Crowdfunding has changed and in ways that have the power to change everything in the commercial real estate development financing and business financing markets. Business, like life, involves measured risk taking, and when it comes to obtaining capital financing, the risks are akin to walking into a minefield blindfolded.
For small business issuers and commercial real estate developers, the odds of failure are 4 out of 5. That’s the system we have been working with and the question regarding the new crowdfunding rules passed in November 2020, all boil down to whether or not the new paradigm represents a higher potential surety of outcome versus what we have done up to now.
New Rules & New Approach
The game has certainly changed. The new rules allow us to do some things we could only dream about in the past. Setting aside the regulatory filing and legal issues – which are by no means small – we will focus on the process changes that bear directly upon the risk of failure or success.
There are five (5) process changes that directly impact the process that need to be considered in the resulting Monte Carlo simulation used to provide a basis for answering the question of how long one of these fundings would be expected to take.
The new process changes include: (1) pre-offering advertising; and (2) live pre-offering investor presentations; and (3) offering advertising during the offering period; and (4) structured financing impact of using stages of funding to build up to the ultimate raise; and (5) the relative size of the market opportunity for obtaining capital versus that of the conventional/historical models.
The new rules allow issuers of securities to broadly communicate (i.e.: broadcast advertise) the fact the issuer is seeking capital financing before the issuer undertakes the registration-exempt offering itself. This is a big departure from the past where any kind of communication of this type of test-the-waters campaign was strictly viewed as illegal.
Accordingly, by coordinating the timing and type of advertising owing to an offering very closely, the impacts of advertising frequency and Large Number Theory can be brought to bear to increase the response on a scale that is obviously efficient and practical (take note of the success rate of advertised public offerings versus the 4 out of 5 failure rate of private placements).
Pre-Offering Investor Presentations
The new rules allow the issuer to work with a Demo Day event sponsor (think about the TV show Shark Tank in this context) to conduct virtual presentation meetings. The Demo Day event sponsor can broadcast advertise the fact they have investment opportunities (more or less) available to qualified investors.
The resulting process creates a two-fold opportunity that did not exist before: (1) these presentations would have the potential to result in a private communication between an investor and the issuer that amounts to the issuer receiving an offer of financing that sidesteps the need for moving forward with an offering; and (2) the investor participants may be subsequently solicited to invest in the future offering, thus a one-two punch opportunity exists where it did not previously exist at all.
The new rules allow issuers to broadcast advertise crowdfunding offerings of up to $5 million. The previous rule allowed only $1 million. This is the most important change to the process, as an offering of $5 million, if successful, would potentially create a pool of funds of sufficient size to pay the pre-issuance costs of creating and advertising a much larger offering that is sold to the public using broadcast advertising (e.g.: television, radio and social media commercial advertisements) with the expectation of success due to the potential size of the market.
This is further amplified in importance by the fact the larger offering is subject to being leveraged with third-party capital – not the capital of the sponsor, per se. These conditions precedent were not previously available and would not represent a detrimental development in any case.
The impact of the new rule allows developers to deploy a multi-pronged approach to increasing the odds of success: (1) risk segregation that results in both shorter mandatory investment holding periods combined with higher yielding investment constructs; and (2) the aforementioned leveraged approach that mimics the use of initial developer contributions being leveraged by a much larger bank debt leverage financing. This was not done in combination with the other elements discussed above in the past and would not be viewed as detrimental to the odds of success in any case.
Market Size of Financing Prospects Pool
The change in the rules means the entirety of the investing public can be solicited – a defacto public offering being allowed. In the U.S. financial markets, the public offering of securities has the highest odds of a successful outcome (more than 9 out of 10).
The market opportunity owing to the investment represents in almost every possible case, a larger market opportunity for the developer than the market opportunity owing to the project itself.
It goes to follow that, if you cannot sell the investment to the public, then you will not be able to attract enough of the market to support the future business itself. This outcome cannot be viewed as being detrimental.
Monte Carlo Simulation
We created an analysis of the resulting process to determine what the reasonable expectation of its use may in fact be. As with all financial markets transactions, there are too many variables in the mix to have absolute certainty that things will work x% of the time.
The calculus boiled down to what the expectations for cost and time would be for a crowdfunding offering raising up to $5 million. The test case was the classic mini-max construct. Why? Because the mini-max has an even lower threshold of sales to satisfy before you can have initial settlement, thus once the mini-side closes, the argument goes the resulting proceeds may be applied to finish out the maxi-side of the raise.
Results of Monte Carlo Analysis
Our initial results found a range of values based upon discrete conversion rate scenarios where the conversion of rate of the pool of qualified prospects was subjected to an assumed rate of conversion to subscriptions. The analysis assumed every investor bought a single interest (not likely but unarguably conservative) and the average investment would be equal to the average investment surveyed for all crowdfunding investments surveyed by the SEC DERA team report that accompanied the new regulations release. The results showed an expected 15-week total offering period, with 44 days being the expected minimum to 155 days being the expected maximum. The range of costs owing to pre-issuance advertising were computed to be $105,220 to as much as $202,504 – which equated to 1.66% to 2.31% of the total assumed $25 million offering. While this is no guarantee of success, the findings suggest, all other things being equal, the new crowdfunding opportunity construct provides a potentially higher surety of outcome and opportunity than the previous approaches available in the market.