So you’re doing a Regulation D Rule 506b offering, and you need to establish a pre-existing relationship with your investors that may not be as strong as you’d like them to be. How exactly do you do that? That’s what we’re going to talk about.

My name is Tilden Moschetti. I’m a syndication attorney for the Moschetti Syndication Law Group. We’re going to talk today about 506b investors and how you make it so that you have a pre-existing relationship with them prior to making an offering.

It seems rather straightforward, doesn’t it, that you would bring in investors and that you’d automatically have a pre-existing relationship? But a lot of times that relationship isn’t very strong. Many times I get asked, “What if I have a situation where it’s a friend of a friend? And I don’t really know that person? How do I bring them into a 506b offering? Because they’d be a really good investor?” Well, that’s a great question.

When it comes to the analysis of if there is a pre-existing relationship with them, which is important because we need to establish that these investors weren’t solicited (as solicitation is only for Rule 506c, and we’re doing a 506b), how do I establish that that actually occurred? And what would a court or the SEC look at?

The SEC is really looking for two distinct factors, one from the investor’s point of view, and one from your point of view as the syndicator. Let’s talk about the syndicator’s point of view first.

What the SEC or a court would want to see is: Do you, as a syndicator, understand the needs, goals, and general idea of what that investor is looking for in an investment vehicle? Do they have a level of sophistication where they can understand what your investment is, what the downside risks are, and can weigh them reasonably to come up with a good decision whether it was a good fit for them or not?

Now, obviously, that’s not a very easy thing to just say, “Well, yes, of course, I knew that they had that.” But we can do it through issuing, for example, a questionnaire. So a lot of people, including my clients, will give their investors a questionnaire that starts to establish that you have that knowledge and basis for being able to ascertain not only their goals but also their level of sophistication in this investment, prior investments, or education.

The second piece that a court or the SEC is going to look at is whether that investor, in their own mind, feels like if they have a question, which they probably would, that they’d feel free to just pick up the phone and call you and ask you a question. Whether that question seems outrageous or stupid or anything like that, they feel like it would be something that they can easily do and don’t feel like it’s this black box that they’re going to be putting money into without any sort of answers coming out.

So those are the two criteria, looking at it from both the investor’s point of view and from the syndicator’s point of view. Now, how do we exactly establish that as a practicality?

Here’s what many people choose to do, and it is a good practice, and it will work. And I’ll tell you where the gray area is on it as well. First off, you know that there is an investor who may want to invest, and you’ve identified that person. So you go to your brother-in-law, or whoever has that relationship, and you say, “Hey, I’d really like to meet with them and talk with them.”

You have those conversations, and you probably started with an email saying, “Hey, I’d really like to talk to you about real estate investing in general” or whatever it is that you’re offering in general. And you’re just making a nice sit-down meeting either on the phone or in person or on Zoom and have a good conversation about what it is that generally they’re looking for, how they think about the market, or how they think about investments in general. You have a nice, good dialogue that goes through that.

You document that, either in an email (just the easiest way) that says, “Hey, it was great to meet you last Tuesday and talk about your thoughts on the market. And I’ll get to compare notes about what I think too. It was really nice to meet you, and I look forward to talking with you again soon.”

Some time then goes by between that initial meeting and when you talk to the investor again. And so maybe you talk to them again and still have non-substantive conversations as it relates to your investment. But some time goes between that initial conversation and when you decide to discuss your investment.

Now, it would be ideal in the grand scheme of things if you didn’t even have another investment lined up, right? If you didn’t have one in the offing, and then suddenly you do, and then you go to the investor. But the reality is, that doesn’t happen in today’s world. And so what we need to do, and I don’t think it’s prohibited based on no-action letters that we’ve seen from the SEC, is to still have those kind of substantive conversations later about an investment that may have pre-existed that initial conversation, as long as you didn’t have it at that outset meeting.

So now you go back to them, ideally two weeks, three weeks, four weeks later. You can probably get away with one week, but one week is a little short. So just know that that’s there. That’s the gray area that I alluded to before.

So you go back to them some period of time later, and you say, “Hey, Joe, we had such a great conversation about real estate investing, or investing in stocks, or investing in crypto mining operations,” whatever it is that you’re doing. And you say, “I’ve now got this opportunity. And I’m letting friends and family invest into it. I’m not advertising it to the general public. I’m just doing it to people that I know. And I thought maybe you might be interested. Would you like to see it and discuss it later?”

And that’s when you establish that. Now you’ve also got, since you’ve sent that by email ideally, or maybe you’ve just called them and sent a follow-up email about it, another clear demarcation of time. So you’ve shown this lapse of time between the initial meeting and when you’ve actually discussed that investment possibility with them, whether or not they want to invest. And that’s the way you do it. That’s the way most people do it, and it’s probably very, very good.

Now, what are the things that will make it not as good? It’s that length of time from that first meeting until the introduction of the security itself, as well as the gathering of an investment questionnaire and getting a really good sense of who that person is and what their investment thing is.

Now, is the investment questionnaire always critically required? No, because what if it is your brother? I mean, your brother, you have a very substantive relationship with probably. And so there, that level isn’t really required, right? So it’s sure it’s still helpful to have, but it’s not like you’re going to lose the case if your brother was to bring an action and he made a claim that there was no pre-existing relationship because it’s kind of clear that there would be.

So that’s the general thing we look at. Now, here are the key takeaways for this:

  1. The process of turning someone with no prior relationship into someone with a pre-existing substantive relationship involves several important steps. We talked about what those steps were: meet with them, do not discuss the investment, then introduce the investment some period of time later.
  2. It’s helpful along the way if you get, at that time, an investment questionnaire or prior to an investment questionnaire. It’s best practice to provide a detailed questionnaire to get to understand that investor’s level of sophistication and goals.
  3. Building a substantive relationship requires offline conversations, preferably through a phone call or in person, to discuss goals and experience. This is not something that you can do well if “they were my friend on Facebook.”
  4. Fostering interactions that allow for the establishment of a substantive relationship is crucial. And the quality of those interactions is more important than the time it takes to actually establish the relationship. So more time that goes on is helpful, but it’s not dispositive. What really matters here is the quality of those conversations.

So now you have the basic toolkit in order to go change the relationships from “didn’t know them at all” to “probably could qualify fine for your 506b Reg D syndication.”

I hope you found this helpful. My name is Tilden Moschetti. I’m a syndication attorney for the Moschetti Syndication Law Group. We specialize only in Regulation D syndication. So we help syndicators put together all their offering documents and also offer the support and guidance needed to be successful with their offering.