Setting up LLC with my investors and then buying them out

[James Masotti]

Good Morning BiggerPockets

While I know most on here are not attorneys to provide legal advice I am curious to hear from folks who may have done something like this before.

Here is the overview.

I have a few private investors I work with who allow me to make cash acquisitions and then refinance them...basically using the BRRRR method.

I've purchased the first 4 properties out a portfolio and am negotiating with the seller to buy more out of his portfolio that he's looking to sell over the next two years. All told there are 43 more units and I'm immediate interested in 17 which I would like to acquire. 

Going the "traditional" way of using the private investors I would break up these 17 properties into 4 chunks and buy them one at a time for "cash" and then get them refinanced...paying off my investors...and then buy the next batch until we had purchased all 17 over the course of 9 months or so.

When I look at this though...it seems like my transaction costs will be much higher doing so many separate transactions (basically 17 separate acquisitions and then 4 blanket refinances with my credit union)

Instead if I can convince my private lenders to put their money into a new LLC set up to specifically purchase these 17 properties. My partner and I would be the general partners and cover all the administrative costs, much like we do now, and the investors would be limited partners, and we would use their capital for the downpayment. In this way I should be able to purchase the properties...let the loan season for the required 6 months, and then do a cash out refinance on the loan to pay my investors off.

In this scenario there are only 2 transactions and therefore many fewer expenses that would go along with the closings (at least based on my calculations). Structuring the deal this way I could actually increase my cash on cash return by not having as much capital tied up in the property and increase the return for my investors since I would be able to give them preferred returns out of the existing rental income during the 6 month holding period. 

I guess the part I'm not clear on is...

Whether or not this is basically a syndication and I'd need to go through all the SEC requirements to register...and since none of the investors are accredited how will that impact my ability to do this. 

Has anyone done anything like this before? Pros? Cons? Feedback? Advice? Random Commentary? 

[Don Konipol]

@James Masotti, the advice given by people with little or no knowledge in a particular area may be well meaning, however it is often dangerous.

What you propose is the definition of a securities offering. The sale of limited partnership interests or LLC memberships, in which the investors are by definition, or by fact passive, or even somewhat passive investors, is a securities offering.

Whether the offering is subject to Federal Security Laws, and hence regulated by the Securities and Exchange Commission, is dependent on a number of factors.

If the offering is limited to residents of only one state, the general partner resides in that same state, and all the properties are located in that same state, then the offering is probably exempt from Federal regulations.  In that case the offering would be regulated by State Security laws of the state the offering takes place in.  Many state securities regulations mimic, at least to a major degree, Federal regulations.  Some do not, and some are totally off the wall.

If the offering is made to a limited number of investors, all of whom you have an existing relationship with, and no general solicitation or advertising is utilized, you probably qualify as an exempt offering through the private offering exemption.  However, there is no guarantee that the SEC will view the offering the same way; the best you can do is get an opinion of a qualified attorney who specializes in securities law.

More troublesome for this type of "general" private offering exemption is that in the event of a lawsuit you may lose your statutory defenses; i.e., a non Federal judge may decide that your offering did not qualify for the private offering exemption or that you did not fully disclose the risks associated with the investment, and your legal defense would be severely hampered.

In order to rectify this scenario the Security and Exchange Commission has issued "safe harbor" rules, the most popular of which is Reg D 504 b or c.  By complying with these regulations, and filing a form D with the SEC, you are almost certainly assured of being in compliance with the offering exemption for private offerings.

The downside is time and cost.  To prepare the necessary Private Placement Memorandum, to complete and file the form D, and to file notice with whatever states your investors reside in, will cost $15,000 to $20,000.  

Please understand that over time the SEC has become much stricter about compliance.  However, the SEC staff is relatively small and in almost certainty your offering would be off their radar even using just the general private offering exemption and forgoing the safe harbor.  Much more troublesome would be should one or more of your investors lose money, or even not make the return they feel they were entitled to, and sue you.  Without following the safe harbor procedures your exposure in court is increased greatly.