Balancing Act: Crowdfunding Garners Enthusiasm But Requires Thoughtfulness
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Balancing Act: Crowdfunding Garners Enthusiasm But Requires Thoughtfulness

Crowdfunding Garners Enthusiasm So Far, But Investors and Businesses Alike Should Weigh the Pros and Cons

More than three years after the passage of the JOBS Act, the SEC implemented its much-anticipated final rules legalizing Title III crowdfunding. So, what do the rules mean, and how will they apply to real estate investing in the future?

The crowdfunding rules aim to allow business entities to raise capital from accredited and non-accredited investors through social media, but in an attempt to ward off fraud and to protect investors, the rules restrict the amount an issuer may raise and the amount each investor may invest. Specifically, an issuer may not raise more than $1 million through crowdfunding over a rolling 12-month period. This, of course, severely limits the applicability of Title III crowdfunding in the real estate markets.

Since real estate investment tends to be capital-intensive, few projects can be tackled with just $1 million in equity raised every 12 months. Accordingly, projects will likely require a mix of capital sources, including but not primarily crowdfunding. Developers can always leverage debt on top of equity, but given traditional debt-to-equity lending requirements, this too seems inadequate to fund larger real estate projects.

For this reason, many real estate developers may still need to turn to other forms of equity. In addition to crowdfunding, issuers may raise capital through more established private placement exemptions such as Rule 506(b) and Rule 506(c), which do not impose a limit on the amount raised.

In addition to the constraints placed on the issuer by the SEC’s new crowdfunding rules, each investor is restricted regarding the amount he or she may invest via a crowdfunding capital raise. Individuals, for example, with either an annual income or a net worth that is less than $100,000 cannot invest more than the greater of (a) $2,000 or (b) 5 percent of the lesser of the investor’s net worth or annual income. All other individuals are limited to investing up to 10 percent of the lesser of the investor’s annual income or net worth, but not to exceed $100,000 for each investor.

Once again, given the capital-intensive nature of real estate investing, syndication sponsors and others operating within the real estate development industry may wish to weigh the relative benefit and relative cost of this source of capital.

To that end, the SEC’s new rules compel issuers raising capital through Title III to conduct the offering through crowdfunding intermediaries, which are Internet portals meeting specific criteria. The issuer must also file a Form C with the SEC prior to the offering. This filing must disclose a plethora of information, including the names of officers, directors and 20 percent equity holders; the business plan; and risk factors.

Prospective investors should, as always, review these disclosures carefully before investing and may want to seek the counsel of an investment adviser and attorney before proceeding. This is especially true of any investment involving real property, given the potential leverage being used. Investors should have a clear understanding of whether their equity investment is being leveraged with debt, as this greatly impacts the potential downside to the target investment. As we are painfully reminded during real estate downturns, property values can decline substantially. While they rarely plummet to zero, an investor’s share or membership interest in a company owning that real estate can certainly drop to a zero value, especially when the project company is heavily leveraged. Debt will always have priority over equity in a dissolution or bankruptcy context.

Thus far, crowdfunding has been greeted with much enthusiasm both by investors and by businesses seeking to raise capital. Prior to this legislative shift, it was illegal to advertise unregistered securities in the United States. Under Title III crowdfunding, issuers are now free to advertise and solicit private offerings to investors through social media platforms. This less-regulated environment seems appropriate for the times, but prospective investors should, as always, be vigilant because those seeking to defraud investors may also harness crowdfunding as part of their scheme. Proper due diligence, professional counsel and common sense, it seems, remain just as relevant today as they were prior to crowdfunding.


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