"mini mortgage" in partner structure?

Question

Reading Avery Carl's recent STR book and came across a partnership structure I'd like to hear more about in ch. 3, if anyone has details or experience. It could be for any strategy--not just STR...

There's a money partner and sweat-equity partner (I'd say "managing" partner in LLC lingo): the money partner initially collects all profits in a scheme where the sweat-equity partner works off his or her half of the initial downpayment in what Carl calls a "mini-mortgage." Her term might be a little confusing, but it's functional enough (coin something better, anyone?). Once the sweat-equity pays off their half, they split cash-flow, profits, 50/50 like normal.

I have mostly seen much simpler info where both are equity partners from the jump--maybe 40/60, 50/50, or whatever they think is fair in terms of value brought to the partnership. Is this structure as common as she makes it out to be?

At a glance, it skews as a better deal for the money partner, because once the sweat-equity has "paid off" their half, they are (likely) continuing some level of management responsibilities that the money partner isn't worried about. Perhaps it's fair, just because the money-partner made the deal happen in the first place, or there's some other factor that I'm missing.

I know there are a zillion posts about partnership structure and the details...yes, I know "whatever you and your partner decide between you" is true. But as I create a multi-member LLC, I'm wondering if I should use (or feel some obligation to consider) this "mini-mortgage" strategy as the sweat equity partner.

Thanks for your thoughts!

David M. · Answer

@Brett Mach

Just to "finish" the reminder and not to contnue the hashing:  just calc the difference or use the equivalent value of the "jobs" this sweat equity person is doing.  If they are fine with being paid out for it at the completion of the deal TO THE FUNDS available, then it makes more sense either way.

David M. · Answer

@Brett Mach

Well, I haven't read what you are talking about, but it sort of goes with what has been discussed on BP many times.

The biggest issue with the 50/50 split when you have an investor with the capital and an investor 'doing the work' is the risk issue.  "investors" make their profit on the deal.  they also lose money on the deal, too.  "Workers" make money on their labour.  If they don't work, they don't earn money.  But, they don't lose money.

So, the "working investor" pretty always is happy to make a 50/50 split on their "sweat equity."  However, they are always guaranteed their "split" even if the deal loses money.  That's where I, and many others, always point out how the arrangement doesn't make sense for the "capital investor."

As for your example / strategy, you are having the "working investor" work for their share of the investment.  They don't have cash to bring to the table, so instead they labour and their equivalent wage, as I see it, is credit towards the investment.  In the end, the "working investor" should be paid a cut of hte deal proportional to the amount that they have earned/credited to the deal.  For the $100k sized deals this can work out well assuming the "working investor" can understand the pay structure, and how much/little they maybe getting.  Lets face it, not all deals profit another $100k.  Maybe they are splitting $20k profit.  When I lay all this out for potential partners, they get all antsy and upset since they expect much more "profit" from their labours.  Meanwhile, as an investor doing a small deal, I'm not making a lot on a whole flip deal.

Does this make sense?  Does this help you with udnerstanding the issues with "working investors" since they don't bring capital to the table?  You need to separate 'investors' from 'workers.'

Brett Mach · Answer

@David M.Yes, that's all good perspective to remember. Your vocabulary of worker vs investor makes sense. I guess it's all dependent on the deal and specifics. While I recognize the investor is taking more up-front risk, it would also be true that the distribution of value evens out, and tips the other direction over time (right?). If the deal falls apart earlier in the life of the investment, yes, the capital investor stands to lose much more (and yes--the financial scale of deal matters, as you indicate too).

I'm assuming that the "worker" probably has a little financial contribution for skin in the game (say, 5k of a 50k down payment), is also sourcing the deal, swinging the hammer, and listing/property managing for as long as the property is held. If it's a long-term buy-and-hold, there comes a point when the worker adds more value to the deal than most of the initial down-payment.

I'm not trying to defend a blanket 50-50 assumption on most deals. Especially w first few deals, the sweat-equity partner may only contribute 30% of value, so 30-70 is the arrangement, especially if it's a short-term JV...I think we hear the 50-50 talk from established investors who have built a long-term relationship w investor-partners.

Yes, we could get into the minutiae of tracking the dollar-value the "worker" brings to the table over time, which I guess is the spirit of the "mini-mortgage" approach: Estimate the value of their sourced-deal if wholesaled; set an hourly wage for office-work/time spent renovating; charge a leasing fee for tenant placement and 10% of rent or whatever each month for PM moving forward...

That's doable, BUT it can get tricky fast: in a situation like a refinance-step of a BRRRR, the equity is depleted as part of larger plan led by the "worker"--yes, it may not appraise well--there are risks--but, if successful, the harder-to-calculate value contributed by the worker suddenly yields a large downpayment for the next property. And, of course, there wouldn't be the knowledge or investment without the worker in the first place, so people are always wanting to assign value to these less calculable items (like you, the investor, wants to assign value to the less calculable risks involved).

At some point w complicating factors, and without degrees in actuarial science, most of us throw up our hands and decide it's easier to just split 50-50, 60-40, or whatever, assuming both parties are educated and comfortable with the risks and values over the life of the investment.

I think the difference in the two approaches is that the one you describe is a capital investor who is not much more than a private lender (functions for JVs and flips more clearly), vs a capital investor who is an involved and long-term member-partner in establishing a portfolio together with the worker (managing partner) within an LLC for the life of a long-term investment (or two or three...).

I know we're rehashing an ongoing discussion (I mean it, David M.: yours is a really good reminder), but does anybody also have any experience doing this "mini-mortgage" scheme that Avery Carl depicts as relatively common?