Pros and Cons of Equity Crowdfunding for Real Estate Investments | JD Supra


Crowdfunding is an easy and popular way to raise money. According to MarketWatch, the world crowdfunding market was $12.27 billion in 2020 and is expected to more than double to $25.8 billion by 2027.

Classical music isn’t immune to crowdfunding. Go Fund Me has been used to raise money for a music student to attend a summer music program, travel to an audition, or to buy a new instrument, and a musician might use Kickstarter to raise money to produce an album.

One product of the pandemic is classical concert crowdfunding. Earlier this year in London, Through the Noise started crowdfunding classical music concerts.

Under this concert crowdfunding, called “noisenights,” people may become backers for concerts that interest them by committing to pay a certain amount of money. If the concert has sufficient backers to move forward, each backer will receive tickets based on the amount contributed. If the concert isn’t able to move forward, the backers pay nothing.

Other popular crowdfunding platforms, like Kickstarter and IndieGoGo operate backer-based platforms similar to noisenights. In backer-based crowdfunding, backers who contribute a minimum amount usually receive the product or services they are funding. And if there aren’t enough backers for the project to move forward in a backer-based system, the backers usually will pay nothing.

Go Fund Me or MightyCause are donor-based crowdfunding platforms. The difference between donor-based and backer-based is that payments in a donor-based system are donations, and there is no minimum. Donor-based systems work best for projects or needs that are charitable in nature.

Another type of crowdfunding is equity crowdfunding. Using platforms like WeFunder, Seedinvest, and StartEngine, equity crowdfunding enables investors to buy a small ownership share in startups and small businesses. This article discusses equity crowdfunding mainly focusing on its uses in real estate.

Why Equity Crowdfunding is the Sale of a Security (and Backer-Based and Donor-Based Crowdfunding Aren’t)

Equity crowdfunding is more heavily regulated than backer-based or donor-based crowdfunding. That’s because equity crowdfunding is subject to regulation by the Securities and Exchange Commission (SEC).

The Securities Act of 1933 (Securities Act), adopted in the aftermath of the stock market crash of 1929, defines security broadly. All notes, stock, bonds, evidences of indebtedness, profit-sharing arrangements, investment contract, and many other listed items are defined in the Securities Act to be “securities” and are subject to regulation by the SEC.

Equity crowdfunding involves the sale of stock or other equity. So, it falls squarely into the definition of “security” in the Securities Act.

Even if crowdfunding doesn’t meet neatly into one stated category, it can still be a security if it is an investment contract. An investment contract is (1) investment of money, (2) in a common enterprise or pooling of assets, (3) with the expectation of a profit, where (4) the profit comes from the effort of a promoter or third party.

With both backer-backed and donor-backed crowdfunding, people “invest” cash in a common enterprise. But they don’t expect a profit. In donor-backed crowdfunding, donors expect nothing in return for their contributions. Backers in backer-backed crowdfunding expect to receive a product or service in exchange for their contribution, but they don’t expect a profit.

Readers wanting more background on investment contracts should check out my previous article Orange Groves, Pay Phones, Visas, and Violins: Why Your Real Estate or Business Investment May Be Subject to Securities Regulation.

What is Regulation CF?

Unless there is an exemption, anyone selling a security has to register that security with the SEC. The two most popular exemptions are Rule 506(b) and Rule 506(c), neither of which works well with equity crowdfunding.

Rule 506(b) offerings can’t be sold by general solicitation or general advertising, which may make it challenging for a startup to obtain investors outside of friends and family. Plus, Rule 506(b) offerings can have only 35 unaccredited investors, and enhanced disclosures are required if unaccredited investors purchase the securities.

Rule 506(c) offerings can be advertised (within limits established by the SEC). But only accredited investors can purchase securities in Rule 506(c) offerings, and those investors’ accredited status usually must be determined via a third-party certification process.

Regulation CF (Reg CF), effective in 2016, allows advertising and sales to unaccredited investors (with limits), but the securities must be sold online through an SEC-registered intermediary.

An issuer must have been organized in the United States and had operations for at least six months to use Reg CF. The issuer also cannot be a reporting company under the Securities Exchange Act of 1934, a blank check company, or have previously failed to comply with Reg CF reporting requirements.

Reg CF requires the issuer to file Form C with the SEC and disclose specified information about the issuer, its principals, the offering, the issuer’s business, and investment risks to investors. Depending upon the size of the offering, the issuer must provide financial statements that are either certified (for offerings of $107,000 or less), reviewed (for offerings from $107,000 up to $535,000 or up to the maximum offering amount for first-time issuers), or audited (for offerings over $535,000) by a Certified Public Accountant.

The issuer also has to file updates to Form C within five business days after reaching 50% and 100% of its fundraising goals and must file annual reports with the SEC on Form C-AR for three years (or less under certain circumstances).

The SEC reported that from July 1, 2018 through June 30, 2019, issuers raised only $54 million using Reg CF, with the median raise being only $80,000. Reg CF was the least popular way for companies to raise capital. By contrast, issuers raised $1.4 Trillion using Rule 506(b), $210 Billion using Rule 506(c), and $260 Million raised using Regulation A.

Crowdwise reports that $214.9 Million was raised in 2020 using Reg CF, with an average of $275,000 raised in each campaign. Those are huge increases relative to previous years, but Reg CF offerings still are eclipsed by offerings under Rules 506(b) and 506(c). And in 2020, only 48 companies raised the maximum annual amount–$1,070,000.

Earlier this year, the maximum amount allowed to be raised under Reg CF was increased to $5 million from $1.07 Million. This increase will likely make Reg CF offerings more attractive, especially to real estate companies, which typically need more than $1 million in equity.

What are the Drawbacks of Equity Crowdfunding?

Because there are limits on how much money unaccredited investors can invest, average investor amounts will be smaller in a Reg CF offering than in a Rule 506(b) or Rule 506(c) offering. And smaller investor amounts mean there must be more investors in an offering. A small issuer may find it challenging to manage investor relationships with potentially hundreds of investors. More investors also can add complexity to the issuer accounting or tax returns.

Also, SEC-registered intermediaries charge significant fees for their services. Depending on the intermediary and the offering, those fees can range from 9% to 12% of the equity raised. Those fees may be in the range that an issuer would experience if it utilized a broker-dealer in a Rule 506(b) or Rule 506(c) offering, but they are still not insignificant.

Another drawback is that ” blank check” companies cannot use Reg CF. Due to the fast pace of many real estate transactions, real estate funds may raise money before identifying the specific real estate assets they plan to acquire. These funds may be considered blind pools and, therefore, be prohibited from using Reg CF.

Reg CF may also not be feasible for real estate funds that have targeted property for acquisition. In today’s competitive market, many real estate transactions close within 60 days of going under contract. However, according to one popular Reg CF intermediary’s website, it usually takes much longer than 60 days–from three to six months–for a company to reach its funding goal.

Crowdfunding and Real Estate Funds

Crowdfunding usually isn’t the first option real estate sponsors should…


Read More:Pros and Cons of Equity Crowdfunding for Real Estate Investments | JD Supra