Any seasoned or newbie real estate investor will agree that large real estate ventures often require significant capital. To obtain this capital, many real estate companies seek passive investments from multiple sources. When selling public securities, it's important to keep in mind that Section 5 of the Securities Act of 1933 mandates that companies issuing securities must register them by filing a registration statement. Failure to comply with Section 5 means any securities offered or sold are considered unregistered, putting the issuer in violation of federal law. If a real estate operator does not want the expenses, extensive disclosures, and time constraints of a public offering, private offerings may be an option.
Public Offering
A public offering differs from a private placement in that the issuer aims to offer and sell securities to the general public, typically through listing on a public exchange. This typically allows anyone to buy and sell the security, regardless of income, financial knowledge, and/or business acumen. While a public offering can be beneficial for raising substantial capital from numerous investors, the issuing company must comply with extensive disclosure and reporting requirements mandated by the SEC. During the initial public offering (“IPO”) process, the company must register its securities via a registration statement under Section 5. Upon SEC approval, which typically takes many months, the company must continue to report financial documents and forms regularly. These reporting obligations are not only time-consuming but also costly to initiate and maintain. Despite this, certain real estate vehicles like REITs and real estate investment trusts, may find public offerings advantageous as the potential capital raised may outweigh the initial costs associated with going public. But before taking your real estate ventures public, it is important to understand some of the time and costs involved with that to ensure the public option is suitable for your objectives.
One of the central purposes of the Securities and Exchange Commission is to promote fair dealing, the disclosure of important market information, and to prevent fraud. As mentioned earlier, the SEC aims to safeguard investors from making uninformed financial decisions by providing them with essential information. One of the main ways the SEC accomplishes this is by mandating companies planning public offerings to disclose specific information about their operations and finances. Once the SEC approves the registration statement, allowing the company to offer securities publicly, the company must provide current reports, quarterly reports, and annual reports. These reports offer crucial insights into the company's performance and financial health.
The various reports provide information or context regarding significant events that impact the company and its financials and offer a detailed overview of the company's business and financial status including details such as material legal proceedings, management discussions on the company's financial condition, updates to risk factors, and audited financial statements. These reports resemble the initial disclosures made during the company's IPO, but they are ongoing and provide continuous updates on the company's performance and outlook.
The costs associated with becoming a public reporting company are significant and are usually in the hundreds of thousands of dollars. When coupled with the fact that IPOs often take more than seven months, many real estate investors opt for private offerings instead, due to many of the private options concluding significantly faster and are dramatically less costly. Most real estate closings happen much quicker than seven months, so if a real estate operator wants to go public, typically the IPO takes place well before any deal is under contract to ensure that the registration is complete, allowing time to acquire a given asset.
Private Placements
If a real estate operator seeks to raise capital quickly and does not want the costs and time constraints involved with public offerings, private placements are an option. While Section 5 requires that securities be registered, the other option is to find an exemption from registration. Some of the most commonly used exemptions for real estate are found under Section 4(a)(2) and Regulation D of the Securities Act. These exemptions allow companies to avoid violating Section 5 when offering or selling unregistered securities. It is important to note that these exemptions only provide safe harbor for the issuing company. Individuals reselling these securities must seek their own exemptions to comply with securities laws, and many times private securities have strict limitations around resale.
Section 4(a)(2) of the Securities Act of 1933 ("Section 4(a)(2)") offers an exemption for issuers to offer and sell securities, provided they meet specific criteria. In response to this provision, the SEC developed Regulation D to establish more precise criteria and offer a safe harbor against claims from investors under Section 5. Within Regulation D, Rules 506(b) and 506(c) are the most commonly utilized safe harbors, allowing issuers to raise an unlimited amount of capital.
As mentioned earlier, Rules 506(b) and 506(c) offer significant advantages, notably the absence of limitations on the size of the offering. Given the potential for rapid cost escalation in real estate ventures, the ability to raise capital without monetary constraints or time limitations on issuing securities is immensely beneficial. However, it's important to note that these safe harbors prohibit the issuance of securities to the general public and require certain information to be disclosed to investors.
Under Rule 506(b), issuers can offer securities to an unlimited number of accredited investors and up to 35 non-accredited investors. Conversely, Rule 506(c) allows for an unlimited number of accredited investors but prohibits any non-accredited investors from participating. These distinctions are important because Section 5 of the Securities Act of 1933 aims to safeguard investors by ensuring they receive comprehensive disclosure to make well-informed decisions. While Regulation D eases reporting requirements for private placements, the SEC still prioritizes investor protection by categorizing investors into accredited and non-accredited groups. Accredited investors who meet specific financial criteria or hold professional certifications are deemed capable of evaluating investment opportunities independently. On the other hand, non-accredited investors do not meet these criteria. Under Rule 506(b), issuers may rely on investors’ self-certification of their accredited status, while Rule 506(c) mandates a verification process to confirm accredited status, typically involving a review of investors’ financial records by a third party.
Both Rule 506(b) and 506(c) have specific disclosure requirements to ensure investors can make informed decisions. The PPM typically includes an overview of the security, a description of the issuer, the issuer's financial status, and material risks associated with the security. Although primarily used in the registration statement for public offerings, the PPM serves as a valuable document for providing adequate disclosures to investors during a private placement.
Public vs. Private
The ultimate answer depends on the issuer and their aims, but there are a few things to consider:
Public offerings require extensive disclosures, ongoing reporting, a multiple-month-long runway, and lots of expenses. In exchange for that, public offerings can take investments from anyone and everyone and the securities can be advertised.
Private offerings can be completed much quicker and are typically less expensive. However, private offerings typically have constraints on who can invest and/or what solicitation and advertising, if any, can be done.
Should you go public? Should you go private? The answer to that is the lawyer’s favorite answer: it depends. It depends on your goals and objectives and which option is more suitable for your unique situation.
About the Author:
Nic McGrue is a tenured professor of law and the founder of Polymath Legal PC. At Polymath Legal PC, Nic helps real estate investors lawfully raise capital allowing them to generate passive income while creating generational wealth.
Disclaimer:
The views and opinions expressed in this blog post are provided for informational purposes only and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.
