In this video, Dugan Kelly discusses the transition from a Regulation D Rule 506(b) offering to a Rule 506(c) offering, shedding light on the differences, implications, and challenges involved. He explains how this transition can be a strategic move for those aiming to engage in general solicitation while navigating the intricate world of real estate syndication.
HOST: This is the Syndication Closer. We’re here with Dugan Kelley, principal partner for Kelley Clarke, PC. Dugan, in our last episode, we were talking about what is security and defining that through the Howey test and how to do all of this legally, especially the offering of securities and raising money.
HOST: Let’s say, for a moment, that I am a prospective client who has come through your doors, trying to raise money, and I’ve already raised $1.5 million. I want to up my game and raise even more money from more people out there. What do I do?
Raising Money for a Potential Real Estate Investment
DUGAN: Awesome. So, James, I thank you for that question. That’s great. Imagine you’re James. Imagine that you’re working very hard as a W-2 employee in corporate America. You’re trying to figure out how to get out of corporate America. You’ve heard about this awesome thing called syndication, how to generate passive income from owning and operating real estate investments. You’ve identified an apartment building with a purchase price of $3 million, and you think you theoretically have friends and family who would invest with you, perhaps $1,000,005. How do you raise that $1.5 million from your friends and family, and potentially from others you may not know?
Create an Entity
First and foremost, after we engage and negotiate the purchase and sale agreement, after you get your property under contract, and James has inspected it, identified the capital expenditures and rehabilitation budget, and completed the underwriting process, we create an entity. This entity is typically a limited liability company or a limited partnership entity. James will provide a business plan discussing potential returns, terms for potential investors, whether it’s a 70% to investors, 30% to James or an 80% to investors, 20% to James, and whether he will offer a preferred return or not. All of these business terms, along with the plan of distribution, will be included in the private offering. Once we form that entity, we structure that private placement memorandum with all the key ingredients.
Are you Considering General Solicitation? 506(b) versus 506(c)
We have to determine if James is going to engage in what we call general solicitation or not. Remember, historically, you couldn’t engage in general solicitation, meaning advertising or talking to someone you don’t already have a pre-existing substantial relationship with. Why? The SEC aims to protect investors, ensure they are fully informed about the merits and risks of the transaction, promote capital formation, and govern all individuals, exchanges, and entities involved in the sale of securities. So, when James is looking at his Rolodex and considering not engaging in general solicitation, that aligns with the historical rule. However, with the Jobs Act under President Obama, we had a split, allowing general solicitation.
Many offerings are exempt from registration under Regulation D, Rule 506(b) or 506(c) of the Securities and Exchange Act. 506(b) is the historical rule that prohibits advertising, while 506(c) allows it. James, like most people, will likely do a private offering under 506(b). 506(c) permits advertising, but it requires diligent steps to independently verify the accredited status of each investor.
In 506(b), individuals can self-certify via a questionnaire. In a 506(c) offering, you must independently verify investors’ accredited status, which can be administratively, economically, and resource-intensive. But it offers the ability to engage in general solicitation.
For those considering using social media or advertising to attract investors, keep in mind that advertising to your Facebook friends may not qualify as a pre-existing substantial relationship. Converting from 506(b) to 506(c) is possible but comes with increased administrative costs.
HOST: In the next episode, we’ll discuss accredited and sophisticated investors, the difference between them, and touch on fund-to-funds. Stay tuned for more in the Syndication Closer series. Thank you for listening to the Syndication Closer with Dugan Kelly. Follow us on social media and visit our website, syndicationcloser.com, so you don’t miss an episode. If you enjoyed this episode, please leave us a review. We’ll see you next time.”