Raising Capital From Friends and Family

[Jeff Matlock]

I would like to do bigger deals and get into multi-family investing. My wife and I own one single family house but I would prefer to jump to bigger deals as quickly as possible, whether a 6 unit or 20 unit apartment. I am trying to educate myself and get an outside perspective on the process. I am a commercial mortgage broker so the financing part is easy and I know a number of sales brokers that can help me find property. My questions surround how to set up the LLC and the splitting of the profits if I put a minority share of the equity but want to get paid for the work I put in to acquire, organize and asset manage the property.

Where do I learn about profit sharing and how to set up a win/win partnership with friends and family?  Let's say we put in a minority part of the equity 10% or 20% how do I structure it so I get more than my share of the equity invested?

Can anyone give direct examples of their first couple deals they did their first deal with friends and family?

If I am the active partner finding the property and making all the day to day decisions how do I get paid for finding the property and making the asset management decisions? (not day to day property management decisions, we will hire a 3rd party.) 

To warm up friends and family did you put together a "hypothetical package" and say if I find something like this will you invest?  Or did you get the project under contract and then go find the money?

Thanks,

Jeff

[Brian Burke]

@Jeff Matlock you've been given some great advice above as to legal constraints so no need for me to repeat that. So I'll focus on structure. 

There are two parts to a deal.  1. The "work". This means finding the deal, arranging the financing, raising the capital, asset management, selling the asset, etc.  2. Investing the money.  In your structure think of these two components as separate functions even if the same person (you) is doing both.

Here is the most simple structure (freshman class):  You do the work, a friend invests all of the money.  You split the profits 50/50. 50% for doing the work and 50% for bringing the money.

Adding some complication (sophomore class):  You do the work and invest half of the money. Your friend invests the other half of the money. You split the profits 75/25. 50% to you for doing the work, 50% of the other 50% (25%) for investing half of the money, and 50% of 50% (25%) goes to your friend for bringing the other half of the money. 

And more complication (junior class):  You do the work and invest 10% of the money. Five other friends invest the other 90% of the money. You get 50% of the profits for doing the work.  The other 50% is split pro-rata amongst the investors so you get 10% of that 50% and each other investor gets the amount invested divided by the total invested by everyone (which establishes an ownership percentage) multiplied by 50% (the total investor share). Example:  $1MM total invested. Investor contributed 250K.  Ownership percentage is 250,000 / 1,000,000 = 25% X 50% = 12.5%.

Getting advanced (senior class):  You do the work and invest 10% of the money. You raise the other 90% from 50 accredited investors. You get an acquisition fee of 3% of the purchase price and a fee of 1% of the loan amount for obtaining the financing and signing on the carve out guarantees and providing the net worth and cash reserves to qualify for the loan.  You get an asset management fee of 1% of the gross collected income each quarter and a disposition fee of 1% of the sales price when you sell.  The investors get an 8% preferred return, which means that they get 100% of the profits until they've earned 8% annualized return in their money.  Everything after that is split 70% to the investors pro rata and 30% to you. You also get 10% of the investor distributions because you invested 10% of the capital.  This includes both the 8% pref tier and the 70% surplus tier. If the property doesn't throw off enough cash to pay the pref current, it accumulates, so you have to keep track of the capital account. In other words, if the property throws off 4% year 1, 8% year 2, 12% year 3 and 14% year 4, the investors (including your 10% investment) get 100% of the cash in years 1-3 and by year 3 the pref is caught up so in year 4 the investors get the first 8% and the remaining is split 70/30.

The granddaddy (graduate school):  Same set of fees as in the senior class. But you get incentivized for great performance.  Here's how:  Investors get an 8% preferred return, then they get 70% of the profits until they reach a 12% return (cumulative on unreturned capital contributions), then they receive 60% of the profits until they reach a 15% return, then the remaining profits are split 50/50. This is called a "waterfall" and it rewards the person doing the work if they do a great job and produce a great return.

Extra credit (postgraduate class): There are variations on how pref is treated. Is it compounded or non-compounded? Is it based on an annualized return or an IRR? If it's compounded (or based on IRR which is compounded by definition) is it compounded monthly, quarterly or annually. Is the compounding calculated with an arithmetic or geometric calculation? Are the distributions considered to be a return of capital (which reduces the pref accumulation)? If the hurdles are based on annualized return, how is the return of capital achieved?

I like to keep mine simple--non-compounding and based on annualized return.  It's just easier to understand. 

There are other structures where splits shift to 100% to sponsor after the pref to catch the sponsor up before the subsequent waterfall tiers and probably a thousand other structural nuances but a lot of that stuff is just either ridiculous, disingenuous, or downright designed to be confusing so that the investors can't possibly figure out how much the sponsor is getting. I won't  even cover those because you just shouldn't do them.

At one time or another I've used each of the structures above (except the ridiculous stuff) but these days I'm nearly exclusively using the graduate school version with minor variations when necessary.