“It is natural to indulge in the illusions of hope. We are apt to shut our eyes to that siren until she allures us to our death.” – Gertrude Stein.
For many real estate investors, the thought of raising capital to increase their purchasing power is an irresistible allure. However, how one goes about this business can have serious long-term ramifications for the uninformed.
When you’re dealing with other people’s money, you need to make sure you are setup correctly. In the post Madoff climate, we now find ourselves with state and federal agencies that are pursuing a take no prisoners attitude when it comes to investors who raise money. Failure to comply with the securities laws increases an investor’s risk of lawsuits by other investors – and can even lead to criminal prosecution. Remember, ignorance of the law is no excuse and even an innocent mistake can lead to court and likely jail.
If you are not deterred by these warnings . . .
Here are a few things to consider if you plan on raising money for your real estate investments:
If you plan on raising money with an LLC, start by registering your LLC in the state where you will be working. A mistake made by many investors is raising money through a Nevada entity without proper registration. This is a path to jail where you will not pass “go” if things turn south for your investors.
Draft an operating agreement that details how the funds will be invested, distributed, managed and any fees paid for management. This is a crucial step for any investor because the operating agreement puts everyone on notice as to how the funds will be handled i.e., it’s a point of agreement between you and your investors about how the LLC will operate.
Many real estate investors will not proceed past this point in their fund raising activities. In other words, I have my LLC so let’s start making money. Unfortunately, to stay completely legal (out of jail) you must also be mindful of state and federal securities laws.
When one or more people buy into your LLC, you are selling what the government calls "securities" and there is an extremely complicated set of laws that govern this activity. For example, most real estate investors are not aware that borrowing money from outside investors can be construed as a security. It’s sad but true and I have read of a few situations where the SEC put promoters in orange jump suits for their borrowing activities.
It sounds scary, but if you follow the rules from the beginning, it’s not that bad. Generally, when raising money your fund will fall under "Regulation D," which gives several exemptions. Here are some general guidelines, but as I tell everyone with this idea – CONSULT A SECURITIES ATTORNEY IN YOUR STATE:
- Try to Partner only with Accredited Investors who meet one of the following criteria:
- An individual with annual income of more than $200,000 per year, or a joint income of $300,000, in each of the last two years and expect to reasonably maintain the same level of income.
- An individual who has a net worth exceeding $1 million, either individually or jointly with his or her spouse excluding the personal residence.
- An individual who is a general partner, executive officer, director or a related combination thereof for the issuer of a security being offered.
- Keep your offering private, never blatantly advertising to the public. On the other hand, you can provide general information about what activities and why you need money.
- Raise no more than $5 million
- Require your investors to sign a Subscription Agreement
- Do not guarantee a rate of return or refer to performance of past offerings
These are just some of the concerns you should address prior to raising money for your investing. Remember, it is better to spend a few thousand with an attorney on the front end of your business rather than tens of thousands if things go wrong.