Generally speaking, federal securities regulations and Blue Sky laws were established to protect unsophisticated investors from committing cash to investments that carry risks which are not fully disclosed or appreciated. Navigating these laws is critical to avoid liabilities in the future and can be daunting. However, lawyers who specialize in securities laws can streamline the process and help you structure your investment vehicle and capital raise.
When you first embark on your capital raise, you’ll learn about federal and state securities laws. They regulate the types of interests that can be sold to investors, who can buy them and what means the principal can use to market the investment opportunity at hand.
Under the Securities Act of 1933 (the “Act”), any offer or sale of securities must either be registered with the SEC or qualify for an exemption from the Act’s registration requirements. The first step is to determine whether the investments you are soliciting for your project are “securities”. Per the Act, “security” is very broadly defined and includes, “investment contracts,” which are contracts providing for the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.
When considering the structure of your new hotel investment vehicle, you need to determine how much control you want to give your investors. If your desire is to have “passive” investors that allow you to make all investment decisions, you will have to comply with the requirements of the Act. If, on the other hand, your investors will play an active part in the venture – lending expertise, committing time and effort to running the business alongside you, and having control over major decisions such as financing/refinancing, selling, renovating, investing additional capital, etc. – it could be that you are not selling a “security” at all. As you determine how much control you are willing to share with your investors, you should consult a securities lawyer who can help you determine whether your new vehicle needs to satisfy an exemption from registration under the Act.
One very common misconception about the Act is that it only applies to investment vehicles with a large number of investors. In fact, even if you are soliciting investments from a short-list of close friends and family members, you could be selling securities. Your investment may or may not be a security, but complying with these laws is important.
If you ultimately determine that based on your desired structure, investments in your project would qualify as securities, you will need to identify an exemption from registration that will allow you to raise the equity without the overwhelmingly burdensome task of registering your offering as a public company. The two categories of exemption used most by real estate investors are Regulation A (Reg A) and Regulation D (Reg D). There are many different factors that influence which exemption you select for your capital raise, including how much money you are raising, whether your investors are “accredited investors” (explained in more detail below), and where your investors reside. This paper will provide a high-level overview of the elements of Reg A and Reg D exemptions to the Act, but legal counsel is required to navigate these issues because if your investment doesn’t go exactly as planned (and let’s face it, they never do), your investors could raise objections under the Act, adding layers of complexity to an already challenging situation.
In an effort to prevent individuals and entities from investing money they cannot afford to lose, in risky investments they don’t fully understand, the Act distinguishes between accredited and non-accredited investors. The list of accredited investors is extensive, but the qualifications for individuals are simply that (1) the individual have a net worth or joint net worth with a spouse of at least $1 million (not including primary residence), or (2) income in excess of $200,000 in the most recent 2 years ($300,000 taken with spouse) and a reasonable expectation of the same level in the current year.
Even when a capital raise is not required to be registered because it qualifies for an exemption, it remains subject to the anti-fraud and civil liability provisions of federal securities laws. Further, issuers who have previously committed “bad acts” as defined in the act, are generally prohibited from availing themselves of the exemptions to regulations.
Below is a high-level summary of the exemptions from registration that are most commonly used by private issuers. As you will see, each has its advantages and disadvantages and which you select will depend on a variety of factors.
Regulation A (aka Reg A+ and the Mini-IPO)
Reg A+ refers to the most current version of Reg A, which was amended in 2012 by the Jumpstart Our Business Startups Act (“JOBS Act”) in order to further increase accessibility of capital for small businesses. One form of capital raise made possible by the JOBS Act is “crowd funding” (e.g., GoFundMe.com and Kickstarter.com).
Reg A+ is an exemption program provided by the Securities and Exchange Commission (“SEC”) allowing the sale of securities to investors (accredited and non-accredited) while also allowing the same public promotion of the offering and investment opportunity as would be provided for in a fully public registered offering. The program also allows for a fast track to becoming publicly traded or the issuer can opt to remain privately held.
Reg A+ provides a more streamlined and cost-effective method to execute a public offering to raise capital, sell to any investor whether they be accredited or non-accredited, and still maintain status as a private company that is not subject to the reporting requirements of a fully public company. Securities issued under Reg A+ are freely traded from the outset – unlike securities sold under Regulation D which are subject to restrictions on transfer.
Regulation A+ is divided into two programs, referred to as Tier 1 and Tier 2:
Tier 1: Offerings of securities of up to $20 million in a 12-month period, with not more than $6 million in offers by selling security-holders that are affiliates of the issuer; and
Tier 2: Offerings of securities of up to $50 million in a 12- month period, with not more than $15 million in offers by selling security-holders that are affiliates of the issuer.
Tier 1 Regulation A+
Tier 1 allows for securities sales of up to $20 million in any 12-month period.
State Interaction: Notably, Tier 1 of Regulation does not preempt state law, so the offering must be registered in each state where solicitations are made. Thus, the costs involved in obtaining State qualification under the Tier 1 program becomes prohibitive unless the offering is limited to a small number of states.
