What is due diligence?
According to Investopedia, due diligence is “An investigation or audit of a potential investment. Due diligence serves to confirm all material facts in regards to a sale. Generally, due diligence refers to the care a reasonable person should take before entering into an agreement or a transaction with another party.”
Due diligence in the context of EB-5 investments
At a high level, an EB-5 investment is an at-risk investment made into a qualifying business that creates or preserves at least 10 full-time jobs. At the time of the writing of this article, the minimum investment amount is $1,000,000, or $500,000 in the case of an area that, at the time of investment, is a rural area or an area experiencing unemployment of at least 150 percent of the national average rate. The primary objective of an EB-5 investment is usually to obtain a US visa. However, since the visa requires an investment, the secondary objective is often to receive an investment return or at least a return of capital invested. As a result, due diligence for EB-5 investments generally centers around successfully 1) obtaining the EB-5 visa and 2) receiving, at the minimum, a return of the capital invested.
The stakes are high with an EB-5 investment. Not only is the dollar amount large, but the immigration penalties that may occur with a failed investment are severe. It is important for investors to hire the necessary experts to help them analyze an EB-5 investment. Investors should consider hiring the following advisors:
- US immigration attorney: Since the primary objective of the investment is immigration, this will be one of the investors’ key advisors. Don’t just pick any immigration attorney. The immigration attorney should be well-versed in United States immigration laws and have plenty of experience with EB-5. Ideally, look for an immigration attorney that has processed a lot of EB-5 cases with multiple different projects so they have diversified experience.
- US corporate attorney: A corporate attorney can help analyze legal paperwork that investors are asked to sign when making the investment so that the investors better understand their legal rights under the investment documents. A corporate attorney can also review project documents to advise investors if they match the terms of the deal summaries or if there are any issues. In some instances, the corporate attorney may also be able to help negotiate the investment. As with the immigration attorney, look for a corporate attorney that is very experienced with EB-5; an inexperienced corporate attorney may try to negotiate for items that may actually harm the investor’s immigration application.
- Investment adviser: EB-5 investments are real investments into companies or projects. If investors do not have experience analyzing and making investment decisions on their own, then an investment adviser is strongly recommended. The investment adviser should be knowledgeable with the EB-5 program, the investor’s objectives, financial analysis, and be intimately familiar with the industry that the investment is in. For example, if the investment is into a real estate development, the investment adviser should understand real estate investments in the United States and preferably in the specific region that the project is located. That same investment adviser, however, might not be qualified to analyze a restaurant project or a manufacturing project. It is possible that different investment advisers are needed to analyze different projects.
- Tax advisor: Investing into EB-5 and becoming a US resident could have significant tax implications. Investors should understand how taxes will affect them for the transaction and in the future. With enough advance planning, a tax professional might be able to assist the investor in minimizing tax liabilities. Many projects might offer advisors to help investors. While those advisors are certainly helpful, investors might also want to seek second opinions from their own advisors. It is extremely important to understand that some advisors might be biased in EB-5. Take the effort to understand what incentivizes the advisor to give the information they give, and might they give biased information because they are directly or indirectly paid by the EB-5 investment opportunity or the EB-5 industry? Bias is not necessarily bad; it’s just important to understand how conflicts of interest and bias might affect the information that an investor receives.
EB-5 investments are required by law to be “at-risk”. Even if they weren’t, almost all investments bare some sort of risk. Investors often look for the risk-free or guaranteed investment, but that doesn’t exist no matter what people say. Of course, a project sponsor and its agents or representatives will tell others what a great investment opportunity their EB-5 project might be because they want investors. The primary function of due diligence will be to confirm that the information provided is accurate. Often times, summaries of the investment opportunity will be provided to the investor. While they should be the starting point of any investment analysis, they should not be the end. Investors should review the entire offering documentation thoroughly and ask for more information if they need it. Summaries by their nature cannot describe the entire investment, so investors should read through the actual agreements and project documents to understand their investment on a more detailed level.
Investors should verify information with third-party information where possible. Much of the information may be publicly available. Investors can visit www.USCIS.gov to see a list of approved and terminated Regional Centers. They can often determine if a company has already been formed and if it is it good standing by visiting the Secretary of State website of the state that the company is formed in or conducts business. Investors may be able to determine the status of a project or public perception of a project by running internet searches on the project. Investors may be able to order background checks inexpensively on project principals through online background check companies. Investors may be able to use public sources to determine whether project assumptions are reasonable. For example, if the investment opportunity is a franchise restaurant of a publicly traded company, then investors might be able to see how the franchise financials match with the information that the public company provides.
Due diligence is not fun, but it’s worth it for an investment as important as an EB-5 investment. Break down the diligence project into smaller, more manageable tasks. Assign different priorities to different items of diligence and focus primary efforts on the key information. Start diligence by taking the following steps:
1) Confirm that final versions of all documentation, including business plans, economic studies, offering memorandum, LP or LLC agreement, escrow agreement, subscription agreement, loan agreement, and other ancillary documents have been delivered. Not all projects will have all of these documents, and some projects may have additional documents. Try to obtain as many documents as possible and ask for documents that are referenced and not provided if they seem material.
2) Review project summaries and presentations and the entire offering memorandum. Offering memorandums will vary in the quality and quantity of information they provide, but the best offering memorandums will provide information described in Regulation S-K. For more information on Regulation S-K, visit: https://en.wikipedia.org/wiki/Regulation_S-K
3) Review underlying documents to confirm that they match with summaries and ask questions if anything is confusing. Pay particular attention to investment structure, what company an investor invests in, which company actually creates the job, which company owns the collateral (if any) in the project, and confirm the relationships and interplay between different parts of the deal. Many investors mistakenly believe that they have collateral when they might being investing in a company that’s investing into another company that has collateral. It’s important to fully understand the structure of the investment and follow how the money flows into the project and back out to the investor as well as how the investment creates jobs.
4) Use online and other resources to verify the background and experience of the management team and key information about the project. Use diligence checklists to assist in the process and ask a lot of questions. Sample diligence checklists can be found online easily with a search term such as “sample due diligence checklist”. In addition to the investment structure items outlined above, pay attention to USCIS approvals, TEA expirations, capital stack, use of proceeds, timing and certainty of job creation, quality of third party reports, exit mechanisms, and other items that may seem important.
5) Know when to stop. One can never really complete diligence. It’s up to each investor to determine how much diligence is enough to make an investment decision. The goal of due diligence is not to guarantee that an investment is safe and will achieve its intended goal. Due diligence is supposed to only uncover and confirm information. Ultimately, an investment decision still has to be made and risk will be involved even if thorough diligence has been completed.
The key to due diligence is to get to a point where there are little or no questions remaining as to the investment opportunity itself so that an investor can just make the investment decision. Instead of relying on the accuracy and completeness of information that others provide, proper due diligence gives investors the ability to make an investment decision after they have already verified that the project is real and understand the risks vs benefits of the investment.
Jor Law is a co-founder of Homeier & Law, P.C., where he practices corporate and securities law, including helping companies take advantage of alternative forms of capital raising such as venture capital, EB-5 finance, Regulation D, Rule 506(c) offerings, Reg A+ offerings, and crowdfunding. Jor Law is also a co-founder of VerifyInvestor.com, the resource for accredited investor verifications trusted by broker-dealers, law firms, companies, and investors who insist on safety and reliability. These verifications are required by federal laws for generally solicited Regulation D, Rule 506(c) capital raises. Jor is licensed to practice law in California and New York. Jor received his J.D. from Columbia University and his B.A. from UC Berkeley.
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