What's the simplest way to structure private equity deals legally

15 Replies

I have multiple friends/people in my network interested to be private equity investors/partners in my flipping deals in WA. The agreement is that I will be receiving 20% of profit for managing a deal from purchase to sale. Every partner will then get a percentage out of profit equal to the percentage their investment represents out of the needed funds. If there is a loss, it will be divided according to the same percentages. 

What is the simplest legal way to structure these deals given that every deal will have different partners/investors and the property being purchased for each deal is not defined beforehand?


Whether the answer is an LLC or not, what is the tax, title, profit/loss division and liability implications?
I am a newbie in such matters, so please explain in plain english :)

If you also have a recommendation for a real estate attorney in the Seattle area let me know.

Originally posted by @Reda Eldehiry :

I have multiple friends/people in my network interested to be private equity investors/partners in my flipping deals in WA. The agreement is that I will be receiving 20% of profit for managing a deal from purchase to sale. Every partner will then get a percentage out of profit equal to the percentage their investment represents out of the needed funds. If there is a loss, it will be divided according to the same percentages. 

What is the simplest legal way to structure these deals given that every deal will have different partners/investors and the property being purchased for each deal is not defined beforehand?


Whether the answer is an LLC or not, what is the tax, title, profit/loss division implications?
I am a newbie in such matters, so please explain in plain english :)

If you also have a recommendation for a real estate attorney in the Seattle area let me know.

 That sounds like a security requiring $50 k to $100 k in legal fees for rule 506 PPM, prospectus, subscription agreement with risks identified, 6-page term sheet, reg D filing. Stay away from doing a security without the right disclosures.

I'm not a lawyer so talk to your lawyer on this opinion of mine. Disclosure: this is not legal advice.  It was taught to me by my attorney and so it as it is. Rather than dividing profit equal to the percentage of investment (which could be considered a general solicitation, here are some alternatives.

1) Fund each property in it's own LLC and each investor brings money on that that LLC for one property.

2) Set-up an LLC through your attorney (don't do this on your own) where you are the managing member at 20% and 4 friends are members who buy in at lets say $10,000 each as members. The members can always loan money to the LLC, let's say $100 k at 7% each. If your attorney says this is not a security, then discuss how this can be done. The members get interest on their loan collateralized by chattel (assignment contracts, houses owned while the LLC is flipping, etc.) and they also get their membership interest in the LLC.

I can't emphasize enough the importance of getting a good lawyer that understands Securities in this type of deal structuring.

If all of the investors are in your state then a 504 exemption is likely more flexible for your situation.  There may be other state exemptions too.  You need to speak with a securities attorney in your state, but you can probably get an offering memorandum (or PPM), OA, and subscription agreement set up for about $15k or so.  

Call Jillian Sidoti

http://www.syndicationlawyers.com/

If you are long time friends with the lenders. Then a Joint Venture and JV agreement might be a path. I'd suggest: one partner per deal. No pooling, no multiple partners. Then a JV could be a path. The partner must be an active investor working with you making decisions. Not a passive investor just lending cash. I suggest a 50/50 split not 80/20. You bring the deal, you hustle they get 50%. You'll find that after doing the math you can't afford to work on 20% of the proceeds!!! Unless it's a 200 door multifamily. Then the managing partner (team) usually gets 30%.

I'm in this org, good folks.  I'm not suggesting their materials would pass your Attorney's review.

As the other posts have alluded to, you need a local attorney on this matter. There are hundreds of local legal rules that could impact the analysis of how you ought to do business, under what type of ownership structure, and what that might mean for any taxable income. Generally speaking, an LLC isn't the only option available to you. Some other options include a Limited Liability Partnership, which has a low amount of incorporation cost, low reporting standards, and an informal organizational structure. No matter what, you should thoroughly discuss your objectives with your attorney for a better game plan of how this should be structured.

Originally posted by @Bryan Hancock :

If all of the investors are in your state then a 504 exemption is likely more flexible for your situation.  There may be other state exemptions too.  You need to speak with a securities attorney in your state, but you can probably get an offering memorandum (or PPM), OA, and subscription agreement set up for about $15k or so.  

 In Washington State, everything is way more expensive because the state level (department of financial institutions) is way more strict and demanding than the SEC. DFI will go through every property you've purchased. I have heard of investors getting fined for doing subject-to and lease options with the loan purpose of owner occupancy because the investor was not a licensed lender. DFI often makes you change the prospectus over and over. 

Well then maybe a Reg. D, 506(b) or (c) offering is better.  A local securities attorney will know best.  

Hi @Reda Eldehiry , nice to see another Seattle software engineer on BiggerPockets!  I myself am a retired software engineer at the age of 27 thanks to real estate.  I can't imagine someone at Amazon being able to take on flipping alone though; it's definitely another full-time job, and at times even more taxing than a 60-hour workweek.  Kudos to you!

I'm not an attorney, but I can definitely refer you to the one I use in the Redmond/Kirkland area if you want to PM me.

Everyone is bringing in SEC/DFI, and I don't think it has to go there. Since you're a new flipper, I would just create an LLC for the first deal/property, and then see where it goes from there. That's the simplest and least riskiest way to get started.

You can lay out of the terms in the operating agreement (of the LLC you created) for that specific deal, and because everyone is considered a partner (and not a lender) and a PPM isn't involved, I don't believe the SEC needs to get involved. Of course, talk to an attorney to verify this.

