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234 Brian Dally, Co-Founder and CEO, Groundfloor
A New Approach
The summary is that my co-founder Nick Bhargava and I were looking into a bunch of ideas that would allow us to test the theory we have about capital markets and in the end we found that real estate was the best arena in which to test those ideas – and as we tested the ideas it became a real business. We both come from a different perspective compared to a lot of other founders in the industry. A lot of people approach this business and ask the question how can we make real estate financing better? Some people have seen an opportunity to cut out middlemen in the financing supply chain, for example. I think all of those are good worthwhile motivating factors.
For us because our approach is a little bit different we look at a world in philanthropy, in fields as diverse as wireless and finance and we see a world of people who don't trust intermediaries; who see opportunity to use their connections to others through social media; to see an opportunity to use the information which is newly available courtesy of the Internet. It's a global phenomenon. People believe that they're capable of making their own decisions. In finance what Nick and I found was that 96 percent of us aren't allowed to make our own decisions in real estate because of a combination of the way the industry is structured and how our securities laws are formulated. We aren't allowed to utilize our independent discretion to access some of the most lucrative investment opportunities out there and those are the ones that are typically known as being in private securities markets. We set out on a mission to open that up. Now it's five and a half years ago after we found ourselves in the first beachhead market in real estate market. That's the broader mission and that's why we started GroundFloor.
How it Started
I was introduced to Nick because I thought there was an opportunity to invent a financial product that would allow people to participate in private securities offerings spread out amongst thousands of investors. One word that people used at the time was crowdfunding; Nick was actually an expert in that area, it's why I was introduced to him. He helped to work on Title III of the 2012 JOBS Act. He was in the Rose Garden when President Obama signed the Act into law and was very thoughtful about how to apply securities law to crowdfunding use cases. I was introduced to him because I was interested in creating a financial product that would that would allow lots of people to participate in something that typically only large private financial intermediaries could participate in. We recognized that we needed, if we were to be successful with a mass consumer product we needed a few ingredients. Number one if you look at our product today and that the subsector of real estate needed that we actually delivered on was a high yield product. People are pretty irritated that they only earn 1 percent in their bank account in terms of interest so we wanted to provide something that provides a really high yield.
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We also wanted a short term product so that we could test and iterate our own credit. LendingClub and Prosper had terms of three to five years on their loans. We imagined something much shorter where people could get their feet wet and get confident they would be repaid quickly. And then of course as entrepreneurs we needed a profitable sector. We needed somewhere that the users of the capital that we provided could afford to pay to feed our business model which is based on origination fees. Over time we found ourselves drawn to the residential renovation market. We ended up making some loans in our first loans in February 2014 about a year after we started the company.
We funded our first loans on small fix and flip projects that were in developing neighborhoods in Atlanta and we realized that investors snapped them up very quickly. We set a minimum investment of just ten dollars so that it would actually be acceptable to many people and over time we've added many more investors, until now when we have thousands of investors. Our loan sizes are larger but the yields are still very high and the terms are still short term still 12 months or less. Yields are still about 11-12 percent, and it's a very popular product for the mass market investor.
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The Grading System
If you're investing $10 you're not going to do hours of due diligence on your investment. What you need is a shortcut as an investor that you can trust to understand the risk of a particular loan and incorporate it into a portfolio of loans. What's different about Groundfloor is we uniquely allow you to build your own portfolio. There are REIT products out there that use Regulation A as well that are available to non-accredited investors online that will allow you to invest in a fund and then that fund will go out and choose investments and put them in there. Some of the REIT products that are out there have 10 or 20 loans in them for example, whereas we offer a 30 to 40 loans a month and you can pick and choose so the grading system is your shortcut. With an A Grade loan you learn over time for a whole bunch of reasons is a lower risk product than a D or an E or an F grade loan. We go all the way down to G. Lending Club and Prosper did that same thing when they set out on the same course in consumer debt. And it worked really well for them. So we adapted it to the real estate use case.
