Crowdfunding is not a revolutionary concept. It combines three centuries-old practices: crowdsourcing, dividing larger tasks among individuals, microfinance, making small loans to borrowers, and investment syndication, pooling investment dollars from an array of individual investors. With the dawn of the Internet age, crowdfunding is exploding globally because millions of people with trillions of dollars can be reached in a matter of milliseconds with deals, and invest in those deals with the click of a mouse.
Merriam Webster officially recognized the term “crowdfunding” in 2014, defining it as “the practice of soliciting financial contributions from a large number of people, especially from the online community.” While many know crowdfunding for its use to fund creative projects (such as movies or musical recordings), new federal securities legislation and continuing technological advances are fueling its rapid growth into other arenas.
Crowdfunding advocates argue that consumer dissatisfaction with the relatively insular and expensive existing financing aggregation models and distribution mechanisms (such as REITs, banks, insurance companies, institutional private equity, and publicly raised debt and equity), combined with the efficiency of crowdfunding, will continue to drive crowdfunding’s rapid expansion. Over the past five years, online syndication of debt, equity, charitable giving and product sales have grown from $1.5 billion in 2011 to an estimated $34.4 billion in 2016. By 2025, Congressional reports predict the global crowdfunding market could reach $300 billion — roughly twice the size of the entire global venture capital industry today.
At present, the crowdfunding universe is divided into four sectors. The divisions among the sectors are grey, however, with sites borrowing characteristics from different sectors to provide unique value propositions for their participants.
FUNDRAISING METHODOLOGIES FOR REAL ESTATE
The JOBS Act altered the capital markets landscape in a profound and lasting way by lifting many of the restrictions concerning securities registration and the solicitation of investors. Online syndication of debt and equity to individuals with $1 million in net worth–so-called accredited investor crowdfunding–continues its exponential growth. An increasing number of real estate sponsors are now turning to the Internet to raise money for deals, complimenting traditional institutional capital aggregators and distribution providers like REITs, banks, insurance companies and private equity. This is a predictable trend. Over the past twenty years, banking (bankoftheinternet, allybank), charitable giving (Kiva, Crowdrise, Global Giving), securities trading (Fidelity, TD Ameritrade, Schwab), travel (Kayak, Orbitz, Travelocity, TripAdvisor), wealth management (Betterment, Wealthfront, HedgeCovest), and property, casualty and life insurance companies (GEICO, esurance owned by Allstate, Progressive) have lowered the cost to the consumer by eliminating intermediaries and creating a direct route to investment, giving and purchase. The same is now true for private investing, including real estate and other capital raising activities.
Generally, a real estate developer or operator (called a “sponsor”) looking to raise money online has two options: build a proprietary website, or list deals on a so-called “marketplace” website.
Electing to develop a capital raising website or “platform” offers a number of advantages, not the least of which is the development of a syndicate of direct investors to whom investments may be sold with a minimum of economic friction. Sponsors can establish greater personal brand strength, tailor features offered to investors, and eliminate the payment of points and fees for money. Of course, there are costs to set up the platform and risks inherent in capital raising and securities sales.
Sponsors who elect to establish a funding portal rather than posting their deals on a marketplace website do so because they anticipate syndicating a number of deals and are willing to amortize the upfront investment over many transactions. Sponsors electing to create their own platform contract with a variety of key service providers:
Legal Counsel. Engaging experienced legal counsel at the beginning of the process helps a sponsor streamline the development of a platform. Experienced counsel can help sponsors adequately protect themselves in each of the contracts entered into with the other service providers. Many sponsors interested in crowdfunding are aware of the various securities laws concerns about which so much has been written; yet, they neglect the myriad other legal concerns surrounding the launch of a platform. For example, most participants in the crowdfunding space are startups, including the various service providers sponsors will be relying on to operate and market a platform. Thus, sponsors need to concern themselves with how to protect against the risk of a provider going bankrupt or being acquired by a larger company. In a world where data is paramount for business decision-making, a critical question is who owns the intellectual property associated with a platform. Also, sponsors must be ever vigilant to protect against unauthorized access to data or a competitor “scraping” listings. Experienced counsel navigates these and many other issues. The laws pertaining to advertising, partnerships, corporations, securities, privacy, licensing, banking, lending, consumer protection, government investigation, tax and real estate all come into play.
White Label Developers. A software company that creates product for a sponsor is called a white label developer. The white label developer builds and maintains the operation of the platform. A number of providers exist, offering products ranging from low-cost prebuilt sites, to expensive custom designs. The sponsor must decide among the product offerings, how much time and money they are willing to invest in developing the site, and how much support the site will require in the future. The time required to launch a platform varies widely. Even if a sponsor elects to use an existing template, a large amount of information will need to be developed and supplied by the sponsor -- from team member bios to disclaimer language to payment systems. As a result, the timeline for getting a site to market is dictated not only by the complexity of the site design, but also by the sponsor’s ability to produce timely the required information.
