Raising Capital through Syndication and Private Placements
I used to work for a company that raised money from high net worth individuals using a syndication.
Basically, the company brought in investors, and used their money to pursue real estate projects. The Securities and Exchange Commission or SEC, defines a real estate syndication as “a group of investors who join together and pool their funds to purchase a specific piece of real property”.
Legally, those investors were required to be accredited. While there are multiple ways to qualify as an accredited investor, the most common definition is someone who has a net worth (excluding their primary home) of over one million dollars, or an annual income over $200,000 a year if single or $300,000 in joint income if married, for at least the past two years.
Many people are curious about syndication because they see it as a potential means of acquiring capital and being able to invest in something they couldn’t otherwise afford to do on their own. Below, I’ll discuss syndication, securities exemptions, and lessons learned along the way. Before continuing however, I need to provide the standard “I am not an attorney disclaimer” and remind the reader that everyone’s situation is unique and nothing in this article should be thought of or interpreted as legal advice. Please consult your own attorney before taking any action.
Co-Managers or Passive Investors?
One way to raise money is to start a company and bring in partners. Each partner contributes a certain amount of capital to the company in exchange for a percentage of the equity. Partners are supposed to take an active role in managing the company that they own an interest in.
So what happens if you don’t want active partners, but rather passive investors? If you (or your team) want to be the sole decision maker, then things change. This is where securities law comes into play.
What is a Security?
There are a number of different ways to legally raise money from passive investors. Yet, regardless of what you call it… a loan, an investment, a bond, equity shares, limited partners, etc. it all comes back to security law.
The Supreme Court ruled in the case of SEC vs W.J. Howey Co, that something would be labeled a security is there is “a reasonable expectation of profits to be derived from the efforts of others”. This is known as the Howey Test. In short, it means that any time you have passive investors you’ve potentially created a security, and must abide by securities law.
While I am not an attorney, my personal definition of a security is basically any investment where the returns are based upon the efforts of another person or party.
There are only two basic ways around securities law. You can create a legal entity such as an LLC or partnership where your “investors” are active participants and their returns are based, at least in part, on their own efforts, or you can qualify for an exemption.
Creating a Fund
The company that I used to work for knew that it didn’t want tens or hundreds of co-managers all actively running the company, and so a decision was made to create a security. Taking this approach, the executives could exclusively control the direction of the company and still bring in investor capital to pursue projects.
The company decided to set up a private placement fund; basically, a private sale of stock. Next, the company sought to file for an exemption from registering with the SEC. This would allow them to avoid having to make various required disclosures and filings thought to be overkill for such a small company.
They hired a law firm to assist with the paperwork, which included the creation of a private placement memorandum (PPM). One lawyer half-jokingly told me that a PPM is basically a giant disclaimer document telling your prospective investors all the reasons why they shouldn’t invest with you. This particular PPM was about sixty pages long. It discussed how the investment worked, how investors would get paid, and went into long descriptions of numerous risk factors that potential investors should be aware of.
Perhaps the biggest and most impactful decision that the company needed to make was how to pursue an SEC registration exemption. Regulation D of the Securities Act of 1933 goes into different types of registration exemptions. The company was referred specifically to Rule 506 of Regulation D and was asked to choose between Rule 506(b) and Rule 506(c). Many other companies have been faced with this same decision.
In this particular case, the deciding factor came down to two factors: working exclusively with accredited investors and the ability to advertise. If the company went with Rule 506(b) it would not be permitted to do any marketing or advertising, but would be allowed to include up to 35 non-accredited investors in the fund. With Rule 506(c) approved advertising would be permitted, but the fund could only be made available exclusively to accredited investors.
Each company has to make their own decision about what makes the most sense in their case. As a fledgling company, the CEO ultimately went with Rule 506(c) in order to publicly market projects and deals, and in doing so acquire investors.
One of the biggest lessons I learned in working with a Reg D, 506(c) Fund was that even having a large database of potential investors is not a guarantee of success. We regularly marketed to over 300,000 potential investors. But because we could only work with those who were accredited the number of eligible investors immediately dropped to around 3000 (assuming the proverbial 1%). From there we had to find people who were interested in what we were promoting, who had the liquid capital available, who believed in the company, and who were ready and willing to write a check. With each qualifier, the pool of potential investors shrunk ever smaller.
It was difficult finding accredited investors. We attended a number of nationwide conferences and spoke with a number of people who expressed a desire to invest, but who we ultimately had to turn down because they were not accredited. This all came back to the decision to go with Rule 506(c) and the ability to advertise.
The company was later introduced to another means of acquiring SEC registration exemption. Regulation A+ (an updated version of Regulation A) allows companies to openly market and advertise and to work with more than 35 non-accredited investors.
Regulation A+ was still rather new at the time that we pursued it. It initially seemed like a no-brainer, and yet there were only about 40 or so companies at the time that had ever obtained a Regulation A filing exemption. It made me wonder why.
Our attorney promised us that it would take about a year to get approved because of the greater level of scrutiny. We were lucky and were approved in less than ten months.
One of the rules that the company had to abide by what that it had to raise all the necessary capital within a twelve-month period. Falling short of the minimum capital needed for the fund, the company attributed its shortcoming to limited resources and personnel.
In the process, I learned another important lesson. When you deal with non-accredited investors you end up dealing with smaller investment amounts. In our Regulation D fund, the minimum investment was $50,000. In the Regulation A+ fund, the minimum was less than $500. That meant that to hit the same financial target we would need significantly more investors in the latter fund.
With more investors comes more work. Regardless of the amount invested, each investment that came in required the same paperwork. As the Regulation A+ fund grew, I found myself spending more and more time answering investor questions, dealing with paperwork, updating our database, and handling other administrative tasks that kept me from the actual real estate projects we were pursuing.
Had we continued to grow and hit a hundred, two hundred, or a thousand plus investors, I can easily see how out of hand it could have become. While the minimum investment could’ve been set higher, when you’re dealing with non-accredited investors, you’ll inevitably be working with a larger number of investors to reach the same capital threshold. In the meantime, all that administrative work takes a toll.
When I spoke with other syndicators and private fund operators, this was the number one reason they decided to stick with Regulation D over Regulation A+ exemptions. The simply felt the benefits were not worth it.