Exit strategies for partnership dissolution

[Thomas Combs]

Hey BP,

I am a new investor entering into a 3-person partnership & we are currently developing an exit strategy before approaching an attorney. We are having a hard time deciding how to approach dissolution as one of the partners wants the ability to liquidate the property at any time if he decides he needs to for any reason (emergency or not).

We also want to work in a statute that gives the other 2 of us the ability to buy a partner out before they liquidate the property.

I am curious to hear any dissolution strategies you have outlined before buying real estate with a partner & members' thoughts on freedom to liquidate. For more context, we are looking to live in a single family property for 365+ days then keep it as a rental.

[David Gotsill]

Hey @Thomas Combs - welcome to BP.

I'm a big fan of partnerships/joint ventures in real estate, and am involved in a few myself.  I'd like to clarify a couple of aspects of your plan, and share a few thoughts for your consideration.  Some of it's pretty technical, so feel free to ask follow up questions.  Also, I sound like a wet blanket.  Ask my other real estate partners, I'm good at that...

Why? Why are you partnering? Just in general, I would typically expect to see partnerships when going after bigger fish, rather than one SFH. Can one guy just buy it and let the others lease?

Financing.  Are you intending to obtain financing?  In my experience, the lender will have to rely on your personal accounts (of one or more of you), and that person or persons will be signing on the loan.  Probably not feasible (or worth it for any of you) for you each to be on the loan.  If, ultimately, one of you is on the loan, then is that partner entitled to an "extra" piece to compensate him for the extra risk?  If you're not using financing and instead are coming out of pocket for the full purchase price...THEN I'd strongly encourage you to reconsider and instead strategically use a loan to get other property.

Exit.  

(1) You've picked up on one of the key issues for any partnership. As to the Two to buy out the One, that's easy enough in principle. You have a ROFO/ROFR provision of your governing agreement (we're referring here to "partners", but I presume that you would actually be forming an LLC, and therefore would all technically be "members", and in such case your governing agreement would be the LLC Agreement/Operating Agreement (same thing, different name used by different folks)). With a ROFO - Mr. One would have to offer his interest for sale to the Mssrs. Two and Three prior to being able to sell to a third party. The fun starts when you try to value the purchase price for Mr. One's portion. Could be agreed in advance, could be FMV, could be something else. You'll also want to set out the process, including how long Mssrs. Two and Three have to exercise after receiving notice, what happens if both Two and Three want to exercise, and what happens if Two and Three don't exercise. Meaning, can One sell to anyone? Or are there limitations, such as a buyer reasonably approved by Two and Three. In a partnership of this size, I would personally never permit unrestricted transfer. There is too much risk. IMHO, a lot of work for one SFH.

(2) As to allowing Mr. One to sell whenever he wants (subject to the ROFO above), you'll have to confirm it's permitted under any loan that he is signing under.  Lender would typically restrict any transfers that alter "control".  So if One is deemed to control the borrower, he might not be able to sell without Lender approval.  Also, I would be sure to build in certain protections - such as a sale "in the ordinary course" or "in a customary, orderly manner" or some such.  You want to avoid allowing him to cause a fire sale, particularly if he has less to lose than the other partners.  Again, in general, I would never allow "sale at any time" without some protection.

Eventually, you want to consider what each partner is contributing, and how much it's worth of the whole.  You'll also want to decide how decision making works.  2/3 votes for any action?  Certain action requires unanimous consent?  Set out the business plan in detail in the beginning, and any variation requires unanimous consent?  

Again, this is not meant to discourage you.  Just get you thinking.  

Good luck!

David

[Christopher Smith]

If you are already having a hard time agreeing on basic structuring issues, perhaps a partnership isn't the best vehicle.

I was the lead partner in a 5 person investment partnership and outside of financial ownership interests (where everyone was equal all the way across the board), I requested and received final say so on all operational and tax matters which was fully memorialized in the partnership agreement. 