Broker/Dealer/Registered Investment Advisor Requirements. Depending on how a sponsor structures its platform, the sponsor must partner with, become licensed as, or acquire a registered securities broker/dealer or “BD”. This decision is made in consultation with legal counsel. Regardless of ultimate structure, if a BD is required for the sale of offerings, it is important to identify the BD upfront to ensure that the broker dealer coordinates with the white label developer and ensure raising money online may occur as quickly as possible. If the sponsor elects to have its own BD, then securities examinations must be satisfied and supervising BD arrangements made.
Marketing to create an investor base and create deal flow. A sponsor’s life’s blood is its investor base and its product offerings. It’s pretty simple: No money means no deals are funded; and, conversely, no deals offered means no investor interest. Whether a sponsor chooses to conduct marketing campaigns in-house or hires a third-party service provider, the sponsor bears full responsibility for all marketing efforts. Sponsors must often contract with Google, Yahoo, Trulia, Facebook, Twitter, as well as other crowdfunding sites, news services and publications. Verification services are also a source of accredited investors. A successful platform requires a tremendous amount of effort be invested in both online and offline marketing. Many sponsors personally call each investor who signs up on their site in addition to managing extensive email and social media campaigns.
Listing on a Marketplace
The alternative to launching an online syndication platform is to post a deal on a marketplace. Examples include sites such as RealCrowd, Realty Mogul, Crowdstreet, and Fundrise. Many sponsors prefer to pay a fee to the operator of a marketplace to host their deal. Lawyers help sponsors understand the risks associated with and the selection of the best site. Factors include:
Stability of the Site. Leading sites such as Fundrise, Realty Mogul, Crowdstreet and RealCrowd successfully raised significant capital through venture capital financings, enabling them to hire top-tier talent and develop operations quickly. These sites enhanced investment features, strengthened security measures and built larger investor syndicates. The stability of a given platform is an important consideration as not only will the platform handle fundraising, but many remain involved post-closing as the manager of crowd and the payouts to investors.
Existing Investor Base. Leading marketplaces have invested millions of dollars developing a community of interested investors. Gaining exposure to these syndicates is the primary advantage of posting a raise on a marketplace.
Fees & Structure. Each site calculates fees in a different way. The general categories are posting fees, access fees, assets under management fees, verification fees, licensing fees, and per transaction charges. Despite the savings that should result from online syndication, sponsors must find a site that offers reasonable fees and a structure that aligns the site’s interests with the sponsor’s. Similarly, each site structures the deals it hosts in a different way. Some marketplaces create an investment vehicle for each deal, in which the investors on the site become limited partners in the host site’s LLC or partnership. The host site’s LLC then invests in the sponsor’s deal as a limited partner or non-managing member, and the sponsor acts as the general partner or manager of this investment vehicle. This approach provides the sponsor with a single point of contact for all investors throughout the life of the investment. Other marketplaces allow investors to directly invest as limited partners in the sponsor’s investment vehicle. The amount and nature of the fees associated with each structure differ.
Prefunding. A significant distinguishing characteristic among marketplaces is the ability to prefund deals. Sites like Patchofland.com have revolving lines they use to fund deals at closing and then syndicate their position to investors. Raising money with such sites is akin to working with a conventional lender that obtains participations from correspondent banks. This arrangement allocates the risk of successfully completing the online raise to the platform, but it can come at a cost. Points are often as much as four percent plus investors pay a portion of their yield to the marketplace.
RELATED REGULATION AND LEGISLATION
There are a host of regulations, both state and federal, to which crowdfunding sites and syndicators must adhere. Failure to do so may result in enforcement actions. Although the JOBS Act and the consequent SEC regulations stand to benefit crowdfunding sites, many of the relevant securities regulations not only predate the modern crowdfunding marketplace, but the advent of the Internet. In order to understand the current regulations and their impact on the market, it is important to first understand the securities regulatory framework. The following are extremely brief summaries of the major pieces of legislation that crowdfunding participants should drill down on and know well.
Online syndication of debt and equity through JOBS Act compliant activity will continue to boom as the paradigm of paying institutional intermediaries at every step of the capital raising process gives way to crowdfunding’s efficiency, transparency and social metrics. Traditional sources will continue as the dominant aggregators and distribution channels for capital. Yet, crowdfunding will profoundly augment the universe of financing alternatives for borrowers, lenders, investors and sponsors. Indeed, in the words of Darth Vadar of Starwars, “The Force is strong with this one.”
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