Managing Private Money

26 Replies

I have some private money I can use from multiple people. How should I go about managing it? Do I create one checking account and have everyone transfer money in there? Would this get flagged by the FBI if there's transfer of 40k to 100k going into it? Or do I get a lawyer and do an escrow? 

I would be very careful as it sounds like you might be creating a security by managing money in a pool. Reg D (Particularly 506(c)) is the exemption from registration that most funds like ours use, but it has strict rules on who you can take money from (accredited/qualified investors). We have a private offering memorandum set up to create the fund and a management agreement between the fund and our company to manage the fund. We don't do business in NJ, so I don't have an NJ attorney to refer you to, but you would want to chat with a securities attorney about the possibility of forming a Reg D offering if you are accepting $ from a lot of people. If it's just one or two in a partnership of some sort, then that's a different story. I hope that helps. Good luck!

@Uneeq Khan Generally private money is used per-property via a loan secured by the property  property (Mortgage or deed of trust). The problem when you just borrow money not allocated to a specific property is; how do you decide when to pay it off? It is too easy to spend some money on this and some money on that and then the money is gone and you are unable to pay back your investors.

Pooling money as @Doug Smith suggested can be considered a "Security" and get you in trouble with the SEC.

@Doug Smith @need Carey 

thanks for the advice. Not trying to create a securities. Just 3 to 4 investors looking to put funds together on a per property basis to BRRRR.

@Uneeq Khan Securities laws are tough. It is very easy to break them without meaning to or realizing it. If someone invests with you and they are a passive investors without control of the investment, then you have created a security.

That said on  the scale I suspect you are considering the risk of any enforcement is low. Lots of real estate investors do this every day with no problems. Just be aware that you may be breaking a low without knowing it. 

@Uneeq Khan If it's just three or four people that know each other, then I don't think you will have an issue with creating a security. Creating an LLC should work. I would certainly put together a strong Operating Agreement though that clearly defines everyone's authority, roles, responsibilities, percentages of profit, how it will eventually wind down, etc. Many, many years ago when I was a banker and thought I could do everything myself, I had the opportunity to invest in a non-real estate related business with a family that I thought were friends. As soon as my money was in they stuck it to me. I thought I could negotiate the operating agreement on my own without an attorney's help. That cost me over $150K and almost cost me my marriage. I'm not saying you have to get an attorney to represent you...that's your call. Ever since that day I always get an attorney to draw up my docs. Good luck. I hope it goes well and you have great success.

@Doug Smith @ned Carey

One of the partners would be actively involved and would be forming an LLC with while the other would be very passive basically offering funds to help support us (my mom). When we combine funds, where and how should it be stored and used for the project.

If you have more than one investor then it falls under securities law. The statutory definition of securities is as follows:

The term “security” means any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a “security”, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.

@Jillian Sidoti I have always wondered about the word "note".  Why are private loans, hard money loans, etc not a considered security?   Is this a case of technically it is, but SEC has always looked the other way?

You mentioned "If you have more than one investor"  Private Money Guru Alan Cowgill used to say that. He called it "Pooling Money" I have never read anywhere about the law that says there has to be more than one investor to be a security. It is not in the definition above. It is not in the "Howie test."  I have never seen the word "Pooling" in any law or regulation. Have I missed something?

Thank you

@Ned Carey its the fractionalization of the note that gets you into trouble and also the fact that is is not secured.  A private money lender is a) one party, so not fractionalized, and b) secured in 1st position (exempted).  @Uneeq Khan any time you take money from investors where the returns are generated by YOUR efforts (passive investors v active) you are issuing securities.

@Mauricio rauld

then how do I make it not a security? I'm always hearing about "using other people's money", what's the legal way to do it? 

This sounds like you're acting as a bank, which is not allowed. If you are getting private loans, the lender should put a trust deed or mortgage (depending on the state) against the property and you would simply receive the money at the time of closing, which should be done through a lawyer or title company (again, depending on the state).

@Uneeq Khan Reading all the comments above, I think it is fair to say that there are some people out there teaching these OPM [Other Peoples' Money] strategies and they themselves have no idea about the legal structures necessary to stay SEC-compliant. 

@Ola Dantis Alan Cowgill and John Ulmer were both teaching this for years before they got slapped with a violation from the SEC. John Ulmer got hit really hard and I think may have gone to jail.

Originally posted by @Mauricio Rauld :

@Ned Carey its the fractionalization of the note that gets you into trouble and also the fact that is is not secured.  A private money lender is a) one party, so not fractionalized, and b) secured in 1st position (exempted).  @Uneeq Khan any time you take money from investors where the returns are generated by YOUR efforts (passive investors v active) you are issuing securities.

In my Hardmoney days in CA  as a CA real estate broker I did fractionalized loans all the time in fact all of them were.. but that's CA and you need a licensed broker to do them.. 

I am wonder if a TIC type situation would work here.. they pay cash own it out right as tenants in common with written agreements.. ???

