Should I Give Up a Piece of the Action or Give a Promissory Note?

Private money deal structuring is one of the most important skill sets you can develop as a real estate investor raising capital. I'm assuming, of course, that you've already made the decision to raise private money - perhaps you have an investor already - and you're looking for ways to set up the deal (amount invested, ROI, timing, etc.) so that both you and the investor are happy.

Admittedly, this can be a tricky balance to reach. After all, you would prefer to pay the lowest return possible to get the money and your investor wants the highest return possible for placing their funds. Don't worry: this is nothing devious from either party, it's just basic business.

A thousand years ago, when somebody wanted

capital to make more of something or to take goods to a far off place- there was most likely a back and forth between principal (the investor) and agent (the business owner) about how much of the spoils each party would get. The middle ground where both principal and agent meet is the return that is paid.

Businesses may change and evolve  over time, but guiding principles don't. If you can afford to pay 15% per annum to an investor but the investor is happy with 9% on their money, which return are you going to pay?

This begs the question that real estate investors run into all the time: "should I give up a piece of the action (e.g. profits) or simply pay a fixed rate or return (e.g. promissory note). One option offers the investor a fixed return, which some will like, and the other offers the investor a chance for potentially larger gain but not explicit return on investment.

Let me submit that you're going to be giving up a piece of the action either way - so you might as well structure the deal so that both you and the private investor get the biggest benefit. What this means is that your loan payment on a promissory note is paid out of your cash flows just the same as divided profits would. There aren't two sources of cash for paying each investment type.

If all things are equal, a big issue to tackle would be the tax treatment of the profits for each private money investment. For instance, interest paid on a promissory note is taxable as ordinary income to the private investor and is a pre-tax expense for your company/project. Profits paid out of coffers to a private investor are not tax deductible for your company/project but they may be taxed at lower rates (e.g. passive income) for the private investor. Private money equity sharing could also give you more flexibility in when cash flows are distributed from your company or investment project.

As you evaluate your investment project with private capital factored in, you must take all factors into account. I have found many equity deal structures to work extremely well as opposed to using private money loans. You're still using private money, but the set-up is different. Many of your private investors will be at least interested in the tax treatment of their investment with you. Structuring a deal so that they get dividends or capital gains versus ordinary income could mean the different in getting $100,000 or $500,000 in funding.