Offering Circular: Submission of Form 1A via the EDGAR system for review, comments, and qualification
Financials: One benefit of Tier 1 is that it does not require the company to include audited financial statements and does not have any ongoing SEC reporting requirements. Note, most States will require audited financials so the issuer should expect an audit requirement even though not required at the Federal level.
Tier 2 Regulation A+
Tier 2 allows for the sale of up to $50 million in a 12-month period.
State Interaction: Tier 2 preempts state blue sky laws, which means that if your investors are located across many different states, there is no marginal cost of registering in each state like under Tier 1.
Offering Circular: A company may elect to either provide the disclosure using Form 1-A or the disclosure in a Form S-1. Note – for issuers that want to file a Form 8-A and register under the Exchange Act – the Form S-1 format is a precondition to that filing.
Financials: Tier 2 offerings require audited financials. For new special purpose entities (such as a newly formed LLC for a real estate fund) – only the issuers balance sheet would need to be audited.
Reporting – Tier 2 issuers are required to submit certain annual (Form 1-K) and semi-annual (Form 1-SA) reports. If the issuer has fewer than 300 shareholders of record, they may file to withdraw from these reporting requirements after the first annual report.
Both Tier I and Tier 2 Regulation A+ offerings contain certain minimum basic requirements, including issuer eligibility provisions and disclosure requirements. Regulation A+ is available only to companies organized and operating in the United States and Canada. A company will be considered to have its “principal place of business” in the U.S. or Canada for purposes of determination of Regulation A+ eligibility if its officers, partners, or managers primarily direct, control and coordinate the company’s activities from the U.S. or Canada, even if the actual operations are located outside those countries.
Typically, the advantages offered by Regulation A offerings make up for the stringent documentation requirement. Among the advantages provided by the exemption are more-streamlined financial statements without audit obligations, three possible format choices to use to arrange the offering circular, and no requirement to provide Exchange Act reports until the company has more than 500 shareholders and $10 million in assets. As the nickname signifies, the Reg A exemption is a good alternative to a public offering, with Tier 1 being most advantageous where the capital raise is smaller (required to be less than $20 million) the offering is made across only a very small number of states. Tier 2 is appealing if the capital raise is larger and the offering is made across many states.
Reg D is the most common exemption utilized by real estate investors when raising capital. It applies to a wide variety of capital raising scenarios, including ventures with only one or two investors, small capital raises or very large ones.
While a company relying on a Regulation D safe harbor can avoid Securities Act registration, it must file a Form D with the SEC within 15 days after the first sale of securities. Form D must also be filed at the state level, in accordance with blue sky law requirements if the offering is conducted under Rule 506. Form D is a brief notice setting out specified information about the offering, including the amount and value sold, whether broker-dealers were used, and the states where the securities were offered and sold.
Under Reg D, there are two main rules that provide safe harbors from SEC registration: Rule 504 and Rule 506. Rule 504 is for smaller capital raises that target non-accredited investors at least in part. For larger capital raises targeting fewer than 35 non-accredited investors, Rule 506 provides an attractive exemption.
Rule 504 of Regulation D
Rule 504 under Reg D is available for certain offerings with an aggregate offering of up to $5 million. Rule 504 is the updated version of the former Rule 540. This safe harbor was established to help small businesses raise capital. One major advantage of the Rule 504 exemption is that it allows capital to be raised from an unlimited number of both accredited and non-accredited investors (subject to certain limitations). It also preempts state Blue Sky Laws so issuers under Rule 504 only have to file a Form D with the SEC, and do not need to register in the states where the offering occurs. Another advantage of Rule 504 does not impose any ongoing reporting requirements upon the issuer. As Rule 504 targets smaller capital raises and contemplates transactions between familiar parties, it does not allow general solicitations or general advertising (other than to accredited investors), and it also imposes restrictions on the sale of original issue investment interests. Specifically, securities (investment interests) sold under Rule 504 cannot be transferred within the first six months to one year of acquisition.
Rule 506 of Regulation D
For larger capital raises, Rule 506 under Reg D provides an attractive safe harbor from registration. Rule 506 is the most frequently used Regulation D exemption and one of the most important means of raising capital in the United States. It is the updated version of Rule 146. Under Rule 506, there is no cap on the number of investors that can buy the offered securities (although, no more than 35 can be non-accredited investors) and there is no limit on the amount of capital that can be raised. To the extent that capital is raised from non-accredited investors, the issuer must confirm that the buyer is sophisticated or is represented by a sophisticated agent. Rule 506 can be utilized by both US and foreign vehicles and it preempts state level Blue Sky Laws.
As far as reporting, there are no ongoing obligations. The issuer must only file a Form D with the SEC, and comply with certain disclosure requirements (disclosure requirements for the non-accredited investors are more burdensome than those for accredited investors, and are similar to the disclosure requirements under Reg A).
Historically, the use of general solicitation and general advertising in any private placement was prohibited. However, in connection with the JOBS Act, Rule 506 was amended to add a new subsection (c) that permits general solicitation in offerings made under that subsection as long as the securities are sold only to accredited investors and other specified conditions are met. Issuers that wish to conduct a Rule 506 offering without using general solicitation may continue to do so under subsection (b) of Rule 506.