By Bruce E. Methven
When someone raises money for a real-estate venture, often called a syndication, the securities laws apply. There are a few rare exceptions, but this is generally true even when selling promissory notes or TIC (tenants-in-common arrangements) interests. If the securities laws are violated, the money raised may have to be returned to the investors, the founders/promoters can be barred from making any future offerings and they may be subject to civil fines and even criminal penalties. On the other hand, if done correctly, offerings can be an excellent way to raise money (and not just for real estate but for other businesses as well).
In terms of structure, to shield the syndicators and investors from liability, a legal entity is almost always formed. For tax reasons, usually a limited liability company (LLC) or, for larger offerings, a limited partnership is used. Generally “C” and “S” corporations are not used.
(A “C” corporation has two levels of taxation: If profitable, it pays its own income taxes and then the owners pay income tax on their distributions. An “S” corporation often can’t be used because the venture is expected to – or might — have more than 25% of its income in some years from rents. If it violates this rule, it becomes a “C” corporation with very negative tax consequences.)
It is relatively easy to set up an LLC or limited partnership so that there are different classes of ownership if needed. For example, investors can be given limited or no voting rights (or super majorities can be required to remove the manager), can be given priority on distributions (before the syndicators), or can be paid in a different manner than the syndicators, such as a specified rate-of-return percentage. The manager or managers (who may or may not be the syndicators/founders) can be given virtually total control over the operation, or the investors may be given the right to approve certain transactions or major decisions.
Often the syndicators/founders/promoters have an ownership interest in the entity. They may receive that without contributing any money, or they may contribute at least some money if having some “skin in the game” makes potential investors feel more secure. The syndicators/founders/promoters may also be given salaries or a percentage of profits or revenues if they are also managing the venture, which is frequently the case.
All of this is driven by what the syndicator believes will be most attractive to the target investors.
The types of offerings that are almost always used by California ventures are the federal Rule 506 exemption, the California 25102(f) and 25102(n) exemptions, and the California qualification by permit procedure.
(The federal Rule 504/SCOR exemption, federal Rule 505 exemption and federal Reg. A exemption are virtually never used, for reasons that will not be covered here.)
In choosing an exemption to use, the primary factors are: 1) whether the offeror is willing to limit its potential investors to California residents; 2) what investor qualifications (requirements) the offeror can live with; 3) what type of promotion the offeror believes will be needed; and 4) where the majority of the offeror’s business (real property) will be located.
Federal Rule 506 and Non-Public Advertising
With a Rule 506 offering, an unlimited number of “accredited” (based on high levels of assets or income) investors may invest, plus up to 35 non-accredited but “sophisticated” investors may invest. This type of offering can be made in all 50 states (although New York requires filing in advance).
An “accredited” investor includes an entity with more than $5 million in assets. It also includes an individual 1) whose net worth, or joint net worth with his/her spouse, exceeds $1,000,000; or 2) who either had income in excess of $200,000 in each of the two last years or joint income with his/her spouse in excess of $300,000 in those years and is reasonably expected to have the same income in the current year. Unfortunately, as of the summer of 2010, the personal residence may no longer be included in the calculation of net worth.
A “sophisticated” investor is one who is sophisticated in terms of investments, either personally or with the help of a sophisticated and independent financial advisor. This is somewhat subjective, but what is examined is the person’s investment experience, education, career, etc.
A Rule 506 offering cannot be made using “public” advertising but the offeror can send communications to specific persons and entities it reasonably believes meet the investor qualifications. It can also distribute general information about itself and what it does (including on a web site and through educational seminars) so long as it does not refer to any specific past, present or future offerings. Still, this should not be done without consulting a securities attorney: It is easy to cross the line and violate the securities laws regarding public advertising.
With a Rule 506 offering, filings are made with the SEC and in state where the offering has at least one investor.
California 25102(f) Offering
A California 25102(f) offering is very similar to a Rule 506 offering. It also allows an unlimited number of accredited investors and up to 35 non-accredited investors. (As with a Rule 506 offering, no “public” advertising is permitted.) But in addition to sophisticated investors a 25102(f) offering also allows a third class of investors: Those who have a substantial preexisting relationship with one of the principals. This is the so-called “friends, family and colleagues” category. It can be useful if the principals want to allow investors of this type even though they are not accredited or sophisticated.
With a 25102(f) offering a filing is made with California.
California 25102(n) Offering
A California 25102(n) offering is unusual in that it allows some limited public advertising. Specifically it allows the use of a brief “tombstone” ad. (It’s called that because sometimes it feels like one has only as much space as is available for carving on a real tombstone.) There are strict requirements for what the ad must contain, what it may contain, and what it cannot contain. Basically the following is stated: The type of investment, its price, a very brief description of what the company does, and how to obtain more information. Potential investors must complete an investor questionnaire and qualify before receiving any other information. Still the ad can be run in newspapers and magazines and/or on a web site – and it can be mailed, emailed or faxed to anyone.
Investors are limited to accredited investors or, in the case of California corporations only (which frequently does not help with real-estate syndications), also investors that have roughly half the income or assets requirements for an accredited investor.
Filings must be made with California at both the beginning and end of the offering, and the offering may not be open for more than six months.
A California 25102(n) offering is exempt from federal regulation, and there are also about 30-35 states that have exemptions that can be used in conjunction with a 25102(f) offering (and which allow a tombstone ad) IF the offering is limited to $5 million and accredited investors only. Still, the states’ exemptions for this are not identical, so care must be taken to make sure the requirements for all states are met (or at least the ones where investors are expected).
California Qualification by Permit
A California qualification by permit is not an exemption but a registration. That means that a lengthy application must be submitted to the State (which makes the offering more costly) and the State must approve the offering before the offering can start, which usually takes two to three months after the application is submitted.
On the other hand, it allows full public advertising and investor qualifications are quite low. All investors must be California residents, and must have 1) a minimum net worth of at least $75,000 and minimum gross income of $50,000 or (2) a minimum net worth of $150,000. Net worth must be determined exclusive of the principal residence, home furnishings and automobiles and the investment must not exceed 10 percent of the net worth of the investor.
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Methven & Associates
2232 Sixth Street Berkeley, CA 94710
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Copyright 2011 Bruce E. Methven, All Rights Reserved.
The foregoing article constitutes general information only and should not be relied upon as legal advice.