The mechanics are important but I think they even more important part of it is the motivating purpose behind it. We started the company feeling that people are smart enough armed with enough information to choose for themselves. If I told you that you could invest in the stock market but your only mechanism for doing so was a mutual fund index fund or an ETF you'd look at me like I was crazy. It's good that those options exist but we all want to be able to make our own decisions about what stocks we buy and the market lets us. But that's not true in private securities markets. Here at Groundfloor we uniquely created a security that gives you the efficiency of an overall offering like a fund but retains the decision making characteristic that you have with individual investing. Specifically at a mechanical level our investors are making a loan to Groundfloor and we in turn are investing that money as they direct in a series of limited recourse obligations, LROs, that they choose. One of the questions we get from sponsors a lot is, if this is crowdfunding how do I know that my project is going to fund? Well, you don't have to worry about that because we prefund every loan. Like any originator we have access to credit lines and we step in and prefund every loan.
We are one of the few platforms by the way that's out there that actually does originate every loan that we make and that we offer. We go out and we prefund that loan and then we hold it on our books until it's ready to be released for investment. When it's released for investment, people pick and choose which ones they want and we will accept investors until it's fully funded. That usually takes about a week sometimes hours or days; more typically a week and people invest on average somewhere between on average $100 to $500 per loan. On average there are about 20 loans in every investor's portfolio and it means that if you have only $1,000 to invest if you have $100 to invest you can build a portfolio of 10 or 100 loans and be pretty well diversified. Once the loan repays you're repaid exactly what Groundfloor earns. So if a loan is at a 10 percent annual rate of interest and it goes nine months, you get nine months of interest at 10 percent; which is exactly what we earn on the loan. In our agreement with investors and mechanical level is to return exactly what we earn from the underlying loans.
We earn origination fees from the from the borrowers and today Groundfloor doesn't have any fees charged to investors. Investors can put their money in fee free. There's no spread. There are a lot of people out there marketing these investments to accredited investors and I say “caveat investor watch out.” Ask the question, does the platform actually originate its own loans and in several prominent examples the answer is No. They buy loans then sometimes they sell them to Wall Street. One platform out there is backed by Goldman Sachs and then whatever Goldman Sachs doesn't want they float to retail investors. But all along the way they pick a big hefty spread off the top of what the investor earns. They go out and buy a loan that the borrower was willing to take at 12 percent and then the platform goes and buys the loan and then turns around and offers it to investors at 8 percent. Investor beware. The second thing you see out there in do they originate and do they actually pass along the full interest. Those are the two things to watch out for out there and crowdfunding Wild West.
What’s great about our platform is that people can make their own decision what loans to invest in. Some people want to only invest in the most secure stuff where they are willing to accept a lower yield. Other people say you know what I have elsewhere in my portfolio outside of Groundfloor I have secure positions, so I want to roll the dice and go for high yield loans. People who go for the high yield loans typically understand over time that there's greater risk to those in terms of maturity default maybe those loans take longer because it's a more expensive renovation. There's more maturity risk or sometimes loans do experience losses. Fortunately in our case we've only had three out of over 300 that have returned capital that are realized some kind of loss. But that's why we have structured the product to encourage people to diversify. Most people do. Most people put some money into the higher yield loans, some in the middle and some in the conservative end of the range, and over time our investors get the choice. They don't have to wonder what they're buying and whether the fund manager is doing a good job because there is no fund manager, they are the fund manager.
Also we are the only place that people can buy the securities that is fully disclosed publicly with the SEC so people can see everything about how we make our loans how we offer our investments how we handle the portfolio. It's all on file in a publicly disclosed offering circular on the SEC website and we report our performance regularly to the SEC as well. No other issuer that can say that about a direct investment for accredited and non-accredited investors. This is because we're in a Reg A plus and it's because of the way our Reg A Plus is structured. You can you can see those disclosures for REITs but you can't use those disclosures to make your own decisions about what the REIT invests in; you have to rely 100 percent on the on the manager. Not only do you rely on the manager but you're also reliant upon keeping your eye on the store of conflicts of interest that are bundled up in these REITs. There are a lot of fees being passed between the corporate entity and the subsidiary. There's a lot of hide the ball in these products and people know it. With Groundfloor you know exactly what you're getting.
