Did you know that investing in real estate was virtually impossible for smaller investors a few decades ago? Once the domain of only the wealthy and well-connected, recent Securities and Exchange Commission (SEC) rulings have broken down barriers for smaller investors and made pooling real estate a popular way to invest.
Many were able to take advantage of the most popular SEC rules investors use to raise capital: Rules 506(b) and 506(c). Choosing between a Rule 506(b) or a Rule 506(c) will affect your capital raising strategies in several ways.
This was the topic of my recent conversation with Dugan Kelley, managing partner at Kelley Clarke, PC, and head of the firm's securities and real estate practice. I would like to share the highlights of our discussion, supported by information from the US SEC website. I hope this helps you learn the key differences between the 506(b) and 506(c) rules before you start looking for investors for your next business. However, I want to remind you that this is not legal advice and you should consult your attorney before making a 506(b) or 506(c) offer.
You can listen to the entire podcast episodehere.
What are rules 506(b) and 506(c) for?
Both rules fall under Rule 506 of Regulation D of the Securities Act, which protects investors against securities fraud. Rule 506 of Regulation D (Reg D) allows companies to sell securities without having to register with the SEC – a very complex and expensive process. Rules 506(b) and 506(c) are types of SEC filing exemptions that allow companies to raise capital from investors without having to register a public offering. As with most investment transactions, fundraising by syndicates is equivalent to issuing securities. Thus, under this rule, syndications can raise money from investors to buy real estate. Under these rules, as an operator, you can legally raise capital from investors with a 506(b) or 506(c) offering to finance a purchase.
“Raising capital is the hardest part of syndication. If you're a syndicator, overcoming that fear factor in raising capital is critical. Go to that place so you can ask someone for money because it's legit. And the first two exceptions we apply for most unions are Reg D, under 506(c) or 506(b),''says Dugan.
Rule 506(b) and Rule 506(c): What's the Difference?
This rule allows syndicates to raise an unlimited amount of funds from an unlimited number of accredited investors and up to 35 non-accredited advanced investors. This capital increase may proceed without prior approval of the offering by the SEC, as long as the exemption rules below are followed.
- Syndicates are not permitted to conduct blanket collections or advertise the offerings in the marketplace
- To prove that they have not sought investors, operators must be able to demonstrate a pre-existing, genuine relationship with an investor that must precede any offer to invest.
- Syndications can raise capital of an unlimited numberauthorized investorsdefined as an individual (or couple) with a net worth of $1 million, excluding their primary residence, or an individual whose annual income exceeds $200,000 (or $300,000 if they have a spouse) for the past two years and has a reasonable expectation of the same for the current year.
- Syndications are limited to 35non-accredited investorsonly. Non-accredited investors must besophisticated investors,which means that they must have financial and business knowledge and experience in order to assess the benefits and risks of future investments.
- When raising funds from non-accredited investors, the syndicator must also follow additional rules, such as:
- Provide disclosure documents that contain the same type of information as that contained in the registered offering, as well as financial statement information
- The syndicator must be available to answer questions from potential buyers
- Investors in a 506(b) offering can self-certify that this is the caseaccreditedofrefinedthrough a prequalification form or questionnaire submitted by the syndicator
- The syndicator must electronically file Form D with the SEC within 15 days of the initial capital raise. This form provides the SEC with information about the company, principal, amount of money raised, and some details about the offering. Once the offering is complete and all funds have been raised, no ongoing reporting is required by the SEC.
The Jumpstart Our Business Startups Act (Jobs Act) of 2012 created Rule 506(c) to give companies and real estate investors more options to raise capital. Under Rule 506(c), syndicators can still raise an unlimited amount of money from an unlimited number of investors. In addition, contrary to Rule 506(b), syndicators may solicit and advertise the offering to the general public, subject to the conditions below.
- That should be all investorsauthorized investors.
- The syndicate must take reasonable steps to screen potential investorsrecognized investorstatus, which may include reviewing documentation such as W-2s, tax returns, bank and brokerage statements, credit reports, and the like.
