How to Structure This Private Money Arrangement

Question

I have two partners that are interested in investing some cash to act as our own hard money fund for rehabs (to resell and hold).  We own our investment company equally but their money is going to be a "side car" so to speak and I won't be throwing in.

I realize we could probably just do this on a gentleman's agreement but I'd prefer to learn a bit about the proper structure so that if someone we aren't as cozy with gets interested we could do a similar deal with that individual (potentially).

This isn't going to be a fund per se so don't tear into me on SEC stuff or any of that noise :).  But, to that point, would it make sense to keep their contributions separate so there's no way to construe anything as "pooling" or whatever nasty buzzword might come up?

The general terms of the deal are 12% interest only, no points or any other fees.  The clock starts as soon as the money is in play.  If it just sits in the bank then our company isn't paying for the money.

So for example, say we buy a home for $40k and are putting $15k into the rehab, we close and start paying on that $40k immediately (so $400/month) and then pull out the rehab money to put into our operating business in a few draws or something (we will establish some terms to dictate this internally).  No predetermined term to the loans or anything...just pay for money in play.

Essentially, this ends up being a way for our business to have access to some reasonable funds and my partners to have a good place to make money on cash they want somewhat liquid (in and out 3-12 months sort of window).

First off, what do you think of these terms?

Secondly, how would you structure this and do we need an entity for their money?  What sort of docs would we need to draw up for each loan (or would we just have some sort of blanket agreement that puts the terms above into proper legalese)?

Sorry for this post getting a little long.  I really appreciate any insights anyone could provide!

Jon Holdman · Answer

I think you're saying that two other people, call them A and B, want to fund you, call you L, to do rehabs.  They're 50/50.  A and B want interest only payments on the money when you're using it.

A and B should for an entity.  Just an LLC will probably suffice.  Call this C.  A and B form C.  They put money into C.  C is ENTIRELY their problem.  You are not at all involved.

Now, C makes a loan to L when L buys a property.  L gives C a deed of trust (or mortgage, if that's what's used in your state.)  L gives C a promissory note outlining the terms.  At closing, C makes L a loan (in your example) of $55K.  $55K gets transferred to the title company.  $40K goes to the seller, $15 K goes back into an escrow account controlled by C.  L makes payments to C based on the $55K loan (typically, I guess you could make this more complex.  But the $15K rehab money IS tied up and IS committed.)  As the work progresses, the rehab money is paid from C to L in draws.

Once the property sells, the $55K loan is paid off from the proceeds from the sale.  That money goes from the title company to C.  Any leftovers (hopefully) go from the title company to you (L).

C will file a partnership tax return and give K-1's to A and B.  A and B have to pay tax on their share of the earnings C allocates to each.  This doesn't have to be 50/50, though the accounting is easier if it is.  It doesn't matter if C distributes earnings to A and B or not, they still owe taxes.  Again, you should not be involved in the operation of C.

L deducts interest paid to C on his taxes.

SEC regulations apply whether you care about them or not.  If A and B know each other and go in business together, forming C, then they can only duke it out with each other if push comes to shove.  C is making a loan to L.  Whether or not that counts as "selling securities" is a subject of debate.  Some folks say the loan is a security, some say it is not.

If you, as L, have A and B investing directly into your company, then it is certainly a security.  Strictly speaking, you need to follow SEC Regulation D (section 504, 505, or 506) rules.  Now do friends form companies among themselves all the time?  Yep.  Is that a security?  Probably.

Brian Burke · Answer

Brandon Laughridge, the above well thought out responses are excellent advice.  You said a couple of things in your original post that are important.

You said that you "have two partners" and you "own your investment company equally".  From this, I intrepret this to mean that you are all active participants in the business.  If this is true, you guys can just write up an agreement amongst yourselves as to who gets paid what. Just an addendum to your partnership agreement or memorandum of understanding should suffice.

The reason that you can get away with such simplicity is because no security is being created.  One of the key federal tests to the creation of a security is "...the presence of an investment in a common venture premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others." (United housing Foundation, Inc. vs. Forman (1975)).

If all three of you are active participants in the business, for example, you all make the decisions of the business together, then there is no reliance upon the "efforts of others."

If you are not all active participants, then the above doesn't apply and you need to follow the advice of the previous postings.

The second important thing that you said was that you wanted to structure it so someone else could join in.  If you do that, you have created a securiy and the simplicity of just doing a simple agreement is out the window and you have to comply with the federal and state securities acts.

Bill Gulley · Answer

Agreed, but really, I'll spill some of my tactics so to speak.

My capital company set up allows two classes of membership in an LLC. This is addressed in the Operating Agreement.

