Equity crowdfunding has become an effective method for investors who either need funding for their real estate deals or want to earn passive income from real estate. There are several ways to get involved with crowdfunding in either capacity, but like all things real estate, there are several things to consider. Take a look at exactly what crowdfunding is and how each type of equity crowdfunding works.
What is equity crowdfunding?
Equity crowdfunding is a method private companies use to raise capital. A company puts out an offering through a crowdfunding platform to sell securities to investors. Equity crowdfunding is popular in real estate investing and development, as well as several other types of private companies.
Equity crowdfunding allows anyone to be an investor in a real estate project or company. It also allows entrepreneurs to raise capital without having to spend years jumping through hoops to meet the Securities and Exchange Commission's (SEC) requirements.
For example, say an experienced real estate investor secures a safe and profitable deal. However, they don't have the necessary capital to purchase the property. The investor can take the deal to an equity crowdfunding platform to offer other investors the opportunity to get involved in the project.
It is important to note, however, that crowdfunding platforms don't accept all deals that are submitted. Crowdfunding sites vet all investment opportunities very carefully. They want to minimize the amount of risk the investors on their platform take.
How does equity crowdfunding work?
Historically, real estate developers and private companies were very limited as to how they could raise investor capital. As crowdfunding has evolved, it has allowed more people to fund deals and startups with investments from the public.
When a real estate investor gets an investment property under contract, and has met any legal requirements, they can submit their deal to an equity crowdfunding platform to review. If the deal makes it through the platform's due diligence process, they will start a crowdfunding campaign.
Once the investor has a crowdfunding campaign going for their deal, the investment opportunity is listed on the crowdfunding platform's site for investors to review and invest in. Different campaigns on different platforms will have different minimum investments.
The campaign will have a target amount. If enough investors like the deal and fund the campaign, the deal gets funded, and the real estate is purchased. The investors now have their equity in the deal and will begin receiving distributions based on the deal structure.
Some details of a crowdfunding deal will depend on the platform being used. Different platforms have their own requirements on the deals they will post and how the investments are handled. Some crowdfunding platforms simply act as a matchmaker, while others will provide a funding portal along with an escrow account.
How is an equity crowdfunding deal structured?
When someone invests in a crowdfunding deal, they're buying equity in the deal. They actually become part owners. However, they don't play any sort of active role in the investment.
The person who puts the deal together is the issuer, sometimes referred to as the sponsor. They find the deal, negotiate the price and terms, and manage the asset once it's purchased. The issuer is also the one who guarantees any loans.
The sponsor typically either forms a limited liability company (LLC) or a limited partnership with most crowdfunding strategies. This LLC or limited partnership will purchase the asset.
In an LLC, the angel investors are buying Class A membership interest. The Class A members are the ones who provide the capital contributions and make up a certain percentage of ownership. The sponsor has Class B membership interest. Class B members own the remaining membership interest in the LLC and act as the management for the entity.
If the deal is a limited partnership, the investors are limited partners and the issuer is the general partner. Limited partners provide the capital but don't participate in the management of the partnership. The general partner doesn't contribute capital but manages the partnership.
In some instances, the sponsor can also have Class A membership and can also be included as a limited partner, if they also provide capital contributions. In this case, they would normally have a separate entity that has Class B membership interest or is a general partner.
The amount an investor pays for their piece of the deal doesn't normally correlate to the purchase price. The issuer gets a percentage of the equity for putting the deal together. That percentage can vary but is normally somewhere between 20% and 35%.
Many of these deals are structured so that the investors get their target rate of return before the sponsor gets any distributions. This is referred to as a preferred equity deal.
For example, say the issuer offers the deal with a preferred return of 6%. That means if the investment doesn't reach a 6% return, the sponsor doesn't get a share of the profits. Once returns are above 6%, the sponsor begins to earn their profit.
There are different ways the amount of money the sponsor gets from the profit is calculated. Usually, the sponsor will begin receiving their equity share worth of the profits on anything above the preferred rate of return.
For example, suppose the equity is split 75/25 between the sponsor and investors. The preferred return is 6%, and the actual return for the year was 8%. The investors would get the full 6% and then share 25% of any net income above that.
In some cases, the split changes once the return hits a certain threshold. The split may increase to 50/50 once the returns hit 10%. In this case, the sponsor gets 25% of any returns between 6% and 10% as well as 50% of anything above that.
Most of the time, there is a target exit date. This is when they plan on either selling or refinancing the property so the investors get their capital back. This timeframe is normally between five and ten years.
