Reduce Risk While Raising Equity

(November 8, 2016) In the last blog post, we talked about senior debt as the primary source of development funds. Unfortunately for developers, senior debt is rarely sufficient to fund the entire project, and the next most common source of funding after senior debt is equity. Senior lenders will not close on the senior loan until the developer can provide the lender with sufficient proof of equity.

To raise equity, the developer typically sells an ownership interest (stock in corporation, a membership interest in a limited liability company, or a limited or general partnership interest in a limited partnership) in the project entity to one or more investors. While this sounds simple and straightforward, in reality this is an area that is fraught with risk.

One risk that is often overlooked or outright ignored by developers is compliance with securities laws. A developer’s sale of an ownership interest in the project entity can (and nearly always does) constitute the sale of a security. As a general rule, every security sold in the United States must either be registered with the SEC and/or a state securities agency, or exempt from federal and state registration requirements. Given that securities registration is a long, expensive process, developers almost always rely on registration exemptions when raising equity.

Many exemptions exist, both at the federal and state level. At the federal level, two common exemptions used by developers are as follows: (a) Rule 506 of Regulation D, which allows a developer to sell an unlimited amount of securities to “accredited investors” and, if proper steps are taken, to use general advertising and solicitation in the sale of such securities; and (b) statutory and regulatory intrastate offering exemptions, which generally permit the sale of securities without registration where the developer, the investor, and the project for which the funds are invested are all in a single state. While exemptions are nearly always available to a developer, many exemptions have restrictions or conditions that must be met in order to avoid very severe consequences, including criminal and civil actions, fines, and penalties.

Another risk with selling an ownership interest in the project entity relates to how the relationship is structured between the developer and the investors. If structured properly, both the developer and the investors will profit from a successful development. If structured improperly, a successful project’s returns will be unfairly distributed to either the developer or the investors. This results in a strained relationship, at best, or an insolvent developer, at worst.

These and other potential risks can be avoided with advanced planning, including consultation with experienced legal counsel before finalizing a deal with potential investors. In my experience, careful structuring of the equity side also helps facilitate and expedite closing on senior debt.

If you have any questions about raising equity, please contact one of the Real Estate Attorneys at Rhoades McKee.