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Posted over 4 years ago

Forming Your Business Entity

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Forming your business entity tends to be akin to "the chicken and the egg" conundrum for many people. Maybe they have a project that they're considering, and they've started talking to friends and family, or people that might be potential investors.

The real question is:

Where to Start

Most people tend to gravitate towards pondering the name of their company first, when, in reality, they should be asking themselves:

"Do we get the money first? or, do we find a deal first?”

That's the challenge a lot of people have. Breaking it down into an entity. Ultimately, if you're going to do a deal at some point before you close you will need a corporate structure. The two most common corporate structures in real estate syndication deals and multifamily primarily are:

  • An LLC structure
  • or
  • A Limited Partnership Structure.

A Limited Partnership Structure

Two separate types of structures and models, but both are widely respected and commonly used. There are pros and cons with each, it just depends on the deal.

A limited liability company is one of the simplest forms of an organization that you can set up, and they are set up in two ways. An LLC can either be member-managed, or manager-managed.

Member-Management

Let's say you and I are partners, and we are going to do a real estate project. We don't need any other partners, we don't require more equity, it's just you and me. We are 50/50, then, we can be member-managed in a sense that in order to make major decisions, or do certain things, we would need the member buy-in. You would have to sign off and I, your partner, would have to sign off. There are lots of nuances we could then figure out:

“Okay, my partner is the main boots on the ground, he can do these deals without having to come back and ask me, whether it's doing a repair for $500, or hiring a property manager.”

There might be certain things that each of us can be responsible for, but, essentially it's the members of the company who are making the predominant day-to-day and business decisions.

In a member-managed setup you may have somebody who may not have put in the requisite amount of capital or may not be an actual member, but they manage and drive many of the decisions.

For example, say I'm 80% of the deal, or 80% of the capital, and you come up with the rest. We can make you a member at 20%, whereas, I would be a member at 80%. We could also make you the manager of the entity, whereby you would have a set of responsibilities and duties as the manager, but you're not the owner of the company. We could have a third person, who put no money in and they could be the manager of our entity. Essentially, to put it in simple terms, they’re kind of like the CEO of the LLC. They're there to make decisions, make some profit and maybe get some waterfall provisions. They're the day-to-day driver of the decisions.

Those are your two types of LLCs. Now the question is:

Which One is Right? and Which One is Wrong?

There's no right or wrong answer here. When choosing the way to set up your company, a lot of factors come into play:

  1. The type of equity pool you're using.
  2. What your bank requires when you go to get debt.
  3. What your investors want.

Oftentimes, your investors who have a lot of capital will say,

“Look, we want you to be a member, we want to make sure that anything that will impact our business will come back to us to make the decision."

You have to select one, either be member-managed, or manager-managed. When someone is getting into the syndication business, they usually start an entity that is normally an LLC, but, that's probably before they have done a large apartment deal. We need to understand this is probably going to change, or we're going to have other entities. What does that look like going into that first deal, should we still have that first LLC?

Now, as far as how to set up, you really have to decide first; what type of deals you're looking at. That can alter your decision. It doesn't relate to the size of the deal. I have seen 20 million dollar deals that chose to go with an LLC and I've seen two million dollar deals that go with an LLC. The size doesn't matter; It's the pieces that you are putting around it that matter.

In most instances, the primary driving factor is going to be your lender and what your lender requires you to do. Imagine you've set up an LLC and you spent the $300 or whatever it is to set up the entity and you think to yourself,

“Now what do I do?”

Usually, you can use that entity and convert it. You can convert it from a member-managed to a manager-managed. You can also convert that entity entirely to a corporation, or another type of entity. There are lots of provisions for that. Sometimes, you can even start over, it's not that hard to do.

To conclude, there is no right or wrong, but the best advice is:

If you have lender friends and contacts, start asking them what they need and like. Your best bet is to give them a structure that they're comfortable with, that they know and recognize, so you're not working harder to get the same amount of money.



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