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Crowdfunding & CRE: What are New Rules? Do They Work?

Voices columnist Richard Blunk says raising money online has attracted commercial real estate sponsors like bees to honey. Here, he offers a short history lesson to help with the learning curve.

The thought of raising money online has attracted commercial real estate (CRE) sponsors like bees to honey.

Many assumed that a track record of returns on investment and their selection of quality real estate products would create an internet frenzy and social media buzz, which would generate a huge stable of well-heeled investors that would want to participate in subsequent offerings.

Unfortunately, this has not always been the case as participants in the crowdfunding space have faced a steep learning curve. It is taking real estate investors a while to become comfortable with the use of this approach. To best understand the current state of crowdfunding, we must first start with a short history lesson, which unfortunately requires a bit of legalese in the telling.

JOBS ACTS PROVIDES 3 OPTIONS FOR ONLINE EQUITY RAISES

President Obama signed the Jumpstart Our Business Startups Act (commonly known as the JOBS Act) into law on April 5, 2012.  This law provided three related, but distinct, options for online equity raises.

The first two options — the newly-adopted Regulation CF and the addition of Rule 506(c) to the frequently used Regulation D — are both designed as exemptions from the overarching SEC requirement that equity offers be registered at both the federal and state levels. Modifications to current Regulation A provided the third option. 

With its five-year track record, crowdfunding is not a new and exotic method to raise capital.

Drilling down, we can better understand some of the pluses and minuses the current regulatory landscape provides.

While some in the commercial real estate world started using these approaches when the SEC adopted its initial rules and regulations in 2013, the industry, in general, emerged with a slow start. The development of the industry did not accelerate significantly until SEC rules and regulations were published in 2016. For example, Fundrise, RealtyShares, and RealtyMogul all successful completed CRE equity or debt offerings in 2016.

Drilling down, we can better understand some of the pluses and minuses the current regulatory landscape provides.

Regulation A is the most demanding and expensive of the three paths to follow since it requires a comprehensive filing with and qualification from the SEC. While perhaps a useful step for established issuers in the crowdfunding industry, approximately one-third of recent Regulation A offerings were not able to raise their requirement minimum investment goals, requiring the issuers to return all capital received. Why? Perhaps the minimum capital raise was set too high or the marketing lacked impetus, continuity, and determination or the overall structure of the investment was flawed. 

In any case, it seems clear that merely setting up an online presence does not guarantee success. 

On the other hand, at least eight Regulation A offerings (not all CRE) overcame these challenges are either currently raising or have already successfully raised capital. These successes indicate that Regulation A can be used during the early stages of a business when companies have an existing track record.  The successful history of the issuer will establish the greatest opportunity complete the offerings that they launch.

RULE 506(C) REQUIRES NOTIFYING EACH STATE IN WHICH FUNDS RAISED

Unlike a Tier II, Regulation A offering, Rule 506(c) requires notification to each State in which capital is raised and notification to the SEC, but does not require registration with or review by the SEC.

For those promoters that can comply with those requirements, Rule 506(c) may be an attractive option since the success of Rule 506(c) offerings has been remarkable. Published reports indicate that in 2015, private placement issuers raised as much as $38 billion in startup capital under Rule 506(c). When figures for 2016 become available, researchers expect that the amount raised will approach double the amount for 2015 – that is $76 billion in investment capital! 

When the above statistics are compared to the results of Regulation A, the path for raising capital on the Internet becomes clear. Rule 506(c) is less costly, less regulated, less burdensome and more quickly completed. But this option does still have marketing restrictions that must be considered.

Many Rule 506(c) offerings are based upon the condition, which is confirmed by the investor in the subscription documents, that the investor will hold its equity in the venture for the duration of the CRE investment. The issuer must recognize that while Rule 506(c) permits a great deal of latitude concerning how their offerings may be marketed, sales can only be made to investors with high net worth or recent high-income levels. Unlike offerings based on other SEC rules and regulations, a third party must independently verify that such requirements are met. Even though experienced securities counsel can guide sponsors with some of these restrictions, others must be satisfied.

COMMITMENT TO MARKETING EFFORT A MUST

From a practical perspective, the issuer must not assume that its use of a well-regarded platform provider will assure success. Rather, the issuer must be committed to its marketing effort or risk the collapse of the capital raise.  Simply creating a landing page on the internet and sending out a few email blasts detailing their projects will not result in a successful capital raising campaign.

Statistical experience has shown that the amount of capital raised and the length of time required to complete the raise are generally disappointing to the issuer. 

The entire amount of capital targeted does not flood in overnight. There is usually pent up demand following the initial marketing and advertising campaign, which results in 30-40 percent of the capital pouring into escrow immediately but the remaining amount has to be chased with keenness and perseverance to be raised.

Raising the remaining capital will most often result in extending the closing date of the offering.

On balance, then, Rule 506(c) seems best suited for emerging companies with a good story, strong sponsors and marketing capital.

The last option — Regulation CF — has not been the avenue of choice for CRE capital raising. Offerings under Regulation CF are limited to $1,000,000, which shackles their applicability to CRE investments. Furthermore, Regulation CF offerings can only be made on Internet Portals that are registered with the SEC or the Financial Industry Regulatory Association (FINRA). With this burden, most portals require significant due diligence to invite an offering onto their portal.

In some instances, Regulation CF has been employed to raise capital for small, local market transactions such as residential home purchases, remodels, and resales but Regulation CF is not where the CRE market resides. But market history teaches us that when used successfully, this third option is best used after the company has established a track record through its successful use of either or both of the other two options. These prior capital raises provide the company with historic traction along with a generally enthusiastic investor base.

CROWDFUNDING MAY NOT BE FOR EVERYONE

Crowdfunding has been and is continuing to be a successful method by which to raise capital — but not for everyone. The journey traveled to achieve a full capital raise is not devoid of the requirement to expend effort, money, time and planning to reach the final destination. 

One path to follow can be the completion a series of Rule 506(c) offerings by the issuer, which will create a track record and build a following of enthusiasts for the issuer prior to launching a large-scale Regulation A registration. The history of crowdfunding has shown that this practice results in the most reliable growth of issuers and their capital raising programs.

This column was co-written by Richard J. Hockert.


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Richard A. Blunk is a contributor to Dallas Innovates as well as managing director and general counsel of Thermopylae Ventures, LLC, a Dallas-based alternative investment firm with interests in altern(...)

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