Edited transcript from the Raise Private Money Legally podcast episode, “How to Legally Compensate Capital Raisers and Finders and What Happens When You Don’t”
Presented by host Kim Lisa Taylor, Esq.
Originally broadcast: Friday, April 14, 2023
Kim Lisa Taylor:
Hey everybody. Thanks for showing up. I appreciate the time that you’re taking out of your busy schedules to join Syndication Attorneys’ free monthly podcast. We talk here about topics of interest to real estate syndicators with the opportunity for live questions and answers at the end of the call.
I am attorney Kim Lisa Taylor. Before we get started, please note that all of our podcasts will be recorded and may be used for future promotion, posted on our website, or broadcast in a podcast available to the public. If you don’t wish to have your voice recorded, you can just type your question into the Q&A box or you can schedule a one-on-one consultation. If you do want to have your voice recorded, you can raise your hand and I will get to your questions at the end of the call. Information discussed during this free podcast is of a general, educational nature and should not be construed as legal advice.
We have had a change of topics today because our guest speaker’s wife went into labor last night with their third child, so he’s got more important things to do. So we’re going to have a change of topic. The topic today is going to be “Unlicensed Brokerage (or What is a Securities Broker) and Finder’s Fees,” so that you can understand what this means for capital raisers, and how you can use these rules to your advantage. Make sure that you’re using them correctly, but that you’re also not putting yourselves and your family and your reputation at risk by doing it incorrectly and then getting charged with selling securities without a license as a broker.
So that’s what we’re going to do. This is actually coming out of the chapter of my new book, which is very, very close to being made live. We’ll have it out within a few weeks. We’re working, I’m doing my final touches on it right now, and then it’s going to graphic design and then it’s going to be out.
The name of the book is going to be “How to Raise Capital for Real Estate Legally,” and it’s got a lot of new content from the past book. For those of you who have read the past book, if you want to wait for the new book, that’s great. If you want to read the previous book, it’s still out there on Amazon. It’s an Amazon No. 1 best-seller.
So just to start our discussion, let’s start with “What is a broker?” This is defined initially in the Securities Exchange Act of 1934 Section 3(a)4. A broker is broadly defined as any person engaged in the business of effecting transactions in securities for the account of others. So when you’re calling yourself a capital raiser and you’re making it your business to go around and raise capital for all these other people’s deals, you are putting yourself at risk, and you really shouldn’t be doing that unless you want to become a securities broker dealer.
Because the problem that you’re going to have is … if you get involved with one company and you raise money for the just that one company, you’re part of that company that’s probably a less risky position. But when you’re going out and touting yourself as a capital raiser and you are planning to raise capital for multiple issuers, then you’re likely going to fall within this definition as a person engaged in the business of effecting securities transactions for the account of others. So you’ve got to be extremely careful about that.
So, what is the issuer exemption? Let’s talk about that for a minute. Any of you who have ever heard me speak, one of the things we cover is that if you’re selling securities — which if you’re selling promissory notes or investment contracts then those things are defined as securities — then you either have to qualify for an exemption from registration or you have to register the offering before you can even offer or sell these interests to other people.
So, what are promissory notes? I think you all know what those are.
What are investment contracts? An investment contract is where you have an investment of money in a common enterprise with an expectation of profits based solely on the efforts of the promoter. So when you have those four elements — investment of money in a common enterprise with an expectation of profits based solely on the efforts of the promoter — then you are actually selling securities in the form of investment contracts. So the plain-English definition: When you’re selling interest to passive investors in your company, you’re selling investment contracts. So if you’re selling investment contracts, you either have to qualify for an exemption from registration or you have to register the offering.
What does registration mean? That means that you have to get pre-approval from securities regulators before you can even offer those interests to anybody.
And practically no one does that for real estate because it takes too long and it’s very expensive. So everyone wants to qualify for these exemptions.
So what exemptions are there? There’s Regulation D Rule 506, which has two parts. One is regulation D Rule 506(b), the other is Regulation D Rule 506(c). By far, this is the most common way that people are raising money in the country today. The SEC’s statistics have shown that since 2012 the amount of money raised in these types of private offerings has very much surpassed the amount of money even raised in the public markets and the New York Stock Exchange, NASDAQ, and all the publicly traded markets. So this has become a very important part of capital formation in the country for small business owners and real estate entrepreneurs to fund their businesses and their property purchases.
There are some other exemptions, other ways that people can raise money, but they’re not as common so we’re really going to focus on Regulation D Rule 506(b) and Regulation D Rule 506(c).
Regulation D Rule 506(b) allows you to raise as an issuer of securities. So that’s what the SEC calls you is the issuer of securities. This company that you’ve created that’s going to sell interests to investors is the issuer of these securities.
Regulation D Rule 506(b) allows the issuer of the securities to raise an unlimited amount of money from an unlimited number of Accredited investors and up to 35 non-Accredited, but sophisticated investors, but you can’t find them through any means of general advertising or solicitation. So the way to prove that you didn’t advertise is to be able to demonstrate through a record-keeping system that you had a pre-existing, substantive relationship with every single investor before you made offers for them to invest with you. So that means you have to have a record-keeping system that shows that you had a relationship that predated the offer, and that it was a substantive relationship.
