyone stays actively involved in generating their own profits). You will generally start thinking about structuring a securities offering when you are either repeatedly borrowing from private investors and your business depends on it; or you are selling passive interests in a company to multiple investors. I'm happy to have a further discussion with you about this offline.