[Thomas Combs]

@Christopher Smith I said hard time for dramatic effect. It is more so a healthy discussion but I do appreciate the feedback! We are more interested in the ability to call business meetings & come to a consensus rather than giving one person the final say. If anything did go really wrong (outside the boundaries of our eventual legal agreement), we would just approach an arbitrator.

[Thomas Combs]

@David Gotsill Talk about a wet blanket! Just kidding, your reply was very helpful.

We are partnering more for the experience to learn together rather than the payout. The 3 of us are college friends with unique strengths to bring to the table but we do plan to split all financing equally. We are using financing & have already talked to lenders that have made it clear that we can all be on the same loan (bonus: we all have great credit scores).

We plan on forming an LLC to hold this property. ROFO is a great idea & we think it would be easiest to value One's share at 1/3rd of the FMV. In the last hour, we discussed Three giving One & Two 30 days to accept the offer & start making moves to procure financing to afford Three's share. It seems like if One & Two don't accept the offer, the property is sold & the proceeding would be split evenly instead of One & Two having to deal with a new partner, Four.

We would have to learn more about a Lender's permission to alter control. Building certain protections is a good idea so One doesn't fire sale the property so thank you for bring the legal terminology to light.

We aim to all contribute to a bank account (that would also hold our emergency funds) after making a consensus on any expenses and before paying for those expenses through that account. We think it's possible to rely on unanimous consent and/or compromises OR just not to commit to projects we can't agree on. There will be a set amount defined for emergencies determined in the agreement.

Thoughts now that I have answered more questions? All constructive criticism is welcomed.

[Eamonn McElroy]

Buy-sell agreement provisions in the operating agreement are best to prevent a forced liquidation.

If a partner/member suddenly wants to sell, right of first refusal for the other existing partners/members usually makes a lot of sense.

As does agreement on Sec 754 elections and 743(b) / 734(b) adjustments in the op agreement.  Particularly in RE partnerships.

Make sure your tax professional understands all of this, and can interface with the drafting attorney appropriately to make sure the operating agreement reflects the partners' intent and is as advantageous as possible.

That's the professional answer for multi-million dollar RE partnerships. For a SFR, you're going to have to determine if the cost of the above is worth it, or if you should just hold this property as TICs and hope for the best.

[David Gotsill]

Thanks for the additional information @Thomas Combs.  Seems like you guys are willing to put in the effort to make it work, which, in my opinion, is key.  

I guess I'd also consider how much (in actual money) the One is putting in, and whether or not that's really worth it for you guys to allow him to cause an (orderly) sale at any time.  We could look at it as choosing between paying his portion now (i.e., he doesn't own a portion), or buying him out in the future (in the event he wants to sell and you exercise your ROFO).  Hard to do this comparison without a particular property in mind, but you might play with those numbers.  If you're acquiring at 300k, and his portion is 1/3 of the 25% down payment, then he's in at 25k.  If you buy something that needs sweat equity or other work, and you're in a good sub-market in Denver, you could reasonably be at at 400 in 1 year (just for the purpose of this comparison).  if you have to buy him out after 1 year, the loan is essentially at full amount, so you owe him 1/3 of 400k (fmv) - 225k (loan balance) = apprx 58k.  In that 1 year your purchase price for his portion just more than doubled.  Obviously there are a ton of assumptions in here and it's oversimplified, but I guess the idea that he'd want out so soon really nags on me.  Spider sense tingles danger.

[Thomas Combs]

With appreciation, that payout looks a lot scarier for One @David Gotsill but he is committed to making this property a long term rental. His negative outlook on the situation is more accurately depicted as him playing the devil's advocate to make sure our agreement is strong since it is essentially the "if anything goes wrong" agreement. Glad that you mentioned that though, just another thing to think about before putting any ink to paper.

We are planning on living in the house for 365+ days before renting it out in order to only have to pay 3-8% down payment.

What if we added an option for One to sell his equity without us having to sell the property? I am curious if replacing him with a new partner, Four, who is willing to buy him out could be a safer financial strategy for Two & Three. Are you even able to enforce that in a contract (One selling his equity to Four instead of forcing the partnership to liquidate the property)?