 

@Jay Hinrichs My understanding is that tenant in common, in and of itself, is not a security. An industry developed to do tenant in common investments for people who wanted to do 1031 exchanges.

However last I read there was some dispute over whether the management agreement between the investment sponsor and the tenant in common owner was a security. I don't know if or how it was resolved.

@Mauricio Rauld I'll ask you the same question I asked Jillian. Why is a single investor not a security. You said secured in first position is exempted. I have never seen anything stating that. By the definition of a security, as Jillian posted, it does not seem to matter whether the investment is secured or not to be considered a security. Can you expand or point me to a reference?

Thanks,

Ned

Originally posted by @Ned Carey :

@Jay Hinrichs My understanding is that tenant in common, in and of itself, is not a security. An industry developed to do tenant in common investments for people who wanted to do 1031 exchanges.

However last I read there was some dispute over whether the management agreement between the investment sponsor and the tenant in common owner was a security. I don't know if or how it was resolved.

@Mauricio Rauld I'll ask you the same question I asked Jillian. Why is a single investor not a security. You said secured in first position is exempted. I have never seen anything stating that. By the definition of a security, as Jillian posted, it does not seem to matter whether the investment is secured or not to be considered a security. Can you expand or point me to a reference?

Thanks,

Ned

Developers in San Fran were trying to do tics to circumvent condo and rent control.. it went on for a while then laws were changed never really followed it in detail since I did not do any of those deals..  

the issue with the security things is that so many of these deals are so small IE 4 dudes or dudettes going together to buy a 100k rental.. who is going to spend the money setting that up as a PPM..   I mean to me its hardly worth it for 1 million dollars I did a few of those and the expense and record keeping was such that I just killed them.. To me PPM needs to be 5 mil or above to go through the brain drain. 

 

Originally posted by @Uneeq Khan :

@Jay Hinrichs

So overall, I can't use other people's money without it being a security? I can only use the money of my partner who I'm forming the LLC with?

I am not saying that.. there are many ways to structure deals that don't need to have securities or PPM's issued.. 

but if your putting passive investors that you don't know into a common enterprise that you control then that I think is the definition of the HOwrey or HOwie test.. and I did get stung on that one personally by the state of Oregon department of corporate finance so I am sensitive to it.. my only blemish in 44 years.. there are other ways.. to structure these.. 

 

@Uneeq Khan The way that we do it is we don't offer any equity share in the profits of our deals. In other words someone can make a loan to our business. We create a promissory note outlining the terms of the loan. Often times we offer 8% APR On their money while it is lent to us for up to one year. Sometimes we will offer 9% or 10% if their money is lent to us for two or three years. It is not an investment that goes up and down. It is just a private money loan. It is not an equity share in the property it is just a loan in second position - the same as a HELOC would be.

We also give them a deed of trust on one of our properties that have enough equity to make sure that it is leverage less than 80%.

Regardless of how well the investment does for us, the private money lenders always get their money back plus the interest indicated in the loan documents.

@Shiloh Lundahl

So as long as those involved don't have shares of the equity, it's not a security? My partner, my brother, who I'm doing the LLC with, would have equal shares of all the property. The third person, my mom, is lending part of the fund, at basically 0% interest (because moms are awesome like that). She doesn't want equity, just the entire amount paid back. Would this be a security? Would a note even be required?

I don’t think a note would be required for your mom but it is good business to do that anyway. Depending on the amount, your CPA will want to look at it as a loan rather than a gift where you could have to pay a gift tax if it’s over around 14k.

You'll probably want to create an LLC with your brother and partner if you are all sharing in the profits and outline the expectations of of how profits will be divided and what happens if there is a loss. That is probably the most important thing to explain. When there is a loss and people start to lose money and there isn't a specific thing written explaining how that is supposed to work out, that's where things can go really bad.

@Ned Carey , the amount of investors you have does not matter.  You can have 1 investor and if they are passive and just giving you money, you are issuing a security.  There are certain exeptions to it being a security (but these only apply if you have 1 lender).  For example, a note that is less than 9 months is not a security.  And it is generally accepted that a loan secured with a 1st mortgage is also exempt from a security (there are other exemptions as well that dont apply here), but I listed below FYI.  But the minute you have more than 1 investor in those 2 scenarios, you now have fractionalized it and it becomes an investment contract and you are back within the definition of a security which is quite broad under the SEC definition.

Judicial Exceptions include:

  1. A note delivered in consumer financing; or
  2. A note secured by a mortgage on a home; or
  3. Any short-term note secured via a lien or assets of a small business; or
  4. Any note evidencing a “character” loan to a bank customer; or
  5. Short-term notes secured via assignments to accounts receivable; or
  6. Any note which formalizes an open account debt incurred in the ordinary course of business, especially when collateral is involved.

@Uneeq Khan You raise money from other people by recognizing that you are issuing the a security and simply comply with federal and state securities laws.  Thats what syndicators do.  They raise money from other passive investors and comply with the SEC rules.