Just like private investments are not for everyone, raising private capital is not for every company. However, compared to other funding options, raising private capital is appealing to many small companies looking to take their business to the next level.
There are a few reasons for this. Private capital doesn’t cost as much or take as long as a public offering. It also doesn’t have the pressure of immediate repayments like debt, and it opens up greater access to more significant and higher-quality assets than self-funding.
If you’re considering raising capital from passive investors for your real estate ventures, you need to ask yourself hard questions. Doing private capital right versus wrong could mean the difference between taking your business to the next level versus facing potential legal headaches—not only from investors, but also from the SEC and state securities regulators.
Let’s start with who raising capital from private investors is not suitable for.
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1. This is your first rodeo
You should never start in a new investment class or industry with investor capital. And you certainly shouldn’t take investor capital if you’re not prepared or organized. You should already have experience in the industry and asset class in which you’re trying to raise money, and have a clear business objective and plan for achieving that objective.
If you’re unsure about any of the following key elements of the potential asset or investment, don’t take private capital.
- You’re unsure about current market trends involving your target asset.
- You’re unsure of the demographics or key economic metrics of the area or neighborhood you’re targeting. If there are fundamental market movements you’re missing, such as an exodus of workers, then you could be putting yourself in harm’s way.
- You don’t have experience with number crunching, and you’re not good at estimates, spreadsheets, or bookkeeping.
- You don’t have a team to compensate for your deficiencies with numbers, organizing, marketing, networking, etc.
- You haven’t conducted due diligence on or even inspected your target asset. Your investors will be doing due diligence on the asset. If you’re not prepared to answer questions based on your due diligence, don’t bring on investors.
2. You covet investment capital but don’t understand the actual cost of that capital
Raising private capital is not cost-free or labor-free. If you don’t understand or are not willing to learn about all the ins and outs of what it will take to launch a private offering, then you shouldn’t go down this route. Here are some of the expense and time demands to consider.
- Professional fees and third-party provider expenses to prepare legal documents, financial statements, and marketing materials.
- Personal time required to prospect and engage investors.
- Time and expense required to prepare supporting materials to pitch to investors, including an executive summary (offering memorandum) and financial statements
3. Like your investors, you’re looking for a passive solution
There is no such thing as a turnkey private offering solution. Raising private capital will require experience, knowledge, and expertise on your part and, at the very least, oversight to guide the capital raising process to its end goal. You may hire the best professionals and third-party providers to assist you in your venture, but if you’re not willing to oversee their work, then raising private capital is wrong for you. Here’s why.
- If you’re not willing to review offering materials prepared by attorneys, mistakes can cost you. Attorneys can provide the legal framework for your offering materials, but they can’t describe your business or terms of your offering as you intend. The only way to ensure accuracy is for you to review the docs.
- If you hire licensed brokers, you can get railroaded by their fees and commissions if you’re not vigilant. Did you know that the NASAA and FINRA 10% limits on underwriting compensation and 15% limits on front-end load do not apply to private placements?
- You should only take accredited investors. If you’re lax about this requirement, not only will you run into legal problems, but history has shown that non-accredited investors will be the first to complain to the SEC if they grow impatient. Accredited investors understand risk, are patient, and have the financial means to withstand investment losses. Nobody likes to lose money, but accredited investors are sophisticated and experienced and know to give sponsors the breathing room they need to grow the business.
4. You want to get paid whether your company is successful or not
The successful capital raisers are those who get paid only if the company is profitable. Front-loaded compensation is a turn-off for sophisticated investors.
5. You like your space and don’t like to be annoyed with partners who ask you questions
If you like investor money but don’t like investor questions, then private capital is the wrong path for you. Sophisticated investors prefer private investments for transparency and access to management. If you’re not willing to be open, don’t take on investors.
Who is private capital right for?
Now that you’ve asked yourself the hard questions about whether raising private capital is wrong for you, let’s explore who private capital is suitable for. If this describes you, then raising capital from passive investors should be a viable option for you.
- You’re confident in your experience and knowledge.
- You’re up on market trends and have a finger on the economic pulse of the neighborhood, area, and region in which you intend to invest.
- You have the infrastructure, personnel, and processes in place to execute your business objective and vision.
- You have meticulously calculated your financial projections and gone through them with a fine-toothed comb. You’re good at running numbers, projecting estimates, and accounting for contingencies and worst-case scenarios.
- You understand the risks of your investment and are confident in mitigating those risks. You’re not afraid to lay everything on the line and disclose those risks to like-minded investors.
- You’re thorough and willing to review the work of professionals and third-party service providers.
- You’re willing to give input but would prefer to get out of the experts’ way and let them do their jobs, and would rather defer to the expertise of professionals. In other words, you’re not a micromanager.
- You take your stewardship over investor capital and their trust in you seriously. You’re willing to defer compensation to give them preference with respect to cash flow and profit distributions.
- You’re willing to be open and transparent with your investors. You’re willing to always keep the line of communications open with them—good or bad.
Only you can decide whether to pursue private investors, but hopefully this gives you some essential questions to mull before taking this critical step. Taking private capital is serious business, but if you do it right, have a plan, and have the personnel and processes in place to execute your plan, it could be a gratifying endeavor for both you and your investors.
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.