It is natural to indulge in the illusions of hope. We are apt to shut our eyes to that siren until she allures us to our death. – Gertrude Stein
Does the thought of increasing your real estate purchasing power get your “juices” going? If so, you’re not alone. Talk to any serious real estate investor and you will probably hear the same complaint: “I have more deals than I do money or credit.” Some investors solve this issue through simultaneous closings or with hard-money lenders. Others take a different approach by actively soliciting people with cash to invest in their deals.
The allure is obvious: “get rich through real estate investing.” Heck, who wouldn’t want to do that? You partner with me, we invest together, and we all make money. Right?
Well…yes. If it’s done right.
And That’s the Tricky Part.
Unfortunately, many investors make mistakes that unwittingly trade one problem for another, and it’s not a trade I’d make: lack of cash versus potential civil and criminal liability. If the investor’s fundraising activities are properly structured, then liability diminishes accordingly. But that’s just one of many “ifs” of which you need to be mindful when you’re working with other people’s money, especially when it comes to securities law at both state and federal levels.
My Lawyer Doesn’t Even Want to Talk About It!
Occasionally an investor asks me why his local real estate attorney refuses to discuss the raising of capital or will flat-out discourage such activity. The answer is simple. The federal government requires every company in the United States (corporation, limited liability company, trust, or limited partnership) seeking to sell an interest to be “registered” at both the federal level (with the Securities and Exchange Commission, or “SEC”) and with each state in which the securities are offered or sold. This registration can be an extraordinarily complex and expensive endeavor, which, if done wrong, carries significant penalties.
In this post-Madoff era, state and federal agencies now “take no prisoners” when it comes to the legality of investments and capital. And indeed, that’s a step in the right direction! Failure to comply with securities laws increases the investor’s risk of lawsuits by the investors – and can even lead to criminal prosecution. Remember, ignorance of the law is no excuse; even an innocent mistake can lead to court and, quite possibly, to jail.
Scared off yet? No? Good. Then let’s talk about raising money!
Raising Money with an LLC
1. Register Correctly.
If you plan on raising money with an LLC, begin by registering your LLC in the state where you will be working. While registering an LLC in states like Nevada or Wyoming you have enhanced privacy and asset protection from investors, this is not looked upon as advantageous to those from whom you are seeking investments. Delaware is an excellent choice for forming your solicitation LLC because it offers investor protections and is synonymous with this type of activity. BTW never use anonymity when setting up your solicitation LLC – transparency is very important.
2. Have a Solid Operating Agreement.
Draft an operating agreement that details how funds will be invested, distributed, and managed, as well as any fees that will be paid for management. This is a crucial step: the operating agreement puts everyone on notice how funds will be handled, it’s a binding agreement, and it dictates how the LLC will operate.
3. Watch Your Legal P’s and Q’s.
At this point, many real estate investors think they’re done. In other words, they say, “I have my LCC set up, so let’s get going.” Not so fast, Bunky! You want to stay completely legal —as in “out of jail,” — don’t you? So there are a few more picky details to take care of first!
Plain fact: when people buy into your LLC, you become a seller of what the government calls “securities.” Most real estate investors don’t know that borrowing money from outside investors can be interpreted as a “security,” but it is. Sad, but true, and I’ve read accounts of more than one investor who ended up in an orange jumpsuit for his borrowing activities.
Sounds Like Raising Money Is Risky Business. How Do I Keep From Violating the Law?
As the reader, you might be wondering if anyone does this legally — or are lots of investors actually in violation of the law? Sometimes, yes, but — fortunately — not that often. Most investors educate themselves on various exemptions that, in turn, enable them to operate their businesses with no problems whatsoever.
Both federal and state law base their exemptions around the following criteria:
- the number of investors solicited
- the type of investor solicited
- the amount to be raised and/or
- the manner of solicitation
As a real estate investor, understanding and staying within these exemptions should be your primary concern. But always bear in mind, too, that even an exemption does not necessarily make your offering “legal.” Each exemption takes us down a different regulatory path and knowing these paths will be key in preventing you from becoming lost.
What are some of the BEST ways to legally get your funds on solid footing?
