Finding investors for a real estate deal used to be nearly impossible for most investors. The process involved either already knowing people with the capital you needed or having enough money to jump through the Securities and Exchange Commission's (SEC) hoops.
In more recent years, real estate investors have been able to take advantage of a new way to raise money through Rule 506(c). This is the rule that created the real estate crowdfunding industry and made real estate syndication a popular way to invest.
What is Rule 506(c)?
Rule 506(c) allows companies to advertise their securities offering to the general public without having to register with the SEC, as long as the securities are only sold to accredited investors and the company verifies that the investors are accredited.
Rule 506(c) is one of the favorite ways for real estate investors to raise funds. They can take on an unlimited number of accredited investors and raise an unlimited amount of money.
This rule is a part of Regulation D of the Securities Act, which provides ways for businesses to raise capital by selling securities that are exempt from SEC registration.
This new rule was created as a result of the Jumpstart Our Business Startups Act, commonly known as the JOBS Act. Previously, businesses mostly used the Rule 506(b) exemption, which didn't allow general solicitation.
The ability to advertise to the public opened up a lot of opportunities for real estate investors to raise money for deals that they otherwise wouldn't have been able to do.
Most multifamily syndications are done through the 506(c) exemption. This is what has opened up syndicated deals to investors who want investment options besides a public offering.
How to raise capital with Rule 506(c)
Raising capital under this exemption isn't much different than with Rule 506(b), other than a little additional legwork.
Since the SEC lifted the ban on general solicitation with the JOBS Act, they wanted to take some extra precautions to protect investors. This is most likely why they limited these offerings to accredited investors.
Since Rule 506(b) only requires accredited investors to self-certify, the issuer isn't on the hook if they're not actually accredited. Under 506(c), the issuer is required to take reasonable steps to verify their accredited investor status.
Issuers can verify the investor's status by reviewing tax returns to verify income for the past two years or documents showing their assets and liabilities to verify their net worth. You can also use a third-party verification company to verify the purchaser's accredited investor status.
Whichever verification method you choose, just be sure to keep detailed records for how you verified each potential investor in case you ever need to show the SEC.
While not technically required, you should have a detailed private placement memorandum (PPM) drafted. Most people hire an attorney experienced in this area to handle that. Not only will this make investors more likely to trust you with their money, but it can also help you avoid lawsuits or SEC disciplinary actions by documenting the disclosures and representations.
The next thing to do is find investors. You can use pretty much any type of general advertising. Social media and email marketing have become the most popular methods of advertising private offerings. You don't have to take steps to limit your advertising to only accredited investors; you just have to verify that any purchaser is accredited before taking their money.
You'll have to file Form D to the SEC within 15 days after your first securities have been sold. This form will provide details on your business, yourself, and how much money you're raising and what you plan to use it for.
Some states may also require you to file a notice and potentially a filing fee. You'll want to check the state regulations in any state you'll be selling securities in.
There aren't any post-offering filing requirements, so you won't have to provide any reports or financials to the SEC after you've raised your money.
How does Rule 506(c) compare with other exemptions?
Rule 506(b) is another safe harbor exemption that allows you to sell securities without registering with the SEC. The major difference is that you can't advertise your offering to the general public. You're limited to offering the securities to people you have a pre-existing relationship with. However, you're not limited to accredited investors. You can get investments from up to 35 non-accredited investors.
Regulation CF isn't as common of a crowdfunding method as the 506 exemptions. This is mainly because the amount you can raise is limited. The current limit is $1,070,000. The offering can be advertised, but you have to use a funding portal that is approved by the Financial Industry Regulatory Authority (FINRA).
Regulation A has more rules and requires approval by the SEC. 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 types of Regulation A offerings. Each of them has different limits to the amount that can be raised and different reporting requirements.
Since Regulation A offerings require SEC approval, companies often have to invest close to $100,000, if not more, to have the proper documents and disclosures drafted.
Who can raise funds with Rule 506(c)?
One of the reasons Rule 506(c) is a popular crowdfunding method is because it's open to almost anyone to use. However, there are things that can disqualify someone from issuing a 506(c) offering.
Certain disqualifying events could prevent someone from issuing a private offering or even becoming involved in it. These disqualified persons are referred to as "bad actors." This applies to:
- The issuer.
- A managing member, general partner, or director of the issuing company.
- Executive officers or other officers of the company who are involved in the offering.
- Any beneficial owner who owns 20% or more of the issuing company.
- The issuing company's promoters.
- Anyone being compensated for soliciting investors, including principals, directors, managing members, or general partners if it's a company that's soliciting investors.
The disqualifying events have a look-back period of five to 10 years, depending on the exact situation. In some cases, a waiver or certain disclosures can still allow the bad actor to participate in the offering.
Disqualifying events include:
- Certain felony or misdemeanor convictions related to the sale or purchase of securities.
- Certain restraining orders and court orders issued within the past five years that are still in effect at the time of the offering.
- Orders from state or federal regulatory agencies banning the person from participating in the offering.
- Being expelled or suspended from a self-regulating organization.
- Anyone with a suspension or a stop order from a Regulation A offering.
- U.S. Postal Service false representation orders.
Pros and cons of using Rule 506(c)
Any type of offering has its benefits and limitations. Which is the best one depends on the amount of money being raised and the type of deal being offered.
There are pros and cons to using Rule 506(c) to crowdfund your real estate deal.