So what’s a substantive relationship? A substantive relationship, according to the SEC, is one where you have information about that investor and they have information about you sufficient that you know before you make the offer whether they’re Accredited. If they’re not Accredited, how are they sophisticated? And the SEC goes one step further and says you have to have an actual suitability conversation with every single investor and someone has to do it live. They don’t believe this is information that you can collect with an electronic form. That doesn’t in their minds create the substantive relationship, so you actually have to have a conversation with somebody where you’re talking to them about their investment goals and how long are they interested in having their funds invested. Would they be interested in being in a five- to seven-year deal with you where they don’t have liquidity and they can’t withdraw their money? They would have to hold it until the property is sold.
Making sure that this isn’t their last dollars that you’re taking or that they’re depending on income from you in order to support their lifestyle, their mortgage payments or their car payments or anything like that. So we want to make sure that they could afford to lose the money, and they’re not dependent on the income from that money.
So if you want to know more about that, on our website at syndicationattorneys.com if you go into our Library and select “Articles,” one of the very first articles that comes up is called “How to Create a Substantive Relationship” where I actually go through the analysis that the SEC went through when they made this determination of what’s required. In the past. before this particular no-action letter was issued on which we’re talking about now, there was always this myth of you had to have three touches in 30 days or 45 days or something like that before you had a substantive relationship. That’s not true. The SEC actually clarified that position in this no-action letter that they wrote for this company called Citizen VC.
And they said, it’s not the quantity of time you’ve known somebody, it’s not the duration of time, it’s about what you know about that person and whether you’ve determined if they’re suitable to invest with you and if their goals — their investment goals — are compatible with what you have to offer.
There’s some example questions attached to that article. So again, go to syndicationattorneys.com and click in the Library, select “Articles,” it’s one of the first ones that comes up. While you are there, you might dig around. There’s about 60 different articles in there. They’re all one or two pages, plain English, easy to understand, easy to read and would help you kind of get a better understanding of things that we’re talking about. And there is also an article in there called “506(b) versus 506(c) — That is the Question.” So if you want to recap these rules that I’m covering in this particular podcast, then you can look at that article as well.
So we talked about 506(b). And we mentioned something called an Accredited investor. What is that?
An Accredited investor is somebody who has over $1 million of net worth excluding equity in their primary residence, or they have $200,000 a year income if they’re single, $300,000 if they’re married or a cohabitating couple. And so you’ve got to ask them questions. If you’re doing 506(b) offerings, you don’t actually have to verify that they’re Accredited, they can self-certify. They can tell you that “Yes, I meet this definition,” and then you can rely on that unless you have actual knowledge that they’re being untruthful.
And so with 506(b), you don’t have to go any further. If they say they’re not Accredited, does that mean they can’t invest in your offering? No, because if you’re doing a 506(b) offering that also allows you to include non-Accredited investors, then you would be able to include up to 35 non-Accredited, sophisticated investors.
What is sophisticated? It’s someone who by themselves or with the help of an investment representative is capable of understanding the risks and merits of your offering based on their previous background and experience and education. You can ask them things like: What is their education level? What have they invested in before? Have they ever invested in real estate? Have they ever invested in real estate syndications or funds before?
So, you can ask them all these questions to determine if they’re sophisticated. It is very subjective, but it’s definitely more than somebody with just some savings and a job that’s never invested in anything.
How do people become sophisticated? If you know people in your world who aren’t sophisticated, then send them to some of these training programs offered by the multitude of real estate trainers that are out there so that they can begin to understand how these types of group investments work, or create your own training programs so you can educate them on the process so they understand how these things work and they can become sophisticated enough to invest in your deals. That’s really kind of where this whole thing has fallen out.
So let’s get back to our discussion. We talked about Reg D Rule 506(b). We now know what an Accredited investor is. We now know what a sophisticated investor is.
What about Reg D Rule 506(c)? Rule 506(c) allows you to freely advertise, but restricts you to only allowing verified Accredited investors to invest in your deal. So you’re going to advertise to the whole world and to everybody, but the only people that can invest with you have to go through a verification process to prove that they’re Accredited, and that has to be conducted within the 90 days prior to making their investment with you. Once they become verified with you, their verification is good for five years in subsequent offerings that you do so that you don’t have to have them get verified every single time because it’s kind of a pain, right? It’s like qualifying for a mortgage or a loan and you have to submit financial statements and employment records and things like that, income statements to be able to be qualified.
And then the verification, it can come from you, you can do your own. You would just have to make a record of what records you looked at in making your determination. You as the issuer of the securities have to have a reasonable assurance that that person is Accredited, that was verified within 90 days of them making the investment. So the burden is on you to have that reasonable assurance. You can do it yourself if you have knowledge. If you’re a CPA or if you’re a mortgage broker or something like that and you know how to do that, that’s fine. Just be aware if you’re an ordinary person and you’re going to do that, you now have to safeguard all of that person’s identity information and the sensitive financial records they’re going to be giving you. So you want to be really cautious about how you store those records if you’re storing them online.
Okay, so 506(b) — no advertising, unlimited Accredited, up to 35 non-accredited, have to have a pre-existing relationship.
506(c) — freely advertise, people have to go through a verification process to prove that they’re Accredited. If they invest with you in subsequent deals, then they just have to re-certify, re-attest that they still meet those same financial qualifications and you can rely on that.