Try to partner only with accredited investors. These are…
- Individuals with annual income of more than $200,000 per year, or a couple with joint income of $300,000, in each of the last two years — and reasonable expectations of maintaining that same level of income
- Individuals with net worth exceeding $1 million (either individually or jointly with a spouse), excluding the personal residence
- Individuals who are general partners, executive officers, directors or a related combination thereof for the issuer of a security being offered
Keep your offering private: never advertise it to the public. You can share general information about what your activities are, and why you’re seeking funding, through such vehicles as a company’s website, seminars and other presentations, flyers, and brochures, and such. Also, keep in mind these restrictions:
- Don’t raise more than $5 million
- Do require investors to sign subscription agreements
- Don’t guarantee a rate of return or attempt to “trade on” performance of your past offerings
These are only a few concerns you’ll need to address prior to raising investment funds. For the full scope of detail, get professional guidance and help. It’s better to spend a few thousand up front with an attorney than having to spend tens of thousands later if you make a mistake!
Why Authoritative Help Is Important
It’s true that, in terms of federal securities, you have just one “playbook” to concern yourself about. However, that’s not the only collections of rules you have to follow; each state has its own set, so just because you’ve exempted your fundraising under federal guidelines doesn’t mean you’re “in the clear” in any particular state. State securities regulations, commonly called “Blue Sky Laws,” can make your own personal sky dark indeed if you violate them! And the more states in which you plan to invest, the more “playbooks” you’ll have to consult — and follow to the letter.
Gloom and Doom?
After all this, you might be thinking, “In other words, I shouldn’t actually plan to fundraise at all!” If you’re feeling that way, rest assured I’m NOT trying to send that message. What I am trying to do is arm you with the right information to begin raising capital on a solid footing.
THE WISE INVESTOR’S RULE OF THUMB:
Every solicitation for capital is subject to federal law unless covered under an exemption.
N.B.: You still need to comply with ALL state regulations unless a given federal exemption specifically pre-empts state law. This is currently the case with Rule 506.
A Quick Look at Rule 506
Rule 506 is the preferred exemption for those investors looking to save both time and money while reducing the complexity of fundraising activity. Since this rule is one of the few that pre-empts state law, it allows you to raise capital without worrying about “Blue Sky” laws.
Rule 506 benefits are:
- The amount of capital you can raise is unlimited.
- You are not restricted in who can use the Rule for fundraising.
- There is no limit on the number of “accredited investors,” as previously defined.
- You are also allowed up to 35 “non-accredited” investors, as long as they qualify as “sophisticated investors.” An investor is considered “sophisticated” when he or she has sufficient knowledge and experience in financial and business matters to competently evaluate the merits and risks of a prospective investment.
- Only Form D is required, for both the SEC and the state where funds are raised.
On the Other Side…
Rule 506 limits are:
- In its primary from, Rule 506 has a general prohibition on public advertising or solicitation to market the securities. In other words, no seminars, flyers, ads, or such.
- In SEC modifications to Rule 506, known as Rule 506 (c), the rule against general solicitation is removed. However, under this modification, you must still take “reasonable steps to verify” that your investors are indeed accredited investors, a requirement not included in the original Rule 506.
What about Advertising? Rule 504 Exemptions
If you want to advertise, a Rule 504 exemption may be perfect for you; the SEC basically takes a “hands-off” approach to any offerings under $5 million within a 12-month period. However, although Rule 504 will allow you to use general advertising and solicitation to raise capital, you must be certain your state laws allow such advertising, AND you must meet state law registration requirements. If all that is in order, Rule 504 benefits also include:
- An unlimited number of investors
- Investors don’t have to meet any sophistication or experience qualifications
- No obligation to provide any disclosure materials regarding the offering
N.B.: Given the modifications to Rule 506, this Rule is likely to fall out of favor.
And Then, There’s Rule 147
This is one of the few exemptions that applies at the federal level rather than a state level. Rule 147 grants you an exemption from SEC registration if you’re raising capital in only one state, and all the following apply:
- Your business is organized in that state
- All of your investors live in that state
- You will use the capital in that state
Under Rule 147, you can also solicit for capital, with no federal limits on amounts being raised; in general, the SEC leaves regulation up to the state in question. This advertising “advantage” is the main attraction to Rule 147; however, be aware that most states do restrict how much capital can be raised when advertising or solicitation is involved.
Bottom-Line Fundraising Smarts
When you’re planning to raise capital for estate endeavors — unless you’re dealing strictly with a closed group of a few friends and family members — I recommend you find the path of least resistance and make the appropriate filings. (Working with what marketers call “love money” doesn’t usually require registration.) But if you’re looking to operate on a grander scale, contact a securities attorney. Professional expertise is a comparatively small investment now that will pay untold dividends, in terms of both your financial and mental well-being, in the future.