What The Difference is Between Rule 506(b) vs 506(c) in Private Placements
If someone told me there would be securities exemptions that would stimulate small businesses and the economy and further give regular investors better opportunities to earn better returns, I would say sign me up.
Back in 2008, as I watched my 401k become a 201k, I remember having discussions with a friend about where would we put our money now? All we knew at that time were stocks and residential real estate. Large multifamily real estate proved resilient during that great recession, but who could afford that? It turns out we could afford it - by purchasing shares of that large multifamily through private placements.
Whether you are raising funds or investing in a private offering, one must take reasonable steps and know the rules - specifically rule 506b and 506c. Private offerings are regulated much differently than a public offering such as a stock. Still, the rewards can be much sweeter if everything is done by the book (and the securities attorney will make sure it is).
Common Exemptions and Registration Requirements
Unless there is an available exemption from registration, The Securities Act requires all offers and sales of securities to register with the Securities and Exchange Commission (SEC). Most startups typically find and rely on an exemption to the registration requirement since they cannot register their securities with the SEC. Unless there is an available exemption from registration, The Securities Act requires all offers and sales of securities to register with the Securities and Exchange Commission (SEC). Regulation D under the Securities Act provides several exemptions from the registration requirements. These exemptions allow companies to offer and sell their securities without registering the offering with the SEC.
Rule 506 of Regulation D provides two special exemptions from registration for companies when they offer and sell securities. Companies utilizing the Rule 506 exemptions can raise an unlimited amount of money. These two exemptions are known as rules 506b and 506c.
Rule 506(b) is a safe harbor under Section 4(a)(2) of the Securities Act; a company is within the Section 4(a)(2) exemption by satisfying specific requirements.
The company cannot advertise to the general public. Advertising includes social media as well, so announcing to your friends on Facebook: "I have a great investment opportunity!" is a big no-no. You cannot take out an ad in the local paper, run a spot on tv or Youtube, or utilize any other forms of general advertising.
The company may sell its securities to an unlimited number of accredited investors and no more than 35 non-accredited/sophisticated investors. As of this date of publishing, the SEC's accredited investor definition is either:
A person whose individual net worth, or joint net worth with that person's spouse or partner, exceeds $1,000,000, excluding the person's primary residence.
In a 506b, accredited investors may actually "self accredit," meaning this is the investor's word that they meet the above qualifications in writing when subscribing to an offering such as a real estate syndication (a group of investors partnering together to purchase a significant real estate asset).
A sophisticated investor has sufficient knowledge and experience in financial and business matters to make them capable of evaluating the investment. If they possess this savvy, they can participate in private placements as unaccredited investors, meaning they do not need to meet the financial criteria of items one and two above. While they do not need to meet the above criteria, they must possess the financial wherewithal to invest.
Potential investors having a substantive relationship with the issuer is one of the key differences of a 506b offering. What qualifies as a substantive relationship? It can be friends, family, or have established some form of communication prior to the offering. The latter is often accomplished through a mail list or educational platform.
By contrast, rule 506(c) is available only to Accredited investors, and unlike the 506(b), there is a verification requirement. The verification process can be a written representation from the investor's CPA or investment adviser, and it can also be through a third party representative such as verifyinvestor.com. In the latter case, the investor can upload brokerage statements, a statement of real estate owned, and bank statements.
People and businesses seeking investors can now advertise their investment opportunities to the general public. Under Rule 506(c), the SEC lifted the ban on a general solicitation that was always in place under Regulation D exemptions. In 2012, creating the Jumpstart Our Business Startups Act (JOBS Act) resulted in rule 506(c). It helped provide more opportunities for businesses and real estate investors to raise capital to help stimulate the economy.
There seems to be an unlimited amount of capital in the united states. Still, issuers of private offerings must meet the sec guidelines of the securities exchange act to have access. The takeaway for issuers is that it removes the burden of SEC regulation and can therefore stimulate the economy as designed. The takeaway for investors is that these rules give them better access to more real estate deals and private investments in general.
I was saved by this whole new world of private placements as it continues to grow my real estate portfolio. Have you heard the saying? "Don't wait to buy real estate. Buy real estate and wait." Real estate does have a healthy habit of growing over time while paying you cash flow and providing you tax benefits that pad your bottom line even more.
While some look at real estate as an illiquid investment, I happen to think that is a good thing. It doesn't suffer from the panics of the stock market, and it just builds over time. If we take it a step further with multifamily real estate, now we are taking advantage of the economies of scale, allowing our assets to be managed by professionals while growing our portfolio and significantly diversifying our risk.
So 506(b) requires a prior relationship, and 506(c) requires accredited investor status. The good news is that each path gets investors to their goal of more access to better deals with better returns. Like I said - sign me up.
If you still feel like you are on the outside looking in, or want additional multifamily investment options, let's have a conversation. You can always sign up, free of charge, to The Fortress Federation Investment Club to remain informed of our upcoming opportunities.
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