So back to today’s topic then. Now we know who the issuer of securities is, it’s the company that’s selling these interests to investors. So when you’re doing a syndicate, you are going to create a company that’s going to take title to a property, and then that company is usually the one that’s also going to be selling interests to investors. There are times when there will be actually a third entity — usually on bigger deals where the loan balance is over $10 million. On development deals, we’ll use a separate title-holding entity one step removed from investors. If you’re doing a fund or a multi-property offering, then you would use separate title-holding entities for each property.
They’re just single-member LLCs that hold title to the property, they’re the borrower on the bank loan, they’re owned by the investment-level LLC, that’s your syndicate or your fund. So this investment level LLC is manager-managed. There’s a separate management entity that’s comprised of you and the other members of your management team. So that’s kind of a separate thing, but the investor entity is the issuer of the securities. So just keep that in mind who is the issuer, because in order for someone to be able to qualify for one of these exemptions, there are issuer exemptions. They apply to the company that’s selling the securities. And they don’t apply to the management entity, they don’t apply to the title-holding entity, and they don’t apply to you if you’re a third party and you’re not involved in any of those other entities. They only apply to the issuer of the security, so everybody who wants to fall under this exemption has to be part of that issuer.
All right, so what does the issuer exemption mean? It means that you can sell securities to anybody you want as long as they meet these criteria for the exemption. You can sell securities to them without having a securities broker dealer’s license because you’re selling your own securities, and your team members don’t have to have a broker dealer’s license. But if you’re going to use a third party, some consultant or liaison — or I’ve heard people call them all kinds of things, capital raisers — they have to come in and become part of the issuer of these securities. You actually have to give them some membership interests inside the issuer of the securities for them to be entitled to this exemption.
If they’re going to go out and raise money by themselves and they’re going to create their own LLC that’s going to house their investors, then they’re doing their own securities offering and they have to follow all these securities rules and qualify for one of these exemptions on their own, and their company could invest in your company. That’s called the “fund of funds” model. We’re not going to talk about that here, but I will tell you that there’s a whole chapter about that in my new book so if you want to know more about the fund of funds model and some of the complications that arise when you’re doing that, please make sure you get a copy of the new book when it comes out.
So the issuer is the company that’s selling the interests in order to qualify for these issuer exemptions. Reg D Rule 506(b) or Rule 506(c), the people who are raising the money have to be part of the issuer. I’m going to read you a little excerpt from some Texas case law because it’s right on point. It’s not actually from case law, it’s from their statutes. Actually it’s something I took from their website. So the Texas State Securities Board’s website contains a really nice explanation of who’s entitled to this exemption, and how they can be compensated, because that’s the real question.
If you remember any person engaged in the business of affecting transactions in securities for the account of others is considered a broker, but there’s kind of two parts to it. One is: Are they doing this on a regular basis, raising money for other people? And two: How are they being compensated? The Texas Securities Board has an opinion about that, and they say, since a business can only act through natural persons such as its owners, officers, or directors, the exemptions from broker or dealer registration will extend to these persons acting on behalf of the issuer, but only if they meet three important criteria. So what they’re saying is the exemption from registration is going to apply to natural persons such as the owners, officers, and directors of the company as long as they meet these following criteria:
The person cannot have been hired for the purpose of offering or selling the securities. So that means you can’t have an outside consultant, you can’t even have an employee whose job is to raise money and just deal with investors. That’s number one.
Any securities activities of the person must be incidental to his or her bona fide primary non-securities related work duties. So I take that to mean everybody in management has a job of raising money and nobody gets separately compensated for raising money.
So then the third thing is the person’s compensation must be based entirely on that person’s non-securities related duties. So everyone has a job of raising money in management. No one gets separately compensated for raising the money, and the other jobs that they do that are not related to securities are what they get compensated for.
And then this Texas Securities agency goes on to say, if these criteria are not met, the person offering the securities must be registered with the state Securities Board as a dealer or agent. Similarly, any person who is not an owner, director, officer, or employee of the issuer who offers or sells the issuers securities is subject to the dealer registration provisions of the act.
So the reason I use Texas is because many states have very similar laws and very similar rules. So just remember, you don’t want to go out and be a capital raiser. You shouldn’t be calling yourself a capital raiser. Just calling yourself a capital raiser is going to draw negative attention to you, and it’s going to be one strike against you already if you are ever hauled in front of a federal or state securities’ agency to try to defend a charge that you were acting as an unlicensed broker. I know this is contrary to popular belief and opinion and what everybody out in the world is doing right now, and I’m sorry I’m taking an unpopular position. I’m just the messenger, I’m just trying to help you guys understand it because I don’t want to see anybody get in trouble.
So what about finder’s fees? You may have heard somewhere along the line, “Well, you can do this thing called finder’s fees” so let’s walk through this analysis.
In 1991, the SEC … so the SEC gets questions sometimes from attorneys on behalf of clients, and in this particular case the client was a celebrity whose name is Paul Anka. Some of you may know who Paul Anka is and some of you may not. You probably might remember some of the songs that he wrote or that he popularized. I’m not sure if he wrote them, but he was the artist that made them very popular. One is called “Put Your Head on My Shoulder.” Another one was called “Puppy Love.” So if you remember it’s interesting because he had been asked to raise money on behalf of a hockey team. He was a Canadian, but he had a database of people that he knew that were wealthy people both in U.S. and Canada. So his attorneys asked the SEC in the United States whether he would be allowed to be compensated if he were to help solicit investors on behalf of this hockey team in a certain way. And in this case, he merely provided a list of potential investors and he did nothing more.
