October 23, 2019

JF1877: The Four Prong Test To Legally Raise Capital | Syndication School with Theo Hicks


As a syndicator, you raise capital, we know that. Raising money from private investors is a heavily regulated industry by the SEC. You may be surprised to know that a lot of investors are not following the guidelines properly and are at risk of being fined or sued by the SEC. If you enjoyed today’s episode remember to subscribe in iTunes and leave us a review!

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Joe Fairless: There needed to be a resource on apartment syndication that not only talked about each aspect of the syndication process, but how to actually do each of the things, and go into it in detail… And we thought “Hey, why not make it free, too?” That’s why we launched Syndication School.

Theo Hicks will go through a particular aspect of apartment syndication on today’s episode, and get into the details of how to do that particular thing. Enjoy this episode, and for more on apartment syndication and how to do things, go to apartmentsyndication.com, or to learn more about the Apartment Syndication School, go to syndicationschool.com, so you can listen to all the previous episodes.


Theo Hicks: Hi, Best Ever listeners, and welcome to another episode of the Syndication School series, a free resource focused on the how-to’s of apartment syndication. As always, I am your host, Theo Hicks.

Each week, every Wednesday and Thursday, we release two Syndication School episodes on the Best Real Estate Investing Advice Ever Show on iTunes, and for the majority of these series – they focus on a specific aspect of the apartment syndication investment strategy – we offer a free resource. These are PowerPoint presentations, these are Excel template calculators, these are how to guides. You can download these free documents, as well as listen to past Syndication School series at SyndicationSchool.com.

In this episode we are going to focus on how to raise money legally. So we’re going to talk about what happens if you don’t raise money legally, and then for some context we’re gonna talk about how to actually make sure you are raising money legally.

When you are raising capital, you are going to be regulated by the SEC, and you must adhere to their guidelines. If you fail to adhere to their guidelines, you are susceptible to fines, lawsuits, and potentially even jail time. Sure enough, the SECs main source of revenue comes from pursuing syndicators who break the rules. They have a financial incentive to find syndicators who are not adhering to their guidelines.

A few years ago we had a conversation with a securities attorney on the podcast who broke down exactly what happens when you don’t raise money legally, and then a test that you can perform in order to determine if you are adhering to the SEC guidelines.

In addition to the SEC fines and potential jail time, the lawsuits are things that will come from your investors. So if you’re not doing right by your investors and you break the SEC guidelines and you get sued, well your investors are going to be exhibit A in court. So if you make a mistake and you do not follow SEC guidelines, and your investor wants their money back, there’s some sort of falling out and you don’t wanna give them their money back, well – they’re gonna use you breaking the guidelines in court when they sue you as evidence in order to get their money back.

So in order to avoid the wrath of both your investors and the SEC, the thing you need to do is avoid making the biggest legal mistake that this securities attorney comes across, which is not understanding the difference between a security and a joint venture (JV).

This securities attorney said “I often hear people say to me ‘Well, if I just use a joint venture agreement or call it a joint venture, then that’s not securities and I’m in the clear.” And she said how she’s been to seminars where people say there’s really no difference between JV and selling a security, and you can kind of just do whatever you want. Obviously, that’s not true, and that’s not the type of advice that you want to hear.

So when you’re raising money for a deal and you think that securities law does not apply to you, because you think it’s a JV, that is what’s gonna land you in legal trouble the most. That’s the most common way people break the law, in a sense, and don’t follow SEC guidelines. And if you’re thinking about just making a JV, even though you know that it’s not, it’s not worth it. It is worth paying the extra money to register as a security, work with  a securities attorney, create a PPM, and things like that.

So that’s the context, but here’s how to make sure you’re raising money legally, and there’s actually a four-pronged test. It’s commonly referred to as the Howey Test, so you can look that up. There’s four prongs, and if these prongs apply to your situation, if these prongs apply to your business plan, what you plan on doing with the capital that you raise, with your deal, then you must adhere to the SEC securities laws, which means you should find a securities attorney for your deal.

