Equity Partners vs Pooling Investors Under Reg D

[Franklin M.]

I was at a real estate seminar and a CPA said “talk with your attorney about difference between equity partners which are not regulated under SEC REG D rules, vs. pooling investor funds to raise funds, an activity which must qualify for one of the SEC Reg D exemptions...."

I've been reading diligently on the issue, and wanted to be certain I understand how to structure so that the LLC does not "sell securities" and hence does not need to meet one of the SEC Reg D exemptions.

Do I understand correctly that if instead of investors, capital comes from non-voting equity members in the LLC, sharing in the profits & risks pro rata to their capital contribution, then the LLC is not "selling a security"?

We already have 8 positive-cash-flow SFH properties tied to our personal credit history, and while local lenders seem are more than willing to keep lending purchase & rehab loans to us guaranteed by our retirement accounts, we want to move away from personal guarantees and toward perhaps using equity partners, as we start investing in small apartment buildings in BRAC communities.

Unless there is a better way to structure raising purchase & rehab capital than using equity partners -- any suggestions?

Thanks
Franklin

[Dion DePaoli]

What the CPA told you is false. That is not a distinction under Reg D. The function of pooling investors is simply more than one investor come together and put their funds into the venture. Whether investors are pooled or you only need one investor is not a talking point of Reg D.

Regulation D is an exemption to registering your company. So all companies must get registered or be exempt if they seek to raise capital. The point of Regulation D is to allow small business a lower barrier of entry to raise capital with less of the requirements.

It is a common misunderstanding by folks that Reg D defines structure. The general rule of thumb or scoping questions are: (1) Is there an investment of money? (2) Is the investment a common enterprise? (3) Does the investor have expectations of profit from others?

In most cases you will setup either a Limited Partnership ("LP") whereas you will have General Partners and Limited Partners or a Limited Liability Company ("LLC") where you will have Managing Members and Members. Whereas, the General Partner ("GP") is the same concept as the Managing Member ("MM"). They both have power and duty over the company. The Limited Partner ("LP") and the Member ("M") are the same concept. They both have limited power or no power to direct the company. I prefer to talking using LP descriptions, since in the name the distinction of power is present. Know, it applies to both company types.

So if you apply the three questions to a General Partner, the first two could easily qualify. The third question is a bit of a subjective topic. It is possible to have a GP and limit their power so as to make them dependent on the "other" GP. This can be done by legal language in the agreement or this can also be inferred by experience. If I am a Rocket Scientist and you are my GP but know nothing about the science, it could be found that you are dependent on me for my skill and knowledge to obtain a profit. If the questions are found to equal the answer "Yes"; you are a selling a security and "structure" is of no consequence.

In the case of a Limited Partner, the questions are almost always "Yes". The partner is limited by nature in their power. Therefore, they rely on the General Partner to make a profit. That is a security. I am not a security lawyer so I couldn't tell you if a LP had been granted GP power, if that precludes it from being a security. My logic would argue, only in name is the LP limited, as the power vests evenly in both types. My point there, is just assume for layman's terms a limited partner is always limited, thus security.

Do I understand correctly that if instead of investors, capital comes from non-voting equity members in the LLC, sharing in the profits & risks pro rata to their capital contribution, then the LLC is not "selling a security"?

After reading the above, I hope you see how the answer to this question is "No". That partner would be limited, they can not vote, they have no power. That is easily a security.

How the profits are allocated is not a defining part of rule. Not all investments are pro rata. Investments can be made in solidum, this is a bit more like public equities. The price of GE stock purchased in 1950 at $2.00 gave the same interest as the price today at $50.00. The investors are not prorated according to the capital they invested. (**I made those stock prices up)

For what you are wanting to do, it will be worth your time to go sit with a securities lawyer. None of this is a DIY project. All of this is a thing that when you need this to defend yourself, you will want to have it. That defense can be spawned from different angles including SEC investigations or investor complaints and law suits. This is intimidating because it is new to you. It really is not as high of a mountain as it may seem to get it done and do it right.