And in exchange, he was offered a fee of 10% of the units sold. So 10% of whatever they invested would be his and he could either get it as cash or he could use it to make an investment in this hockey team himself. So the SEC went through a whole analysis — it’s multiple pages long — but I’m just going to boil it down. In granting this exception, the SEC said, that’s okay. If he just provides a list of potential investors and nothing more, here’s what we think would be okay: Number one, all of his potential investors were Accredited. Number two, Mr. Anka was not previously involved in any other securities offerings. So he wasn’t going around touting himself as a capital raiser or an introducer or whatever he wanted to call himself, he was just doing it for this one thing. He didn’t handle or distribute offering materials. He didn’t handle investor funds, nor did he provide any independent analysis of the performance of the company or the securities, and he didn’t participate in distribution of the securities post sale.
So you can do the same thing as long as you do exactly all those steps that he did, and you can rely on the Paul Anka no-action letter and say, “Hey, I did exactly the same thing he did. I wasn’t involved in previous offerings, didn’t handle investor funds, didn’t distribute offering materials, didn’t talk about the deal, all I did was introduce and then whoever invested, then I would be entitled to a commission from that.” Even though that happened in 1991, that’s still kind of the moniker rule for finder’s exceptions in the U.S. Nothing has superseded that.
You guys may remember that Kim Kardashian was recently in trouble, and so are some other celebrities, for making some broadcast to their databases of their followers in social media talking about a crypto offering. And she got in trouble with something called the anti-touting role. Anti-touting, which means that if you’re a celebrity and you’re going to get compensated for selling or talking about somebody’s securities and trying to solicit investors, then you need to talk about the compensation that you’re getting. It has to be disclosed.
Well, why does the SEC believe that’s important? Well, because if Kim Kardashian, who people follow and thinks she’s really smart and she’s really wealthy and they want to be like her, they think, “Well, if she’s doing this I should be doing this too.” But in reality she’s not doing it, she’s getting paid $250,000 just to post their deal on her social media platforms. And since she didn’t disclose that, then that’s what she got in trouble for. If you’re one of her followers, maybe if you’d seen the fine print that said, “Oh, by the way, I’m getting paid $250,000 to tell you guys about this” you might think twice about it and go, “Oh, she’s not really investing in it. It’s just an advertisement.” So it’s like you’re leafing through a magazine and you can tell when you get to the page that says this is an ad because it says right at the bottom, this is an ad. So all of a sudden it’s not like a credible story within the magazine, you’re looking at an advertisement and you know the difference.
That’s what the SEC says, if you’re going to do something like that and you’re a celebrity, people believe in you, they want to follow you, they want to do what you’re doing, they want to be like you, then you have to disclose to them that you’re actually being paid. You’re a paid spokesperson for this company. You have to tell them how much you’re going to get paid. So she didn’t do it. She ended up settling with the SEC. She paid a $1 million fine plus she paid the SEC a fine equal to the amount of her gain, so that’s called disgorgement. When whatever you earned for doing the illegal act, you got to give it back, and so she ended up paying I believe a $1.26 million fine. So for her, no big deal. It’s chump change, right? But for one of us, that could be pretty devastating.
So here’s another case from 2013. This is a case of some people that actually got in trouble. It was called Rainier Partners, and the SEC issued administrative and cease-and-desist proceedings against Rainier Partners and an independent consultant who was the one who was actually out soliciting funds for Rainier Partners who had a fund and then also for one of its managers. And they were alleging that they were acting as unlicensed securities brokers in connection with a sale of interest in a securities offering. And so the charges against Rainier Partners included allegations that they sent offering materials.
There was this guy, William Stevens, who had sent offering materials, including private placement memoranda, due diligence materials and subscription documents to potential investors. Actually went so far as to suggest that investors should diversify their investment portfolios to accommodate an investment in Rainier. Provided an independent analysis, his own analysis of Rainier’s fund strategy and performance track record. Even offered to disclose and did disclose some of the names, confidential names and capital commitments of other investors.
So when the SEC investigated and gathered all the information, they said, “No, he’s not entitled to the finder’s exception. He was acting as a broker.” And again, we go back to … and they analyzed it according to the Paul Anka no-action letter that the exception does not apply when you’re distributing offering materials and you’re talking to people about the investment. So it comes back to introduction only, you have to disclose how much you’re going to make and that has to be disclosed to everybody that you expose to that offering.
So that’s where we’ve ended up. You just have to be super-careful. So when the SEC or a state securities regulator sends you a letter and says, “We think you’re acting as an unlicensed broker,” they’re going to be applying this test: Were you engaged in the business affecting transactions and securities on behalf of somebody else, or even on behalf of a company that you’re in?
I just want to point out that you don’t have to be a third party to get in trouble for doing this, you can actually be an employee or an officer, director, or manager of your own, the issuer if you’re getting paid this transaction-based compensation that’s based on the amount of money that’s raised, then you are going to fall in that category of a broker.
