Anything wrong with this partnership agreement?

Question

I am going in on a 3-unit house with my investing partner, Mike, and we are trying to solidify an agreement for equity given what each of us is putting into the investment and the fact that we plan to split monthly expenses and cashflow 50/50. Do you see anything wrong with our approach? Or have any thoughts/suggestions?

Context:

Initial investment: 80% Me | 20% Mike

Monthly expenses: 50% Me | 50% Mike

Monthly cashflow: 50% Me | 50% Mike

Mike found the property, scheduled a tour, coordinated with agents and lenders, arranged the inspection, and will be the Property Manager for at least the first few years. He is also the more knowledgable and more networked real estate investor between us. This is his second investment property.

I am providing the majority of the funds and have been in communication with all of our contacts, and plan to take on minimal property management responsibilities from a distance, mainly for the learning experience. I've also been leading the charge on the Operating Agreement for our eventual LLC. This is my first investment property.

Proposed agreement:

• (1) Start at equity split 75% Me | 25% Mike Gives Mike an extra 5% equity from the start for his experience and the initial arrangements he made with agents and inspector
• Gives Mike an extra 5% equity from the start for his experience and the initial arrangements he made with agents and inspector
• 
• (2) Stay at 75/25 split until 75% equity gives me at least the 80% initial amount I put in e.g. Equity split stays at 75/25 for 5 years, if (75% of the equity after 5 years) = (80% of the starting equity)
• e.g. Equity split stays at 75/25 for 5 years, if (75% of the equity after 5 years) = (80% of the starting equity)
• 
• 
• 
• (3) After we reach the point where I get out what I put in (2), all gains in equity will be split evenly between the two of use.g. if total equity is $100,000 after (2), and a month later it's $101,000, the increase in equity was $1,000, so Mike's total equity and my total equity each increase by $500
• e.g. if total equity is $100,000 after (2), and a month later it's $101,000, the increase in equity was $1,000, so Mike's total equity and my total equity each increase by $500
• 
•

• Gives Mike an extra 5% equity from the start for his experience and the initial arrangements he made with agents and inspector
•

• e.g. Equity split stays at 75/25 for 5 years, if (75% of the equity after 5 years) = (80% of the starting equity)
• 
•

• 
•

• e.g. if total equity is $100,000 after (2), and a month later it's $101,000, the increase in equity was $1,000, so Mike's total equity and my total equity each increase by $500
• 
•

•

This approach makes sense to us both, but having minimal experience in comparison to many of you on BiggerPockets, we thought we'd better sanity check ourselves here. Feedback appreciated!

David M. · Answer

@Laura Chevalier

Sorry, don't have much time to respond to your post right now.  This has been discussed heavily before on BP.  The main thing is to NOT turn any one person's labour into a significant equity interest, generally.  As mentioned, if you two feel that one partner does xyz additional work, then they should be PAID for that work. Honestly, an 'unequal but fair' partnership can still work --- its up to you guys.

Remember, investors make their money off the PROFIT of the DEAL.  Workers/labourers make their money off their time, regardless if the deal makes money.  If you keep 'nickel and diming,' for lack of a better term, your contributions to the deal you might as well create a pay structure for yourselves.

It looks like you are both doing "work" on the deal.  Honestly, for this being only his second property, he doesn't have much more experience.  Sure, lots more than you being its your first, but that record doesn't demonstrate him to be some sort of expert.

splitting the income/expenses-profit/losses by equity is usually the best.  It follows the lines of risk and reward.  Its interesting you made a comment for trying to compensate him for taking on the property management work up front.  Hmmm.. how is he compensating you for taking care of the Operating Agreement and associated LLC?  What about the fact that one could say HE is USING your 75% equity?  Its great that he did a bunch of the legwork, but if he is the one nearby and you are further away, that ist he nature of the partnership.  From what's in your OP, that's just regular prospecting.  Why get paid/compensated more for doing something he would have normally done anyway??

Hope this makes some sense.  If you viewing every task/hour that one partner is doing and trying to find a perfect match up, then perhaps its not a good partnership, or you just have a dynamic that puts a dollar value to every bit of effort.

Good luck.

Kamil Baldyga · Answer

@Laura Chevalier In regards to repairs, ideally the business is making enough money that there is enough money in the business account to pay for it. In the event there isn't and more money is needed from the partners, ideally both partners would contribute equal amounts. If that's not possible, both partners contribute as equal amount as possible. Anything over that, the partner who contributes more treats it like a loan to the company. If Partner A contributes 5,000 and Partner B contributes 7,000, both partners made a business contribution of 5,000 and Partner B has a loan to the business of 2,000. Let me know if that doesn't make sense!

