How much equity to offer investor?

[Brian Orr]

I’m in contract on a small deal for 500k. A long time friend of mine expressed interest in being a cash partner, simply looking for a better return than his savings account. This would be through monthly cash flow or the cash return upon exit or refi.

For simplicity sake, if I’m putting down 100k and he offers 50k of that we’re both 50% equity invested at this point. But the loan is in my name and I will be performing all duties, he’s 100% passive.

I know the 50% cash to cash investment shouldn’t be equal to 50% equity. The question is, what should it be equal to? Should it be 10% as it’s 10% of purchase price? It would actually be less I guess because we need about 30k in repairs. Also will need some operating capital to turnover the apartments as we reposition.

I’ve been searching syndication blogs but they don’t seem to address this, or at least I haven’t found one that could give me input on this scale.

Any ideas how to incorporate him into this deal would be greatly appreciated.

[Brian Burke]

@Brian Orr, how you structure this depends on how you wish to address risk.  You have received two suggestions above and both of those could work.  I'll address those two and propose another.

@Ed Matson suggests to not give any equity, and just borrow the money from your friend and give him a fixed return.  The upside here is that you keep all the upside.  Many beginning investors choose this option...I know I did when I was starting out.  I also learned that this option can really hurt if things don't go according to plan.  The downside is if the property under-performs, and there isn't enough cash flow to service the interest payment to your friend, you could be writing your friend checks out of your own personal account.  Or, if the cash flow is only enough to service the loan, you friend would be getting all of the excess cash flow and you'd be getting nothing.

@Greg Dickerson suggests you offer your friend a simple preferred return.  This is similar to the "borrow" option, except that the risk profile is much more favorable to you.  A preferred return is simply an allocation of 100% of the cash flow until the hurdle is met.  This means that if the property is producing zero cash flow, you aren't writing checks to your friend out of your personal account.  But when it does start to cash flow, your friend will be getting all of the cash flow until he gets his X%, and this includes any of that X% that wasn't paid when cash flow was compromised.  This beats the "borrow" option, I think, but the downside for you is you earned nothing for your hard work, but more importantly you earned nothing on your cash investment, while your friend earned it all.  

While either of those options will work, it is up to you to decide which works better for you.  Or, you could consider this third option:

You decide how much your "work" is worth.  This includes bringing the deal, obtaining the financing, guaranteeing the loan, managing the asset, and finally selling it.  Let's say that you decide that's worth 50% of the profits (or whatever percentage you and your friend agree on).  This leaves the other 50% of the profits for the "money."  You are bringing half of the money, so you are entitled to half of the "money's" 50%.

In this scenario, you get 75% of the profits (50% for the "work" and half of the other 50% for bringing half of the money) and your friend gets 25%.  You could complicate this further in two ways.  First, you could charge fees, such as a percentage of the purchase price for finding the deal and getting the loan.  Second, you could offer a preferred return.  Let's explore that for a moment.

In this case, you offer a preferred return to the "money," which means that you and your friend equally share in the preferred return.  What this does is prioritizes the folks that contributed the money (of which you are one of them) over the person in charge of the deal.  You would do this to incentivize yourself to perform, and to show your friend that a return on his investment is more important than compensation for your sweat equity.  

If the deal under-performs, your 50% for doing the "work" can get carved out by you and your friend.  For example, let's say that you have an 8% preferred return.  On $100K that's $8,000 per year.  If the cash flow were $10,000 and there was no preferred return, you would get $7,500 ($5,000 for the "work" and $2,500 for your "money"), and your friend would get $2,500.  

But if there is a preferred return, you and your friend would split the first $8,000 (8%) and get $4,000 each, leaving $2,000 of remaining cash flow.  You get 50% of that $2,000 for your "work," and the remaining $1,000 is split between you and your friend for the "money's" 50% share.  Notice the difference in this example that your friend isn't the only one getting a preferred return, you get one too.  You and your friend got $4,500 each and you got $1,000 for the "work."  The end result is you got $5,500 total instead of $7,500.

But if the cash flow were to be $20,000, you and your friend would split the first $8,000 (the 8% preferred return), leaving $12,000 to be split 50% to you for the work, 25% to you for your half of the money, and 25% to your friend for his half of the money.  You and your friend each get $7,000 for your investment (half of the $8,000, plus you each get 25% of the remaining $12,000), and you get $6,000 for your "work" (50% of the $12,000 left over after the $8,000 preferred return has been paid).

What you doing here is just treating your two money partners equally, it just so happens that you are one of those money partners.  This all sounds complicated, but once you work out all of the formulas on a spreadsheet, it's a simple matter of inputting the cash flow each period and letting the spreadsheet do the work.  It might take hours up front, but each distribution takes only seconds to calculate.