The sponsor can get paid in a few ways. There's the distributions on anything above the preferred rate. The sponsor also usually charges an asset management fee. The asset management fee is normally between 1% and 2%, depending on the size of the deal.
They may also charge an acquisition fee once the entity purchases the property. There could also be a disposition fee once they sell the property.
Finally, the sponsor profits at the end when they sell the property. This is when they get paid on their equity share. For example, suppose the partnership nets $1 million when they sell the property. If the sponsor has 25% equity, they'll get $250,000 and the rest will get distributed to the investors accordingly.
This is just one simple example of how an equity crowdfunding deal may be structured. Deals can be structured any number of different ways, and they often are.
How is equity crowdfunding different from stocks?
While there are several rules and regulations that make equity crowdfunding different from stocks, the main differences are liquidity and investment limits.
Stocks are publicly traded, so investors are able to buy a stock in the morning and sell it in the afternoon. You can also sell any portion of your stocks that you wish.
With equity crowdfunding, you're buying your equity directly from the deal sponsor and committing to the full term of the project. While some forms of equity crowdfunding allow you to sell your shares, the options are limited compared to publicly traded stocks.
The level of risk is usually higher with equity crowdfunding. For the most part, publicly traded companies are well established and stable. With crowdfunding, you're investing in a brand new deal, and you're trusting the sponsor to make it successful and earn a profit for you.
Crowdfunding also has limits in place as to how much capital a company can raise as well as who they can raise investment capital from.
Crowdfunding laws have evolved quite a bit over the years. The laws vary among the various types of crowdfunding in order to protect investors while still providing opportunities for real estate investors and entrepreneurs to raise venture capital.
One place where crowdfunding regulations vary has to do with who is able to invest in a deal. Some offerings are only available to accredited investors, and others also allow non-accredited investors.
- Accredited investor: An individual with a net worth of at least $1 million or an annual income of $200,000 or more for the past two years. The income requirement is $300,000 for joint income. Banks, corporations, nonprofits, and trusts with $5 million or more in assets can also be accredited investors.
- Non-accredited investor: An investor who does not meet the requirements to be an accredited investor. Different crowdfunding regulations place other requirements on non-accredited investments, however.
The Securities Act of 1933 was passed by Congress after the stock market crash of 1929. The act was put in place to protect investors and hopefully avoid another crash. The Securities Act set a lot of stringent rules regarding disclosure requirements and anti-fraud provisions.
With the Securities Act, the SEC regulated the entire process of selling securities. This made the process much more expensive for any company that wanted to solicit investments from the general public. Anyone wanting to advertise their securities to the public now had to conduct an Initial Public Offering (IPO).
This process made it difficult for real estate developers to find investors. The real estate deals were rarely worth the time, effort, and cost of going through the IPO process for a real estate development.
Rule 506 of Regulation D of the Securities Act still allowed real estate developers to sell private securities to investors they had a preexisting relationship with. Developers using this rule could sell securities in their development without going through the registration process and other requirements companies that sold securities to the public had to.
Rule 506 allows developers to solicit investments from up to 35 non-accredited investors and an unlimited number of accredited investors. It is, however, strict about the developer having a pre-existing relationship with the investors. The non-accredited investors have to be sophisticated, meaning that they have sufficient knowledge and experience with investments and business.
Real estate developers have been using the Rule 506 exemption for decades to fund real estate projects by tapping into their personal network of investors.
Regulation A was added to the Securities Act in 1936. This provided an option for developers and private companies to solicit investments from the public without registering with the SEC and conducting an IPO. Unlike with Rule 506, however, any company selling securities under Regulation A is required to file their offering with the SEC for review. If the offering meets the requirements, the SEC may "qualify" the offering, at which point the company can begin selling securities.
Regulation A was created with several limitations in place as to who is eligible to offer securities and how much they can raise. It also didn't provide an exemption under state laws in whichever state the securities were being sold.
The additional requirements with Regulation A involve a lot of additional costs for the issuer. Because of the additional costs and the limits on the amount that can be raised, Regulation A was rarely used for several decades.
The JOBS Act
The Jumpstart Our Business Startups Act (JOBS) was signed into law in 2012. This act was created to help stimulate the economy from the 2008 recession. The JOBS Act provided a new rule that lifted the requirement of having a pre-existing relationship with investors. This new rule was added to the Securities Act of 1933 as Rule 506(c).
Under Rule 506(c), developers can advertise their securities to the general public but can only accept investments from accredited investors. They're also required to verify that someone is an accredited investor.