The hard part is knowing how much each person needs to put in (because you don't know what property you're going to buy yet). You could potentially lock up a property in an uncreated LLC's name, then create it right after mutual acceptance, but that's a bit risky and requires a lot of up-front planning, so I don't recommend this route.

Another route you can simply do is have title in your name, and then have all of your investors in a fractionalized 1st position note (with deed of trust).  You can spell out all of the terms in the note itself, including profit share.  This allows you to really align things per deal with different investors and investment amounts.  If it's a 1st position lien and your investors are friends and family, I don't believe SEC/DFI needs to get involved either.  Again, something to talk to an attorney about.

However, if this is your first flip, all of this is honestly a huge, unnecessary headache.  Try to do your first flip with your own funds if you can (and use a hard money lender to leverage most of the project costs).  Your investors will probably want to see you have some experience anyway.

Be careful what advice you get on the internet.  If you're controlling the deal and the other investors are passive you have a securities arrangement; period.  

Talk to an attorney.  

@bryan 

@Bryan Hancock is correct. Talk to an attorney. I hear a lot of flipper deep in the wrong side of the black and white doing good things with their investors and everyone is happy. The problem is, when the engine fails, you have no parachute. 

Thanks everyone for your advice and suggestions. I think an LLC per deal is a good route for me for now given the scale I am operating at. All the other options seem to be way more expensive and cumbersome for the stage I am at. I am going to consult with an attorney first though to fully understand all my options and take my final decision.

@Ryland Taniguchi Thanks for the detailed response. I will investigate each one of the options you mentioned. Since you are in Seattle do you have any recommendations for attorneys?

Thanks @Curt Smith for the attorney recommendation.

@Bryan Hancock Thanks for stressing the fact I should seek professional help. I will diffidently do. 

@Nghi Le Your story is inspiring. I have kind of a similar story but not as interesting as yours :) I will pm you for the attorney contact. 

From Nghi

However, if this is your first flip, all of this is honestly a huge, unnecessary headache. Try to do your first flip with your own funds if you can (and use a hard money lender to leverage most of the project costs). Your investors will probably want to see you have some experience anyway.

If you get a good price on the rehab house hard money lenders will be glad to finance your deal as Nghi suggests.

Too bad some states like OR, OH perhaps WA are tough states to do JV's in. Many states like GA have in their SEC regs: one lender, on a 1st lien, is not a security. Making it easy to take one lender who gets a 1st lien and note (mortgage) stating the payment terms, on a deal without the LLC etc fuss. BTW the LLC does nothing to setup a borrowing relationship unless you have an Attorney write up the Operating Agreement that typically creates a manager class of stock and lender class of stock and rules for disolution, payout, disagreements... For states that don't require a full SEC filing, PPM, the LLC + Operating Agreement route is functionally (if you read both the PPM and Operating Agreement) about the same level of legalese and nearly the cost as the SEC 504/6 + PPM route. :)

An LLC without a credible Operating Agreement is almost worthless, even for liability containment. My inference is that if you don't know that you need a credible operating agreement then the LLC member(s) surely don't know the practices to maintain the corporate vale... [annual meetings with notes, no co mingling of personal with LLC funds in the LLC's bank account and a few other steps].

My issue with all of this is that this is your first flip, right?  When you're starting out in real estate, I always recommend to keep it simple and focus on the income-producing activities first as opposed to spending money on creating complicated legal structures.  Doing a flip is hard enough, so there's no need to add more complexity to it.

I spent 6 months wasting money on setting up an LLC and asking attorneys and CPAs all sorts of questions. And then when I acquired my first property, to save myself a headache I just put it in my own name, even though I already had an LLC. Because it's not just about setting up the entity correctly, but you have to run it correctly as well.

Flipping isn't for everyone.  And until you do one and decide that you want to keep doing it, I don't recommend spending thousands of money for a legal structure that might possibly be used just once.  And if you do decide to go through with it with your money partners, and you lose money on the first deal, then you'll probably lose your money partners (and perhaps friendships) as well.  I personally wouldn't put my relationships at risk in a new venture.

In real estate, experience and results are what matters to people, especially lenders.  I would get that started before doing anything else.

If you lose money in your first deal and don't have proper disclosures with passive investors they could claim you did something fraudulent.  It is not likely that you'll lose your freedom, but they do put people in jail for stuff like this.  Ignorance of the law is not an excuse when you're in court.  In fact, there is probably a GREATER need for you to do things properly if this is your first deal and you're taking in passive dollars.  

The better advice would be to practice with your own money first and then take in investors; not the other way around.  If you don't know what you're doing then there is simply no reason to be putting investor's dollars at risk.  

@Curt Smith I had an LLC before, so I know about the necessity of having a credible operating agreement and what needs to be done so as not to pierce the corporate veil.

@Nghi Le I totally agree with you, there is no need to over complicate especially in the beginning. Seeking legal advice should be okay though to know my options. I made sure my friends who are going in know the risks and the consequences of this venture. I am also going in with my own money. I am a hustler and I like to solve problems, so I think I will like flipping. I also have a professional investor friend/advisor that is helping confirming I am taking the right decisions.

Thanks a lot @Nghi Le for the attorney referral. We really liked him. He told us about all the different options we have and explained everything in a very simple way. Kudos to you :)

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