So it’s a multi-part test. They’re going to be looking at all these things, but the burden is going to be on you to prove that you didn’t do it, that “No, I didn’t send out all these materials. I didn’t talk to people about the deal. All I said was, ‘Hey, I know somebody who’s got a real estate offering if you’re interested in investing in, I’d be happy to introduce you.’“ Conversation ends. Don’t talk about returns, don’t talk about what kind of property, don’t talk about where it is, anything like that. If you’re trying to qualify under this finder’s rule, then you need to stop right there. And if you’re going to be part of the issuer and part of your job is going to be raising money, then you can distribute offering materials, you can do all of that, but your compensation can’t be based on the amount of money that you’ve raised.
So it’s kind of a finder’s fee, finder’s rule. You can get compensated based on the amount of money that’s raised by the people you introduce if all you do is an introduction. And then the other part of that is if you’re within the issuer and part of your job is to go out and raise capital, then you better have some other jobs and your compensation had better be based on the other jobs that you have.
So I hope that helps clarify it. I know it’s a confusing area of the law. It’s multi-part. It’s all over the place. The best thing to do is if you’re going to be a capital raiser or you want to do this for someone else, talk to a securities attorney. Make sure that what you’re doing is on solid ground, that you’re not going to get in trouble. The thing that’s going to happen if you end up getting in trouble is, first of all, your reputation is going to be immediately ruined, and it could take years before it gets sorted out with regulators. So even if you were vindicated two or three years later, what happens in the meantime? Your reputation is ruined. Nobody wants to work with you. No one wants you to raise capital for them. And you’ve probably been forced to go into a different profession. So you need to be super careful about what you do. In addition, you can get charged or you could get prosecuted by the SEC. Even if you survived at the SEC level and said, “Hey, well, I followed the Paul Anka letter, I should be fine.” The states could take a different view of it, and you’d still have to defend claims with individual state regulators. You could be prosecuted by one or more of them.
The state securities regulators have an organization that meets monthly, so if somebody gets in trouble in one state then they’ll mention it on these calls and then other states will start to look and see if they’ve sold securities in their jurisdiction. So you could get actions filed against you from multiple states at one time. You could also get a civil suit initiated by one or more investors seeking rescission of the offering on the grounds of securities violation. Because there are some provisions of these different various securities acts that say that if you violated the 1934 Act … Here’s specifically what the 1934 Act says: “A contract made in violation of the 1934 Act is void as regards the rights of any person who entered into or performed the contract in violation of the 1934 Act.” So this means if you’re a finder and you’re doing it illegally, then the issuer could fail to pay you because they would just say, “Well, the contract is void. You did it illegally, I can’t pay you.” But also the investors who were introduced by that finder could say, “Well, I was solicited illegally by an illegal finder, and therefore I want my money back.” So they can file an action to render their contract void.
And in that case, then you could be ordered to rescind that contract to them, which means that you have to give them back their money without deduction. So many state securities acts specifically authorized rescission. So when I’m talking about these federal acts and these state acts — there’s the SEC at the federal level, and then every state has its own securities division and its own securities acts — and so the states could have their own rules about who needs to be licensed as a broker or not. There’s actually eight states I know — Texas and Florida are a couple of them, I’d have to look up at the other states —that actually say that anybody who’s selling securities in their states has to be registered as a broker within their state. So it’s rarely done. The thing about Regulation D Rule 506(b) and Rule 506(c) is that there is something called the … let me just get to the reference of it … The National Securities Markets Improvement Act of 1996, NSMIA, that came out and said that any Reg D Rule 506 securities offering, that those rules are going to supersede individual state rules, and that the states can’t add on different rules to Rule 506 offerings. But the problem becomes that when we let the states know through filing securities notices — this is called blue sky notices — that you have sold securities to someone in their jurisdiction, first they have jurisdiction over you.
Now they have the right to investigate your offering. And they can look, and what these state securities exemptions say is that you can sell securities in our jurisdiction under Reg D Rule 506 and we won’t impose further restrictions on it as long as you don’t use any unlicensed brokers and you qualify and follow all the rules of Reg D Rule 506. So if they investigate and determine that you didn’t follow all the rules of Reg D Rule 506, or you actually engaged in the practice of using unlicensed brokers, they can yank that Rule 506 exemption from you and say you’re not exempt under Rule 506 because you didn’t follow those rules. “And therefore, we’re going to look and see if you’re qualified for any other state rules. If you don’t, then you are selling unregistered securities in our jurisdiction and you’re using unlicensed brokers, so therefore you’re in trouble and you need to give these investors a rescission. And you’re going to have to cease and desist from doing that.”
So anyway, I just wanted to go through that. Sorry, it was ad hoc that we had to come up with a different topic just on spur the moment, but this is an important one. It comes up again and again and again. I know there’s a lot of people out there that want to raise for other people.
The right answer is you should be teaming with other people and becoming part of their management team or the issuer of the securities, and you should team with them for as long as you need to until you can start to do your own deals on your own. And your model shouldn’t be that you’re going to engage a bunch of capital raisers to raise capital for you, it should be that you’re building your own list of prospective investors so that you don’t need to bring in other people and put your offerings at risk. And your model should be you’re learning to find your own deals, and you’ve got a team that both finds deals and finds investors. You do it all internally. That’s your ultimate goal.
I know that when you’re early on, you’re going to be co-GPing, even though that’s an incorrect legal term. You’re going to be co-managing with other people, other syndicators, but you need to just be very, very cautious about how you do that and make sure that you’re not getting compensated in a way that’s going to be construed as a commission and that you have other jobs in management. I’ve come up with a list of like 20 different jobs that people can do in management of a syndicate, and really you just need to look back at your previous skillset.