- As with 506(b), Form D must be filed with the SEC within 15 days of the first capital increase.
“Advertisement and solicitation are the main difference between Section 506(b) and Section 506(c). You cannot advertise or generally solicit a 506(b) offering, whereas a 506(c) allows sponsors to advertise broadly to promote your offering."Dugan explains. In addition, 506(c) offerings require syndicators to do the extra work of verifying all investor accreditation statuses using federally mandated "reasonable steps." Be sure to keep detailed records of how you've vetted each potential investor, just in case you ever need to show the SEC.
"However, the vast majority of private syndicated offerings in the country are still covered by 506(b), which allows you to have an unlimited number of accredited investors and up to 35 sophisticated investors with whom you already have a significant relationship."he adds.
How do I know if I already have a meaningful relationship with my investors?
“If you're going to offer a 506(c), take advantage of the fact that it's a 506(c) opportunity. You're missing out if you don't advertise."Dugan advises. He adds:“Take advantage of all the diverse distribution channels to market your 506(c) offering to potential audiences. Whether it's a podcast, your LinkedIn page, your personal Facebook page, creating a new Facebook group, paid Facebook ads, Instagram or advertising a meeting or conference to a potential 506 (c) to discuss the offer. You are really only limited by your lack of creativity.”
However, Dugan cautions sponsors who are historically and primarily in the 506(b) space to use restraint and common sense when posting material about the project on social media and other channels.“The law is there to help and guide us. We don't want to be disrespectful or break any laws. But we also don't want to be so scared of the announcements of blessings we've had, upcoming acquisitions or potential sales. We might just want to say, "We're so glad we sold one of our assets!" but “We are closed. We are excited! If you want to enter the next one, please contact us,”Dugan explains, noting that the last sentences conflict with the compliance aspect. This is because the new 506(b) offering limits you to people you already have a relationship with, so the information should not be shared with new potential investors.
"The latter is designed to attract investors to you, while the former only shares good news about what your company is doing,"he adds.
Educating your investors versus conditioning the market
"There's a fine line between informing and giving general information about your business and what we call 'priming the market,'"says Dugan.
Market conditioning occurs when a social media post or any other material you post indicates an intent to attract new investors to you or elicit responses from potential investors that you personally do not know.“That's a no-no. We don't want to pre-condition the market, but what we do want is to be able to honestly, transparently and authentically share information about the great things that are happening with our company."says Dugan.
Dugan explains that sharing general information that helps people discover your business is acceptable and publishable. This could be sharing your overall vision or mission, your strengths, or in general the things your company does.“However, when we talk about specific returns (investors are expected to get 12% cash-on-cash) or a specific offering or property with the intention of generating more visitors or more potential investors, there is a limit you don't want to cross."he warns.
506(b) or 506(c): Which is Better for Me?
Your decision to choose between a 506(c) or 506(b) will largely depend on whether you already have people in your network who would like to invest in your business. If you plan to raise capital from your personal network, whether an accredited investor or not, a 506(b) may be your best option. Most new syndicators use a 506(b) for their first job because they initially rely on people they already know. However, they may not be able to get another round of funding from their personal network for their next offering, so they need advertising for the offering. If you depend on attracting other investors, a 506(c) is your only option.
Rule 506(c) allows you to pitch your offering to a wider network of investors outside of your own network. Therefore, you need to build your credibility, reputation and experience to become known to new investors. Your historical numbers not only highlight your company's strengths, but should also attract potential investors.
Ultimately, when choosing between the two policies, keep in mind that you'll need to keep detailed records of your relationship with investors if you're using a 506(b), and your accredited investor screening process if you're going with a 506(c). ).
Rules 506(b) and 506(c) both provide excellent opportunities for real estate syndicates to raise capital and finance corporate acquisitions without complicated government regulation. The rules may allow exemptions from registration, but you must carefully comply with the requirements. Hire or consult an experienced attorney to confidently navigate the process and achieve your investment goals.
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