The JOBS Act has created opportunities for people to raise capital to fund their real estate investments or business startups. It has also given investors alternative investment options over the publicly traded investments they were limited to before.
Equity in rule 506(c) investments is not tradeable, so investors aren't able to resell their shares. The issuer may buy them back, but they are not required to. Investors are committing to a long-term investment.
The SEC amended rules to Regulation A in 2015 with Title IV of the JOBS Act. This created what's now known as Regulation A+.
These changes increased the amount of capital that can be raised and make the offering exempt from state registration as well as SEC registration. Many people call this a "mini IPO." Regulation A+ was the true beginning to equity crowdfunding. It was the first to allow non-accredited investors to invest in private real estate deals and private companies through a variety of crowdfunding sites.
The new Regulation A+ rules still require the offering to be filed with the SEC for review to become qualified.
Regulation A+ is made up of two tiers, each with their own limits and requirements:
- Tier I allows companies to raise a maximum of $20 million from accredited and non-accredited investors. Anyone raising capital under Tier I offerings must have a coordinated review with the SEC and any state where the securities will be offered.
- Tier II has a higher limit of $50 million that a company can raise. Tier II does have some additional rules and limits, however.
Investors are only allowed to invest up to 5% of their annual income, or net worth, if it's below $100,000. They can invest up to 10% if their income or net worth is above $100,000. There is also a maximum investment of $100,000.
Tier II does not require state review, but the SEC approval process is more robust. Companies must also have their financials audited and meet ongoing reporting requirements.
Investors are able to sell their shares of a company that uses Regulation A+. If the issuing company registers on an exchange, the investor can easily sell their shares through that exchange. If not, the investor can use certain after-market exchanges or sell their shares through a registered broker-dealer.
The expense of the Regulation A+ process makes it quite difficult for many real estate investors and early stage startups to raise capital this way. The costs, time, and effort required to use Regulation A+ make it more suitable for well-established companies and real estate investors needing to raise several million dollars.
Regulation Crowdfunding (Regulation CF)
Shortly after the changes to Regulation A, the SEC created Regulation Crowdfunding with new rules under Title III of the JOBS Act. These new rules made it much easier for smaller companies and investors to raise money through crowdfunding. This new regulation has fewer requirements, and the cost is much more affordable.
Under Regulation CF, real estate investors are able to take investments from both accredited and non-accredited investors. However, the investments must be made through an online Financial Industry Regulatory Authority (FINRA) registered funding portal or a registered broker-dealer.
The amount anyone can raise with Regulation CF in a 12-month period is limited to $1,070,000. This lower limit may not work for larger companies but likely fits the needs of anyone who can't afford to use Regulation A+.
Investors' shares in a Regulation CF deal can be sold, but with less options than with Regulation A+. An investor must wait at least one year to sell their shares, unless they sell them to a family member or accredited investor. The issuing company is also allowed to buy them back. Companies issuing shares with Regulation CF won't be registered on an exchange, so it's more difficult for an investor to sell their shares.
Besides the rules and regulations discussed here, there are several more that any investor should be familiar with before raising capital through crowdfunding or investing in a crowdfunding opportunity. SEC regulations are so complex that an attorney should always be involved in the process of raising capital with equity crowdfunding.
Since the JOBS Act, several crowdfunding platforms have become available for real estate investors and startups to use. Some of these platforms are specific to real estate investments, while others have a variety of companies available for people to invest in.
The specific platform a real estate investor or startup uses mostly depends on the type of offering they want to use and the potential investors they want to target. Most popular crowdfunding sites are limited to raising investments from accredited investors through Rule 506(c). A limited number of platforms allow for Regulation A+ or Regulation CF projects.
Top real estate crowdfunding platforms for accredited investors only
Top real estate crowdfunding platforms for non-accredited investors
There are several other crowdfunding platforms that offer investments in companies other than real estate. Many of them specialize in certain industries or causes.
Equity crowdfunding has opened up opportunities for real estate investors, developers, and other entrepreneurs to raise capital they otherwise may not be able to. This has led to some exciting new real estate developments.
Crowdfunding has also funded some very innovative companies that have helped boost the economy and provide technology and resources that have helped society in many ways.
Equity crowdfunding also allows investors to get involved with real estate investments and companies they believe in. Many people know the benefits of real estate investing but simply want to earn passive income while an experienced real estate professional handles the asset management.
Whether you want to raise capital for your real estate project with equity crowdfunding or are looking for an alternative investment, you should educate yourself on the rules and the risks involved. You can start by checking out our reviews of the top real estate crowdfunding sites of 2020 here.
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