If you used to write or you did advertising or marketing, these are all skills that you can employ. If you are a web designer, if you have tech skills, if you have bookkeeping or experience as a CPA or you feel like you’re experienced with taxes, these are all skills that are needed. Finding investors, developing relationships with investors, creating status reports for investors, helping package deals for lenders for the initial acquisition loan, for the refinance loan, for a seller or for a buyer in a disposition, putting together all these different skill sets to make sure that you’re keeping everyone informed, getting them the right information. These are all things that people other than just one or two people in management can participate in.
So I would like to open up the floor for Q&A. If you want to ask a question, please either put it in the Q&A or you can raise your hand.
Juan asks, “Can owners or directors of the LLC manager of the issuer sell securities from the issuer? I ask this for the case when the manager and issuer are two different entities.”
That’s a really good question. Yes, that’s technically how it’s done because what we do is when we structure a real estate offering, we will have a syndicate or a fund, and that fund or syndicate is going to have at least two classes of members. Class A is going to be all cash paying investors, including members of the management team. If they are contributing cash to the deal, or if you’re going to leave in some of your pre-closing expenses that you don’t get reimbursed for, or maybe part of your acquisition fee, you want to convert it into an investment, then you’re going to use that to buy Class A interest. Right alongside every other investor, you’re going to get the exact same return on your money that they get on theirs. So that’s Class A. And Class A can be divided into different subclasses, that’s a more involved discussion than we do here. But if you wanted to give different rights like maybe you just have a fixed return class, then they could be Class A1 and then you have an equity class, it could be Class A2. So different ways that we can use that. Then Class B is the management class. So remember that I said that these investor-level entities, whether it’s a fund or syndicate, are manager-managed. So the manager is not a member, the manager is a non-member manager that has the right to operate the day-to-day business of the company. Either the manager entity can be the Class B member, or even better yet, we want the members of the management entity to be the Class B members.
And we do that one, for the securities compliance reason, that way they become actually part of the issuer. They’re members of the issuer, they’re Class B members. And then also we separate the management from the Class B interest also for tax reasons and also for control reasons for if the management entity was to be removed or resigned, then these Class B members could retain their interests just giving up management fees that the management entity is earning. So we separate how they’re getting compensated that the management entity earns fees, acquisition fees, asset management fees, refinance fees, disposition fees, those kinds of things. And the Class B members get their profit share. So they split profits between Class A and Class B. It’s actually we call it distributable cash. So anyway, that’s a really good question, but yes either the manager is going to be the Class B member, so that puts them within the issuer, or the members of the manager are going to be the Class B members, and therefore they are members of the issuer. They’re participating. So really good question, Juan.
All right, Greg asks, “How do you properly determine whether a 506(b) or 506(c) fits your deal properly?”
That’s a pretty easy question. All of our clients start with 506(b). And the reason for that is there’s certain things in the securities world that you’re going to graduate into, and you’re not going to start out doing them right away because you have to build a track record before anybody’s going to do it with you. And one of them is, you’re not going to start out doing 506(c) offerings and start advertising to everybody because number one, you’ve cut out 90% of your prospective investor database. The SEC, they estimate that only 10% of the investing population is actually Accredited. And you’ve also cut out all your family and friends or maybe a large number of your family and friends who would invest with you before you have a track record. If you go out and start advertising right away, the first thing that these Accredited investors that don’t know you are going to ask is, “How many of these have you done before?” So if you don’t have a track record, you’re not going to survive that question. They’re not going to invest with you. There’s no point in advertising. You can bring people onto your management team that have the kind of experience that you want, and then you can talk about the experience of your team, just don’t do it in a fraudulent way.
Make sure that you’re very clear on, “Well, we have a management team comprised of five different people, and collectively our management team has this experience. They have 350 units” or something like that. Make sure you’re not touting that as your experience. So if you’re new and you haven’t raised money before, you haven’t done four or five deals with your family and friends, that’s where you’re going to start. Once you’ve done four or five deals, then you could probably survive that question. You can start advertising. Usually you’re not going to go to an advertised offering until you run out of non-Accredited investors in your immediate circle, and you’ve gained enough experience now that you have some credibility with Accredited investors. So very good. So that’s a great question. If you have follow up questions on that, please feel free to ask again.
Bill asks … Hey Bill, how you doing? Bill’s a client. “Hey Kim, what’s the primary reason some syndicators are moving to funds instead of in conjunction with syndicating their entity?” Well, I don’t think that’s true. First of all, again, this is something that you graduate into. So funds are the hardest way to raise money. If you’ve never raised money before and you go out and say, “Here’s my business plan. I’m out looking for properties, and if I find it, I’m going to go ahead and put your money into the deal. Go ahead and invest with me now.” Everybody’s going to sit on the sidelines until you’ve got a deal, and then you’re going to only still raise the amount of money you need to do that deal. The only thing you’re really saving is the amount of time it takes to set up the offering documents for each deal. But your investors probably prefer to invest in a specific deal.
We’ve had one client in the past that’s tried to do funds twice, and both times rescinded the offer because the first time they just said, “Our investors don’t like it.” And they did many, many, many deals and they said, “Our investors don’t like it. They want to invest in specific deals.” The second time they launched a fund, they were able to raise $5 million to $10 million within a week because they had a launch plan. They had a large group of investors that invested in these many, many deals before, and then they ultimately didn’t have enough deal flow, couldn’t get the money invested within 90 to 120 days and ended up giving back $7 million. So funds are not as easy as you think.