So here is the four-pronged Howey Test that you should use to help you differentiate between a security and a joint venture. The first prong is investment of money. This will be a given, since you are raising money from investors, you’re taking that money and using it to buy the deal. So if you’re raising money from investors, you’re getting an investment of money from someone else. That’s prong number one, which  you’re checking off the list right off the bat.

Number two is expectation of profit. So are the people who are investing this money expecting a profit in return? And for apartment syndications, that profit is gonna be the preferred return, some sort of profit split… So again, another check. Your investors expect to make money, which is why they’re investing with you in the first place, so this will also apply to your syndication if you’re raising money for apartment deals.

Number two, “Is there more than one investor?” This is called a common enterprise. So this doesn’t mean “Do you have one investor?” If you have only one investor, period, you and that investor form the common enterprise. So do you have more than one investor in the deal? Are you raising capital from more than just one person?

And then the fourth prong is through the efforts of a promoter. So this is the prong that mainly differentiates a security from a joint venture. So if you are doing all the work, and your investors aren’t doing any of the work, then it qualifies as a security. So is the expectation of profits coming through the efforts of a promoter, or is the person investing in the deal also having another active role in the deal? That’s the thing that differentiates between a security and a joint venture.

So if you are taking an investment of money from someone who has an expectation of profit, you’re raising money from multiple people, and these multiple people do not have an active involvement in the deal, it qualifies as a security. And if it qualifies as a security, then it is an investment contract and you are required to follow SEC guidelines. And according to the SEC, the definition of an investment contract is “An investment of money…” – again, this is basically the Howey Test written out in sentence form… An investment of money (prong number one) in a common enterprise (prong number three), with an expectation of profit (prong number two), based solely on the efforts of a promoter (number four).

For more information on the differences between the security and a joint venture, I included a link in the show notes that you can click on. It’s entitled “Joint ventures or security? What’s the difference?” And then of course, we always have to say this as a disclaimer, I’m not attorney, Joe is not an attorney, no one that’s part of our team is an attorney, so whenever you are in this area of “Is it a security? Is it a joint venture?”, any decision that could potentially result in legal action against you, make sure that you’re consulting with a securities attorney.

We actually did a Syndication School series on how to find your team, and one of the best ways to find a securities attorney is gonna be through a referral from someone else, who’s using that securities attorney, or when [unintelligible [00:09:49].28] your property management company, your real estate broker, things like that – you can ask them for a referral… Because you’re most likely going to be using, and it’s ideal to use a property management company who has experience with syndicators, or at least with apartment investors. You’re not gonna wanna use a single-family property management company at a 100-unit apartment deal… So they’re more than likely going to know at least a handful of securities attorneys. Just make sure you interview them, make sure that they are experienced with apartment syndications and not some other type of security when you are hiring them, and obviously, make sure you’ve got a good connection with them when you speak with them on the phone as well.

Just to summarize, when you are raising money for deals, you wanna make sure that you are avoiding fines from the SEC, you are not setting yourself up to lose potential lawsuits against your investors, and of course, you’re not going to end up having to go to jail for making a mistake, whether it was your fault or not. In order to do that, you need to understand whether you are regulated by the SEC or not.

In order to determine if you’re regulated by the SEC, you want to walk through the four-pronged Howey Test, which is “Is there an investment of money? Is there an expectation of profit? Is there more than one investor? Is everything done through the efforts of a promoter?” If the answer is yes to all four of these questions, you are regulated by the SEC and must adhere to their guidelines and their rules. And of course, if you are regulated by the SEC, make sure that you’re working  with a securities attorney to cover all of your bases.

That concludes this episode. To listen to the other Syndication School series about the how-to’s of apartment syndications and to download all of those free resources that we have, visit SyndicationSchool.com.

Thank you for listening, and tomorrow on Syndication School we are going to talk about how to communicate with your investors when something goes majorly wrong at your properly. So how do you communicate that to your investors properly – we’re gonna talk about that tomorrow.

Until then, Best Ever listeners, thanks for tuning in. Have a best ever day, and we will talk to your tomorrow.

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