The "preferred members" have voting rights the "common members" do not. Members can be admitted from time to time and as a preffered or common member by a majority vote of preffered members and common members may be removed by a majority vote upon the satisfactory disposition of the capital account of the member removed.

This allows say three parties who would normally form an LLC to operate amongst themselves in any business mission and allow others to join in any particular transaction(s). Remember too that any member can be another business entity, trust or endowment.

Since common members have no voting rights or management in the company, it will allow them to better qualify income passively, see your accountant. This may not apply if any such member has any independently managed business the consent of voting members.

In this set up, the capital LLC is the lending entity and all loans are made in the name of the LLC. The participation between members is an accounting function assigning loan interests to the applicable capital accounts of the members.

As to the question posed above, IMO, since business is generated, structured, processed and serviced under the name of the LLC, there should be a per centage earned by the company. Each participating member of either class, owes something to the company to cover its costs and expenses. That amount can be set, negoiated on a transaction basis or paid annually based on earnings of the total transactions and participations. Whatever is agreed to. Paying for management will help with any claim to passive income as well.

Another issue is liability between members. The managing member(s) will in most cases be liable for losses arising out of their position. As a marketing matter in drawing in other members, there should be an indemnification statement for the benefit of members limited to the assets of the company. As you become more profitable and internal risk becomes greater, you can obtain an E&O policy or performance bond as applicable. Another issue is never use money of others in any transaction without their consent to do so, always have a written consent for the use of funds. If any member refuses, they can always be removed or left idle.

Collateral assignments secure member's interests internally and is an accounting function. The Operating Agreement needs to address the priority of funds distributed, profits and losses. Collateralizing pooled funds can get complicated when defaults occur, this is a seperate matter, but just to say that the best way is for participations to be on a % of participation and paid out as received, losses can be financed as any obligation of the company to any member. This being addressed up front limits demands on the company and disagreements.

While there is much more, this meat can be cut and served. I also use this arrangement in estate planning. Interests of minors can be set in trusts which may be common members and managed by family  that may allow more managing flexibilty than a trustee in a trust company, especially with real estate as trust companies prefer marketable securities. I also like this arrangment for divided interests being accomplished through a capital account.
  
 Lastly, and related to the OP, choosing not to participate should always be an option, but you may want to address the issue of any member conducting other business outside the company, especially when the underlying business became known through company involvement. Investors, qualified investors, act in their own best interest everytime, so having the ability to tag their capital account for any assessment might be something to do upon discovery and prior to withdrawl of any member. It's also an issue for the idemnification by any member to the comapny, fair is fair.

:)

Bill Gulley · Answer

Hey, just trying to pass it along, you can't expect to compress 40 years in 4 weeks, LOL. What I posted above isn't complicated at all, but I know that isn't the 101 description.

First thing to lear is the correct terminology in RE and lending, as Ann pointed out, we were going down the wrong road, sorta.

All that is need here is an hour with a real accountant for small business ventures, it's an accounting issue with an attorney drafting the operating agreement with partner contributions and priority of distributions/interests. The company holds title, all would be fine. :)

Michael D. · Answer

Brandon Laughridge,

Make sure to consider what will happen if the money is still tied up in 12 months. Not saying that you shouldn't do it, just make sure that all three of you consider this unlikely but possible scenario.

Josh Rowley · Answer

Bill Gulley and Jon, I wish I knew as much about the intricacies of finance as u guys do. I guess there are just so many levels of knowledge and we have to use what we know. But imagine if my toolbox had some extra drawers and the associated tools. Nice job guys.

Ann Bellamy · Answer

The reason why we assumed it was collateralized was that Brandon said the above.  Hard money, by definition, is a collateralized loan.

Bill Gulley · Answer

Well, I sure wish you had explained your "side car" a little better, that was sure alot of verbage for putting money in your capital account. That is nothing more than an accounting entry and signing notes by the comapny to each member that "throws in" or let's say contribution to capital.

Were did we get the idea money was going to be collateralized???

And you guys have a financing entity? Is that right?

The note to us is called a "FUTURE ADVANCE NOTE LINE OF CREDIT"

In fact, you don't need no stinkin note, each partner shows the contribution to their capital accounts and the use of funds, transfers and amounts owed members is covered in the operating agreement and addressed again under the events of withdrawl and shown as an obligation in the minutes as well.

Horsefeathers, I went through all of that, as well as others, and all you wanted to do was to make future advances to capital as needed.....Okay, maybe we got it straight now. LOL

Good luck   :)

Brandon Laughridge · Answer

Chris Calabrese Your assumption is correct.  We would prefer not to file mortgages and for all intents and purposes it would function as if all of that cash was in our business account. So that's essentially what you do?

Do you have an agreement that you make for each deal or just a standard agreement that covers everything?

How to Structure This Private Money Arrangement

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