Starts With the Sponsor
Our business model all starts with the sponsor who is looking for capital. Our theory of this company from the very beginning was that the source and structure of capital matters to the end use the capital. We believe that we can offer the sponsor a product that few others can offer at a lower rate than others can really match. And that's because we're ultimately going to sell this at retail gives us a lot more flexibility to be creative. We make a loan to sponsors by using the criteria that are disclosed in our offering circulars so we have to follow the guidelines for lending that we lay out in our offering circular. It is very clear to everybody concerned, what kinds of loans we will do, the kinds of loans we will not do, what kind of rates are available and what kinds of rates aren't available. Once we make the loan we go through standard process of diligence. Like any lender would. We look at the experience of the borrower we are looking at the business plan for the project we're looking at the amount of leverage that they're looking for. We're looking at the exit that they're trying to target and questioning whether that's achievable. We do a full business case workup on every loan that we originate. Once we originate we hold it on our balance sheet while we qualify the loan with the SEC. We submit batches of loans; if you go to our EDGAR filings, you'll see we file a batch of loans about every week. Those loans are laid out and amended into our offering.
Once the SEC qualifies that batch which usually takes us about a week, at this point because we've filed over 70 amendments so we've gotten that down to a pretty good efficient process. The SEC qualifies the batch and then we turn around and offer it on our website to investors. They invest via their Groundfloor investor accounts where they have funds as they would at a brokerage, they have funds on account with us and they can direct those funds into the loans that they choose anywhere from $10 minimum. We have people that invest tens of thousands per loan. Everything in between. They choose which loans. And we see people invest on average about every six weeks.
The Reg A+ Offerings
We actually have two Reg A offerings. One is an offering of equity in the company which is quite a bit separate from the Reg A offering that allows people to participate in the loans. The Reg A offering of debt which is a limited recourse obligations separate from the Reg A offering of equity in the company and here's why it's quite different. One is an investment in these loans which are high yield short term backed by a 1st lien position. These are technically backed by a loan that we've made that is itself backed by as first lien position on that loan. And then the Reg A offering of equity in the company is an opportunity to participate in the future equity value of the company. That's not a real estate investment that's a fintech start up investment.
When you purchase a limited recourse obligation via our regulation A offering you are technically making a loan to Groundfloor itself. Now the terms of the loan that you're making to us are laid out in an Investor agreement. Our investor agreement with you says you get to pick the series of limited recourse obligation that you're investing in and you get to choose the amount that you invest in each series and by terms of our agreement with our investors we then promise that as we are repaid by the borrower behind a series of limited recourse obligations we're then obligated to return the capital you in the exact same proportion as we receive it on that series called a limited recourse obligation. This is the recourse for our investor who is loaning us the money. It is limited to that series meaning they can't, having not been paid in full for one series of limited recourse obligations, they don't have recourse to then go after other loan or other assets of the company. It's the same way that Lending Club and Prosper are structured with their payment dependent notes. But in their case there is no there's no real estate underlying those; it's just borrowers promise to pay.
We do it this way because securities law dictates it and has done since 1933 that any offerings of securities offered to the public must be registered or qualify for an exemption. Registering an offering is very costly. That's what companies do when they IPO. There is an enormous burden of reporting. In general companies need to be fairly far along before they can successfully offer and manage a registered offering. So what a lot of early stage companies do, and this was the purpose of much of the JOBS Act of 2012, what younger companies do, and Groundfloor is now five and a half years old, is to use this mechanism which is an easier path, a less onerous path, with less regulatory burden to raise capital. Now a lot of people have done it with equity. They'll use Reg A in order to sell ownership in their company. We did that. Some people will use regulation A to offer a share of a REIT. There have been a couple of folks out there who have done that and then in our case we actually have invented this very novel and unique mechanism that allows investors to pick and choose the loans that they're going to invest in.
We created a system whereby we could build this mechanism and invent this product that allows people to still retain the power of choice but that gives us an extremely efficient means of operating so that we're able to spread the cost of complying with the regulations across hundreds and thousands of loans and up to $50 million using regulation A. In short we have unlocked the opportunity to invest for the non-accredited investor. That's the fundamental difference between Groundfloor and other platforms.