How to structure the financials when friend is the bank and you are the contractor

Question

Hi!

My husband and I have begun the process of getting into house flipping. We are brand new to this; however, my husband has been in residential construction his whole life, including many years in project management of residential home developments. We have a friend who would like to put up the cash to make this flipping a reality. Our question is, how do we structure the deal fairly? Because my husband is a contractor, this will be his full time job. Meaning, we have monthly bills to pay, and so he has to take a salary. At least at first. Our friend only wants to act as the bank. We already know that hard money lenders make roughly 10-12% in holding costs and all of that. If we don’t structure it in that way, but instead we split the profits at the end 50/50, is that fair for all? My husband would get a salary (a contractor still gets paid during a flip - whether it’s him or someone else). Any advice is appreciated! We do know of all the risks involved in working with friends, but this is a happening deal. We just want to make sure is fair for all! Thank you!

Shawn Parsh · Answer

Shelly,

Is your financial partner willing to pay for the acquisition and the rehab costs? I would not agree as the financial partner to pay a "salary" for the work that needs to be done. I would be more comfortable paying for certain things getting done. You and your money partner could agree in advance how much your husband will get paid for what particular work he completes.

Having said that, what are you and your husband bringing to the table for this deal? If you are going to get half the profit at the end of the deal what are you doing for your half? If your husband is getting paid for the work he is doing on the property he is getting compensated for his time. So is your half of the profit based on you finding the deals, and negotiating the deals? I bring up those questions to highlight that I would look at it from your money investors view point to make sure you keep him or her happy. Would he or she be better off to hire their own contractor and pay them to do properties and not have to split the profit with you or anyone else?

I have done a lot of deals where I had a money partner, but I have never taken any pay for work I did on the property. I find the deals, negotiate the deals, plan and oversee the rehab, get supplies, coordinate for utilities, and have did a lot of rehab work on the properties over the years. From my perspective I earn my cut whether that is 50% or whatever is decided by doing those things. I don't take a salary or pay for my labor and half of the profit. Which means I have to have money to live on or other sources of income to keep me going during a project. I should only make my money (profit) when the deal is successful and my money partner gets their cut.

Having said all of that, as long as both parties agree to the terms then there should be no hurt feelings.

Shelly Byce · Answer

@Joel Forsythe, we are absolutely doing that. Going to get everything hammered out with a real estate attorney. We (construction side) already have an LLC in place, and our friend will form one as well. What did you mean when you said, “I would never do this if I wasn’t involved in the investment side…” Are you speaking from an investor perspective or contractor? Sorry, still learning the verbiage 😁

Shelly Byce · Answer

@Mike

@Mike Klarman  thank you for all that! Still working on the deets but will take that info to my hub. Appreciate the breakdown! 😊

Joel Forsythe · Answer

Shelly, first and foremost, starting out correctly with clear, SEPARATE, entities is very important. You should start getting referrals for an attorney to help you organize the structure and language for your described arrangement.

I would absolutely recommend the Investment LLC be 100% separate from the construction entity. Way too much liability in construction to expose the holdings to. Have your husband( as owner, ceo, whatever) of the construction entity agree to perform Cost-Plus contracts with the Holding LLC, as an outside contract. Organize standard line item for invoices for project expenses, but have him break down all the administrative/overhead line items that are being reimbursed, likely in a prorated fashion ie weekly or monthly percentages. His salary would be represented as a portion of that breakdown. This level of transparency will allow for very clear auditing by any member of the Investment LLC, as to what the construction owner is clearly profiting on the project aside from hard costs of the project. As an aside, I would never do this if I wasn’t involved on the investment side.  In the future, you’ve already built in a transparency of the monetary value for the contractor position, should the salary be  “waived”, “discounted” or “delayed-til-closing” as an added investment element.  I have used this successfully, and have leveraged the transparency for a “piece of the action” when I felt strong about the prospect of the project.  Not much of a value on small budgets, but if you start contracting well into the six figures and higher with the holding entity, it’s real money.

Mike Klarman · Answer

If your friend just wants to be the bank and park his money for a guaranteed rate of return then I think 10% is fair and pay it like a dividend.  So they will earn 5k per year in interest paid out in a monthly dividend of $416 and as long as you hold their 50k you pay the 416/month to them.  When you close the line you return the 50k.

So he floats you 50k.  You and your husband create an LLC that has this 50k in its account and you two go through the loan process, hopefully you get 85%/100% terms from a HML at about 11%.  You want the cost of the entire life cycle of the project to be no more than 40k if you have 50k, you'd want a buffer.  So you figure 25k for a down payment equates to a property worth about 166k that will need maybe 75k in repairs let's say for a total project cost of 241k (loan amount would be 216k approx), then holding and closing costs of about 15k.

Now when the project is over and you sell, you'd want to try and sell it for 241k/.70 = 340kish.  You'll pay:

6% or so in RE sales commission: $20,400

Payoff of a 216k loan to lender

Recoup your 40k for loan costs

That leaves 63,000

Short term gains tax 40% (25,200)

You net 37,800.  This project took 7 months let's say and you paid your friend out $2,800 in interest but now you have his 50k plus 37k more and your working capital is 87k now.  So you can either repeat in same price range or step up a little bit.  You can afford a 60k project life cycle now, maybe a 40k - 50k down payment which equates to a 300k+ purchase.

Shelly Byce · Answer

Shawn,

Just to reiterate, our friend will be doing nothing, except putting money in the shared bank account. If it were you, would you think paying a certain percentage on the money lent (like how hard money loans are structured) would be smarter for both parties for the event where a flip goes really well and our money partner make a bunch, or, where a flip doesn’t do as well and he doesn’t make much. Perhaps more consistent for him in that instance? We definitely will restructure once we’ve got a few flips under our belt. He is really doing this for our benefit. Making some money along the way is a bonus for him.

Shawn Parsh · Answer

Shelly,

If the money partner is good with the deal then go with it. I don't see 50 50 being a bad thing, but I would keep detailed records so you can look at how the deal turns out. You may need to tweak the agreement in the future. Maybe you are able to flip the property within a three month period and your money partner makes 50,000 profit on a 100,000 total investment. The 50,000 would be a lot to pay for only three months use of the money.

If a future deal looks similar I may want to change the split to 60/40 or something so I make a larger portion of the profit for doing the heavy work. Even at that percent the money partner will still make out great if all goes as planned. In the end, you want to keep the money partner happy because having someone that can fund deals on short notice with cash can really elevate your business.

Shelly Byce · Answer

Hi Shawn!

Thank you for your reply! My husband would be doing everything you asked. Finding the property, negotiating, finding and managing any subs for work he would not do (such as plumbing and electric), purchasing materials, doing quite a bit of the labor. I would be just as hands on plus designing. We would manage the sale as well (with realtor friend). Our friend would be funding the purchase and the rehab costs. Trying to wrap my head around this…. Is this scenario any different than a hard money lender lending 100% (we did find one), paying as part of the rehab cost, a contractor, and only reaping the benefits of the interest and points he would charge? My husband would be that contractor that is getting paid as part of the rehab costs. Our lender friend is making money off the split in profits rather than on the interest of the loan.

How to structure the financials when friend is the bank and you are the contractor

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