How to Form an Investor Pool?

Question

Hi All,

I have a few investors looking to invest in a few potential properties.  I need to pool their money together but I have a question.

Typically, do you provide a return on the investment while holding the funds, i.e. while waiting to see if a potential property pans out?

Thanks!

Monty

Dion DePaoli · Answer

I would suggest the 'better' question is, will the investors place money into your care without having an investment to make.  The driving force of that answer is whether they will make return while doing so.  Why give you money which doesn't generate return that I can leave sit generating a return while you hunt for an investment?

Typically when a manager takes on capital, from the day it is received by the manager, the return is calculated against that time.  That is regardless of the investment being made or capital being deployed.  Good managers will perfect the timing of capital deployment and investment identification.  This saves the manager money by not having to pay return or calculate return on capital that is not invested.

It is not exactly clear what you mean by, "...see if a property pans out.".  The interpretation being used right now is you mean, when you have an offer pending.  Hopefully that is what you mean and not whether or not the investment makes a profit.

What you can do, as some other managers do the same, is create a capital call with the investor.  This means you sign them up, get all the agreements set up and then go hunt for an investment.  Typically you would retain 10% in an escrow account from the investor and when the investment is identified you 'Call' on the capital in full balance to be delivered.  Penalty for the investor is he looses his 10% if he fails to capitalize the venture.  Clearly the other similar way to do this is simply escrow nothing and call on the investor for full investment only after the investment is identified.  This really depends on the relationship you have with the investor.  The idea there is you might take a little while to find an investment and want to make sure the investor is ready when the investment is ready and doesn't tall you he is good to invest and then makes another investment without you and ties up his capital.  These types of agreements with the investor can be a little ad hoc, you can let the investor earn the interest on the escrow funds, provide they agree, which will help offset the holding time, even for the 10%, you would have a return to calculate.

There will be some complexity to pooling independent investors.  They may want different terms.  In addition, they may have different ideas on the capital structure, ownership structure, investment structure or other structural issues.  So you need to think through who your investors are and will they all be homogenous investments in terms of structure or can you pair them somehow to make similar terms.  Concerns about rates of return and investment horizon might create more than one grouping of the investors.  For instance, if J. Scott and I both invest, say he wants an investment horizon of 3 years, but I only want 2 years.  Will you liquidate the asset in 2 years?  Will you simply replace me with another capital investor?  If so, how you will you calculate my return, do I share in any equitable upside calculated on the future exit of the asset?  What if one investor likes debt and the other does not want to be in a first loss position?  The list goes on.

You may be able to solve this by putting investors into each asset in smaller groups opposed to taking all investors and pooling all money.  That too becomes a bit complex.  How will you structure your enterprise?  Will you have a parent company owning subordinate asset holding companies with each investor inside each sub company?  Perhaps you will not roll them up into a parent at all.

Certainly the other approach is you go formally into a pooled fund structure.  This means you have to produce a prospectus and subscription documents with all the terms and conditions spelled out.  This creates a uniform investment structure for the investor.  They all have the same investment horizon and have the same powers subordinated to the manager perhaps.   The investors are simply pro-rated in to the fund while it is open for investment.

As you become more formal, you will incur more administrative costs.  Because of this, you will want to really plan that out.  Accounting, including auditing if required for your exemption as a security, distributions to investors, plus asset management all will take time and money to stay on top.  You will want to make sure you have a good team to use.

If you are thinking of this formal investment fund approach you should look up some of the threads on Regulation D and start to become familiar with the general idea of the securities exemptions.

All of the above, by the way, is for an equity investment by the investor.  What if the investor wants to come in as debt, inside the LLC or attached to the property, both have their own new set up situations separate from above.  However, in that case, if you take the capital as debt, you would accrue interest from the day you receive the capital, regardless of deployment.

J Scott · Answer

Will they be actively involved in the business and the real estate transactions?  Or will they just be handing you their money and waiting for a return?

If they're not actively participating, there are lots of time-consuming and costly legal and accounting hoops you'll likely want/need to jump through to do this legally (pool money).

If they are actively participating in the business, there is no reason to provide a return while you're evaluating the properties, as nobody has made an investment yet, and presumably they're doing as much work as you are when it comes to deal evaluation.

Jesse Rivera · Answer

Jillian Sidoti, glad to see you chiming in on the Forum. Investor pooling is a complicated subject, and I'm glad we have an expert on the forum.

I see you are doing a workshop here in Portland on the 20th. I am hoping to make it!

Jillian Sidoti · Answer

Monty Corbett -First, make sure you have all the proper legal documents. If you are "pooling" you need to have  PPM, proper disclosures, subscription agreement, and proper legal formation. You also need to file all of your FORM D's.

Second, I also write in my PPM's for my clients that "NO RETURNS ACCRUE" while money is in escrow and NOT in a property. This is never a problem. It IS a problem, however, if you promise returns from day 1 and then can't deliver.

Jillian

Monty Corbett · Answer

Thanks for the response guys... this is very helpful!

How to Form an Investor Pool?

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