BiggerPockets

Hi all

My partner and I have a few properties under our belt at this point. Up to now we have been using hard money for the rehab phase, it costs a lot but it's a necessarily evil.

We have connections to some folks that would like to invest in our business (meaning we wouldn't be advertising for investors).

We are talking to our attorney about setting up an LLC and selling shares from that LLC to fund our rehabs. We would back up the investor LLC with the property we are working on, we would also pay out 12% per share at project completion.

I know there are a lot of considerations to look out for but is the above idea even legal?

Thanks

You need to work with a securities attorney. They will be able to set you up as needed to do what you are trying to do.

These types of deals generally pay a preferred return and some split thereafter. If you set things up with a "match" or "make-up" return it keeps things in balance and is fairly easy to explain to investors.

Oh and to add to the above, long term it would be possible to use this "Investor LLC" to fund other RE investor's projects with us adding markup.

Seems like a pretty good way to do things so either lots of investors are already doing something like this or it's illegal. I am wondering which is the case.

Thanks Jon

Out of the gate we are talking about 7 to 10 private investors with between $5k to $10k invested each. My feeling is we are talking about $90k to $100k worth of shares total.

I assume that would probably grow later as original investors reinvest and new investors come on board but we are not talking about a couple of hundred thousand dollars for some time if ever.

So you don't believe something like this can be set up by a typical real estate attorney then?

No, this isn't a real estate attorney specialty. Its a securities law specialty. You could, of course, have an attorney that specializes in both.

You don't want to do this. You're talking tiny investments. Maybe Bryan has a cheaper way to do it, but people I know who have done this have spent about $25K on the legal fees to set up a private placement. You're also better off to target "accredited investors", which is a specific SEC term. IIRC, an accredited investor is someone with income over $200K and the expectation of that income continuing, or over $1 million net work as an individual or $2 million as a couple. Don't quote me on that. If you have investors kicking in $5-10K they probably don't meet this test. You can still have them as investors, but that does add complexity and you really will want to be sure all your I's are dotted and T's are crossed.

There were some pretty lengthy discussions a while back on this topic. Maybe Bryan can point those out. I'm pretty sure I'm not sure what the conclusion was. Someone claimed that even a plain vanilla loan might be a "security".

I think there's a case that a loan would not fall under a security. So, if you had three, or ten, investors who were all willing to get in line with one having a first mortgage, one the second, one the third, etc., it might be OK.

I think there's also a case that if two buddies who's know each other for a while get together and create and LLC, then put money into the LLC, and then have the LLC do something like make a loan to a rehabber, you're probably OK.

I think you are over the edge when you convince others to invest into your deal. If you get two or ten people to kick money into one of your deals in the form of units in YOUR LLC, then I think you're just sold securities.

At least, that's what I took away from all that discussion. Not a lawyer, don't want to be.

Ahh...the classic question is now coming up. I have spoken to numerous attorneys about this and IMO it is really a definition of degree. The classical case is SEC vs. Howey where the definition is clearly defined. Here is a decent piece of literature I found doing a quick Google search:

Clear As Mud?

If you Google "Howey and Security" or some such you can read through reams of information and fall asleep quickly.

I saw an opinion recently from a well-known CCIM/Securities attorney that has written several popular books that claimed loans are likely securities. Here is part of that opinion:

//Quote Trowbridge
Sometimes an investor who is looking for one other person to provide debt for a transaction, perhaps in the form of a hard money loan, is not working with a security. In a hard money loan, with a one-on-one relation between the borrower and lender, it is likely that no common enterprise exists. If the borrower does not pay, the lender forecloses, as the relationship is more adversarial than a common enterprise. However, some attorneys take the position that if there are multiple beneficiaries or if the note calls for equity participation, debt may likely considered to be a security.
In a strict equity raise, the issue of whether a security exists is likely dependent on the control of the project by one or more persons, as in a manager-managed LLC. When all decisions are made unanimously, as in many member-managed LLCs, it is possible that it may not be a security.
//End Trowbridge Quote

I don't know all of the circumstances in the questions above, but the passage from Trowbridge points to the common enterprise part of the securities definition. I think a helpful question to ask is whether or not the relationship would put folks on the same side of the table in the event something goes south (a common enterprise) or if the relationship would be adversarial.

I have a hard time believing that individual loans combined to capitalize independent pieces of a transaction could be considered worthy of a reg. D exemption. However, if you start to pool more loans to capitalize your transaction, put together marketing decks for new investors, or pool many investment dollars into "one loan" that to me is more security-like and I would want the exemption.

Really it all boils down to risk tolerance at the end of the day. If the deal goes south I want as much protection as possible. PPMs are set up to protect the promoters...not the investors. If you can pay the loans back out of your own equity and use the loans to keep less of your capital in a deal you really could just pay the loan back presumably. If you can't then I would want more protection.

Clear as mud...eh?

I did search and I didn't find anything. Probably bad search terms on my part. If anyone has a link to one of the other threads I would love to read some more on this.

So as an update, I did talk to our attorney today. His firm does real estate and SMB law (LLC's, LP's etc). I mentioned some of the posts on this thread and he said it didn't sound as complicated as all of that. *shrug*

I am skeptical but I want to hear what he has to say, he is going to get back to me after he researches for precedence etc.

As we were getting off the phone his thinking was that we would just set up a separate LLC for each property in rehab. Yes we would pay for the transfer into our long term buy and hold LLC but that would be worth it to us for various reasons. We would still be the managing members and the other folks would just have a stake in the LLC based on the amount they buy in for.

Because we are not advertising and we would have less than 10 members involved with any given property the lawyer didn't think we would have a huge problem figuring something out.

I guess we will see. If anyone has any other ideas please let me know. I am all ears because I want to go into this with as much info as I can.

Thanks

As Jon said, you really need an expert to tell you.

IMO - I would forgo trying to sell stock in favor of selling DOT's because of these regs.

If you are going to set up an LLC for each property are you not doing the same thing?

I see that you are trying to use small investors to do this, but it is far easier to raise larger amounts of money using them in a DOT/lien position.

What I haven't seen here is what happens when one out of 10 investors want's out or files a complaint with the SEC?

You are looking at a huge liability to the other investors unless you are prepared to automatically repurchase the shares. Even if you do that, it won't make you look better to the SEC or court.

Some others may know more, but on a single asset LLC the court remedy is to liquidate if I'm not mistaken. Now one bad apple makes the whole deal bad and everyone is looking to you to make them whole.

That is really a bad situation to be in with the SEC or in court.

This is a private placement. That simple means selling securities (i.e., signing up members to your LLC) without advertising publicly. It will be a "regulation D" offering.

Glad to hear your lawyer referred you to someone else.