Our guest that we were going to have on today is a fund administrator, and we will have him on in a few weeks after he gets through the era of what’s going on, but it’s a skill to manage a fund. It’s more difficult because you still have to figure out, there’s a lot of other questions that go along with doing a fund. One, if you’re raising money, you’re usually going to be raising money for multiple years, like one to four years, right? Because you can only raise as much money as you can deploy within 90 to 120 days, because that’s how long investors will sit still until they want a return on their money. And if you don’t have deals within that 90-to-120-day span, then they’re going to want you to start paying a return. How are you going to do that when you don’t have deals that are generating it? Or they’re going to want their money back. So you’re really only going to still raise money when you have deals, so you have to figure out what your deal flow is. If you have a deal flow where you’re only buying two or three deals a year and you want to buy six or seven deals in a fund, then you’re going to have to have your raise span a few years.
So then you’re going to have investors in year one who are going to say, “Wait a minute, what if that guy comes in in year two and he gets the same return when we liquidate the fund that I got, but yet it was my equity, it was my money in the first year that created the appreciation on those properties during that first year before he was involved? How are you going to compensate me for that?” And so there’s something called “truing up provisions” where we’ll actually have you establish net asset value on a periodic basis, and then you’ll adjust your unit prices up and you’ll say, “Okay, so we generated 12% appreciation in year one with the investors that are invested in year one. And now investors that are coming in year two are actually going to pay a higher amount for their Class A units.” And then the difference is actually going to get paid to the earlier investors. So it gets distributed amongst them pro rata. So they feel like they’re elevated up, they got compensated for the appreciation they generated. So that’s one thing. In a fund, you’re going to figure out this investment period. So we’re going to raise money from new investors and buy properties for the first three to four years, and then we’re going to just operate properties for a couple of years, and then we’re going to start a liquidation phase.
So you’re always going to have these three phases of your fund: The investment period, the harvest period some people call it, and the liquidation phase. Or you could just have an investment period and a liquidation phase. When you start selling off the properties in the liquidation phase, that’s when you’re going to start returning capital to investors. If you were to sell something within the investment period, you could actually recycle the principal, but you would have to pay them the profits because they would get texts on it whether or not you gave them the distribution. So you’ve got to be cautious and cognizant of all those things.
There’s different ways to do funds. You can just consolidate all the money at your fund level from the individual properties, or you can determine your distributions on property-by-property. So that’s called a deal-by-deal fund, or you can have a whole fund model; both of them are good. So as I said, the documents are more complicated. They’re more expensive, they take longer. You have to have a business plan. It has to be well thought out and you have to have deal flow to make a fund work, and it’s the hardest way to raise money. So once you’ve got a track record, multiple deals, then yes, you can do a fund, but you’re not going to try to do that until you’ve got deals.
And I can tell you that we’ve written a whole lot of fund docs for people that I’m pretty sure are just sitting in a drawer, never raised any money. We really try to screen the people that come to us and want to do funds and see whether they’re qualified to even pull it off before we will agree to do it for them because we don’t want them to waste their money.
Specified offerings is the easiest way to raise money. 85% of them close according to our statistics.
All right, so Andrew asks, “Hey, thanks Kim, I understand what you stated in this webinar. However, is there anything wrong were I to invite some high net worth individuals to a restaurant and ask if they’d be open to investing if I did create a fund or syndicate? I would not advertise myself as a capital raiser. I just want to present an idea that would require syndication or fund and see if anyone would be interested.”
There is some fairly recent guidance that’s talking about testing the waters. Can you do a testing the waters things where you’re not actually collecting money, you don’t even have an offering in hand, you’re just gauging whether people are interested? Yes, you can do that. You just have to be very careful about taking it to the level where you’re saying, “Okay, and here’s how it’s going to look and here’s the property. We have a contract and here’s how our proforma, here’s what we’re offering for returns.” Because now it’s an offering, right? So there’s a fine line between what’s a, “Hey, are you interested in something like this?” where you’re being very vague about the terms versus “Here’s a specific deal or an example deal that we did before.” The SEC considers you doing these tombstone ads talking about previous deals you did as to be the first step in making an offer. So you could do that to this group of investors if you were doing 506(c) offerings, because you wouldn’t have to have a pre-existing relationship, but if you were going to be doing 506(b) offerings, you would have to pre-vet all those investors before they came, before you could start showing them past deals. So again, there’s lots of nuances here. I mean, I think if you’ve heard one thing in this podcast, it’s there’s nuances all over the place in securities laws, so you’ve really got to work with somebody who understands it to make sure that you’re not just running afoul. So anyway, that’s a good question. So yes, you can do that. You have to be careful just don’t let it rise to making an offer. Or if it is an offer, then make sure that you’re doing 506(c) offerings that you can advertise to people that you don’t know.
If it’s going to be an offer and it’s a 506(b) offering, make sure you’ve pre-vetted all your investors, determine their suitability, have them in your database as Accredited or non-Accredited, but sophisticated, and now you can start making offers to them.