Dan Schwartz · Answer

@Laura Chevalier about your original post, I would simplify it the arrangement

1) the business should be capitalized to the extent that neither of you need to contribute additional funds on a monthly basis Capitalize with adequate reserves and pay monthly expenses out of the cash flow. Then if you need an extraordinary capital raise, it should probably continue to be contributed 80/20 as in the original capital raise.

2) absolutely pay your partner wages/salary for the property management services.   This is just good solid business, as addressed above.

3) your partner’s kicker for the expertise and legwork he brought to the table is the 50/50 split of cash flows.  I would not change the equity split from 80/20, but let his bonus be a) fee for property management and b) 50/50 split of cash flow.  If there is $500 net after all expenses ex management fees, then he can take a $200 property management fee and you can split the remaining $300 50/50   He gets $350 and you get $150.  I wouldn’t gift anyone else my capital, which is what you are doing when putting in 80% of the capitalization but only retaining 75%. There are other ways to compensate your partner, as outlined above, and also by paying him out of the partnership capitalization for advance work/setting up the deal.

Good luck!

Laura Chevalier · Answer

Thanks @Basit Siddiqi, I appreciate the advice! I do know Mike personally, and we've altered the agreement based on the feedback others provided earlier (see my last comment).

Regardless, I see this as a learning opportunity (Mike and I both do), and we're trying to get it as "right" as possible this time so that we can continue to partner without having to make too many changes to the basic structure of the agreement. All the input from the community has helped immensely.

Basit Siddiqi · Answer

@Laura Chevalier

Honestly, I don't like the proposition.Will the property be purchased all cash or through financing?if financing, are one of you getting the financing or is it being done through the entity?The cost of property management is normally 10%The way it is currently set up, you are paying him 30% for the service(80% equity minus 50% profit and loss percentage).Furthermore, the way the agreement is currently set up, the partner likely gets 50% of the appreciation from the sale. A property management company wouldn't get this fee.I would think of this more as a learning opportunity. Try to learn as much as possible and do the next deal without an equity partner.Do you know Mike personally?I would be extra cautious to avoid being scammed.Make sure that the property is owned by the LLC and not by him personally.Also, occasionally ask for some sort of profit / loss report to show how the investment is performing.Best of luck

David M. · Answer

@Laura Chevalier

Since there are so many ways to think of it:  the equity split is for when you sell one day?  And the cashflow is really the apportionment of the yearly profit/loss for tax purposes?

a “lifetime” 50/50 split for him finding the deal seems too much to me, but I don’t know the scale of the numbers.  Rhetorically, is it more or less than what an ordinary investor would do or what a real estate agent would actually get in commission (realizing a “commission” is split really four ways) for helping to do all that work — which I do anyway ?

Anyway back to the apportionment… does anybody care or know how the nittygritty is split on the sale in this case?  Eg is the depreciation unrecapture apportioned by equity or by cash flow split?  I would think the latter, personally since it was deducted annually.

Laura Chevalier · Answer

Thanks @David M. and @Kamil Baldyga for your input!

I think we're going to end up doing an equity split that's in line with the initial contribution, where expenses come out of the company's account, and he will be paid a property management fee. As Dan noted, the 50/50 cashflow already accounts for his expertise and up-front legwork. He will also have the ability to buy additional equity from me on an annual basis, up to the amount he earned in property management fees, for the first n years (n TBD).

Laura Chevalier · Answer

@Kamil Baldyga meant to tag you for my question to you above, oops.

If others have different approaches, I'd love to hear them. I've seen a lot of people on here doing what Kamil describes, but I'm curious what's worked for others. Or if anyone has comments on the original approach I outlined, that would be much appreciated!

Laura Chevalier · Answer

Thanks again Kamil! Follow-up question on that: how do you handle expenses like repairs? Does each partner contribute the same percent as the initial contribution? Or if not, how does that factor into the agreement?

Kamil Baldyga · Answer

@Laura Chevalier So there are a lot of ways to skin the cat on this one. The way I'm doing it in my partnership (I also do additional management responsibilities) is for your partner to send an invoice to the LLC each month for "Management Services". Essentially he's another business charging your LLC. You two could make the same/proportional income from your partnership LLC and he gets additional income for his services, which just look like an expense to your partnership LLC. You can do this for a predetermined amount of time and cost. Whatever you two deem is fair. Does that make sense?

Anything wrong with this partnership agreement?

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