You may come across a fantastic real estate investment opportunity that requires more cash than you have available to put into it yourself. This doesn't mean you can't still make the deal happen.
Crowdfunding has become a popular way for investors to raise capital to finance deals they may not otherwise be able to purchase. There isn't a one-size-fits-all method of crowdfunding, though. There are a number of different regulations that have their own rules and limitations, and Rule 506(b) is one popular method of getting investors to help fund your deal.
What is Rule 506(b)?
Rule 506(b) is a safe harbor under Regulation D of the Securities Act that provides a way for companies to raise money without registering with the Securities and Exchange Commission (SEC). This exemption allows companies to raise an unlimited amount of money and sell securities to an unlimited number of accredited investors. It also allows the company to sell securities to up to 35 non-accredited investors. If you're not sure whether you qualify as an accredited investor, you can find out more in this article that explains who's an accredited investor.
There are stipulations, of course. One of the main ones is that general solicitation isn't allowed. This means that the company selling the securities can't advertise the securities to the general public.
A company raising money with the Rule 506(b) exemption can only accept investments from people they have a pre-existing substantive relationship with. What exactly is considered a pre-existing relationship? Well, the SEC isn't completely clear on that. There are some guidelines on this requirement, though:
- The relationship had to be established before the company started raising capital.
- The relationship must be substantial enough that they know how sophisticated the investor is in terms of the particular type of investment. In other words, you would have to know that they are familiar with real estate investments and that they can fully understand the investment you're offering.
- The relationship should be established with multiple communications over a reasonable amount of time. So emailing somebody asking them how much they understand about real estate investing likely won't cut it.
You should be safe if you use common sense to determine who you have a substantial enough relationship with. If you have to remind someone who you are when you call them, you should probably pass on asking them to invest this time.
How to raise capital under Rule 506(b)
This rule provides an exemption from registering with the SEC, but you still have to file a notice to let them know about your offering. There are also specific disclosures you need to provide to the non-accredited investors.
There aren't any disclosures required for investors with accredited investor status; however, it's probably still wise to provide them to avoid any misunderstandings.
You do have to provide disclosures to the non-accredited investors. These disclosures will be provided through a private placement memorandum. The private placement memorandum is similar to a real estate prospectus that a REIT would file for a public offering. It will lay out the details of the deal, how the investor will be paid back, the risks involved, and other important information.
You don't have to give this to the accredited investors, but anything you do choose to give them will also have to be given to the non-accredited investors. So if there are any additional documents you want to provide your accredited investors, you'll have to give them to everyone.
You will also have to file Form D with the SEC within 15 days of the first security sold under your private offering. You'll provide information about the business, yourself, the types of securities you're selling, how much money you're raising, and other important information about the offering.
How does Rule 506(b) compare with other exemptions?
Rule 506(b) is one of a handful of exemptions used for crowdfunding. Each exemption has different rules on how you can raise funds, the amount of money you can raise, who you can raise funds from, and the legal process for doing so.
Rule 506(c) also falls under Regulation D. It's similar to Rule 506(b) in that an unlimited number of accredited investors can participate in your exempt offering. You can raise an unlimited amount of funds, and you're exempt from having to register with the SEC.
There are some important differences, though. Reasonable steps must be taken to verify that investors are accredited, while Rule 506(b) only requires investors to self certify. The same Form D is required within 15 days of selling the first securities.
Regulation A is often referred to as a mini IPO. Securities can be sold to both accredited and non-accredited investors under Regulation A, and you can advertise to the general public.
There are two different types of Regulation A offerings that have different fundraising limits and requirements. This exemption is typically used for well-established companies that are raising several million dollars because it can cost over $100,000 in attorney fees to draft and file all of the required documents.
Regulation CF is a more lenient exemption because securities can be sold to accredited and non-accredited investors and be advertised to the general public and because it doesn't cost a fortune to set up.
The amount of money that can be raised is much less, however. Currently, the limit is $1,070,000. You also have to go through a FINRA-approved funding portal.
Who can raise funds with Rule 506(b)?
Almost anyone can raise funds with Rule 506(b), with a few exceptions. A person who isn't eligible for a 506(b) exemption is referred to as a "bad actor." Disqualification can result from:
- Certain criminal convictions in connection with the purchase or sale of any security.
- Certain court and restraining orders in effect during the proposed sale and entered into within the past five years.
- Final orders of certain state or federal regulators.
- SEC disciplinary orders or cease-and-desist orders.
- Suspension or expulsion from a self-regulating organization such as FINRA.
- SEC stop orders and suspension of a Regulation A exemption.
- U.S. Postal Service false representation orders.
These disqualifying events have a "look back" period of either five or 10 years, depending on the specific situation.
These disqualifying events apply to more than just the principal of the issuing company. They apply to any covered person, who may be:
- The issuer.
- Any director, general partner, or managing member.
- Executive officers or any officers participating in the offering.
- 20% beneficial owner of the issuing company.
- Any person or company compensated for soliciting investors, including its directors, general partners, and managing members.
Pros and cons of using Rule 506(b)
This can be a great method of getting investors for your next real estate investment, but there are some things to consider before deciding whether this is your best option.