Bill says, “We’re seeing many deals now that require 40% equity so our raises are starting to approach $20 million per deal.” So Bill, as you know, if you can raise that much money on your own that’s great, but a lot of times when you get to those sizes of deals you’re probably going to be partnering with private equity or with another syndicator. So maybe you’re bringing in $10 (million), they’re bringing in $10 (million) or something like that. Or you’re dealing with private equity. So when I say that your company can partner with a private equity partner, usually they’ll want to do it as a joint venture. Those deal structures for those become a little more complicated. So we talked about you have the syndicate, it has a manager, has class A and class B members, and if you’re buying larger properties in the range that Bill’s talking about, then you’re going to have a separate title-holding entity. But there’s going to be one more entity in between your syndicate and the title-holding entity, and that’s going to be a joint venture.
So you are going to bring in part of the money — and Bill’s done this before, so he knows this I’m just explaining it for everybody else — the private equity company will come in with the other part. These private equity companies actually want to be mezzanine debt, but since the last recession and the Dodd-Frank Act they’re not allowed to because the first-position lenders won’t allow subordinate debt. But they’ll allow them to become a member of an LLC or a joint venture and get the same returns that they would get if they were mezzanine debt but they’re doing it as part of an LLC. And the reason that the lenders don’t want subordinate debt is they don’t want the second-position lender to be able to foreclose on a property, and then they end up as the borrower on the loan and the lender doesn’t have any privity of contract with them and doesn’t know who they are. It becomes much more difficult for the first-position lender to secure their position. So in a joint venture like I’m describing, this joint venture entity, usually the private equity company is going to provide the operating agreement for that. It’s generally going to be very complicated.
They’re going to hire high priced lawyers, you’re going to pay their legal fees in addition to your own syndicate fees. And then the profits are going to be split at the joint venture level. So if they brought in 50% of the money, you brought in 50% of the money, then 50% goes to your syndicate, 50% goes to them, and then your cut is only of the 50% that your syndicate bought. So that’s typically how it’s done with these larger deals. New syndicators can usually raise $1 million or $2 million by themselves, right? That’s a comfortable raise. Much more than $2 million, you’re going to have to bring in some more experienced capital raisers to your team, get them as part of your team members, part of your management team, use leverage off their experience and get them to help bring in capital and do the deal together instead of trying to pay them some other way. So anyway, yeah, $20 million is a big number for a single investor to raise, but there are also institutional investors out there that will come in for a part of that raise. But they’re all going to exact a price from you, right? They’re going to want you to have certain reporting obligations, debt service coverage ratios that you’re going to have to maintain at all times, occupancy you’re going to have to maintain at all times. And they’re all going to have takeover provisions that allow them to take over the deal, usually for what they’re owed, stripping your investors of their equity if you falter and you don’t meet all of their criteria. So it just becomes a much bigger burden for you and it’s a risk for your investment.
So let’s see. “Is it legal in a syndication to issue tokens?”
I suggest you listen to my podcast about “Is Your Offering Viable?” as soon as that comes out. It’s probably on YouTube right now, but you need to be careful. Every single time you add something new — we’re going to accept cryptocurrency, we’re going to issue tokens, we’re going to do something novel, we’re going to take a picture of a building and call it an NFT — anytime you start doing anything like that, you’re going to lose investors, you’re going to increase the likelihood that nobody’s going to invest in your deal and you’re also just increasing the risk, and you’re increasing your costs. So ultimately tokens, crypto, all of that has to be converted to cash because no buyer or no seller’s going to take your tokens to buy their property.
Okay, so Yukiko asks, “Regarding liability, is it more risk to be a co-GP than a fund manager of a fund of funds when the deal goes south?”
Well, here’s the problem with the fund of funds. I’m going to suggest you got my new book and read that chapter, but with a fund of funds, you open up a regulatory quagmire where you now have to register as an investment advisor and you also have to qualify for some exceptions from the Investment Company Act of 1940 in addition to the Securities Act of 1933, which is the one where the Reg D Rule 506 exemptions are. So it’s not as easy as it sounds to be a fund of fund manager. It’s not just as simple as opening up a company and doing your own securities exemption. Really the right model is to co-GP with other people, become part of their management team, use it only while you are developing your database of prospective investors so you don’t need them anymore.
So Yuri asks, “You might have explained, what is a specified offer and what makes this the easiest way to raise funds?”
That’s a really good question. A specified offering is where you have one thing under contract, you’re raising money for that one thing. You can do a sources and uses of funds. So you can figure out, “Here’s how much money I need to close on this deal, including my acquisition fees, reimbursement for all my pre-closing expenses, my legal fees, some operating capital and reserves, and my capital improvement budget” — so that’s your uses of funds. And then you can say, “Okay, I’m going to get this much from the bank and this much I need to raise from investors. “That’s your sources of funds. So that’s called sources and uses of funds. Then you’re going to do five-year pro forma, or five- to seven-year, however long you plan to hold the property and figure out year by year how you think that property’s going to perform, what kind of a return on investment it’s going to have, and then you’re going to do a proposed exit strategy. So you’ll be able to do that for a specific property, making a lot of assumptions, telling the investors what assumptions you made, making projections and investors will invest in that model. You’ll provide a property information package that has those analyses in it, as well as just general information about the property and what you plan to do to it, how you’re going to make it better and perform better than what the seller had.
So anyway, that’s all we’ve got time for today. We went a little long. Sorry if this wasn’t what you guys were expecting. I hope you got some good stuff out of it and we look forward to seeing you as clients and also on our future podcasts. So see you all soon.