Silent Partner?
First, a little background on me…
My LLC owns two very nice 4-unit apartment buildings in nice neighborhoods full of good established tenants. The rents average $625 a month. These buildings cash flow at around $700+ each. My goal is to buy three similar 4-unit buildings per year in each of the next three years.
I have a good friend who lives out of town and is interested in investing $50K to help finance a future REI purchase. Since his contribution is strictly money, (and not time, i.e. he cannot be involved in management) what is the best way to structure his investment? What kind of returns do silent investors expect to receive? Do I consider his money a loan in which I pay him interest? At what rate?
I want him to take me seriously when we discuss how to structure this. I want to pay him what his money is worth but I want to make money as well (since I will be doing all the work.)I know other people who have expressed serious interest in investing with my company. I know I’m asking a lot of questions that are hard to answer in a forum setting like this, but I have zero experience in using this form of OPM (other people’s money!) Please help! Any advice would be greatly appreciated. Thanks…
Look at the problem from a few angles.
What does such a deal allow? If you were to borrow the funds would think cause a red flag for the conventional lender who is in first (borrowing the down payment)? Would the cash flow support making payments on a loan from an investor?
What sort of returns would an investor like? Are they looking some something steady and regular or do they want to be making a bet on future property values?
If the deal does not work out well are they prepared to lose some of their investment? If not will they accept a lower return to ensure they have less risk.
You can work out the above.
I then start from the statement that a deal between a money partner and the person who manages the full transaction implies a 50/50 split after the money partner gets their funds back at the end of the deal. So, you are splitting the profits after all expenses and return of the original investment.
If the person with the money wants security then they are a lender and I treat them as such. They are in a secure position and earn a good rate of return but have a limited upside (the stated rate of return).
As private partners can be very helpful when a hot deal comes along treat them well but keep it business like. Some investors want too much so you need to know when to say no to the funds they are offering.
Never guarantee any specific rate of return on then when borrowing (a loan). Do not take money through a blind pool where the other party does not have the ability to review the deal before putting their money in.
John
[addsig]
conscider the other side of the coin, if you were in his shoes. how much would you want to make on your money.
keep him happy by not being greedy and he will be there as the money man for the next deal as well
For some reason money men and I are never on the best of terms. I think it is because on the first transactions they make their return and then are out. On the next one they want more and on it goes until it becomes not worth while. Either the continuing demands or the intrushion into the deal structure. My usual lender lasts about five transactions and then their demands are too much. I mean 70 for them and 30 for me and I do everything? Soo I decline as they become ever more greedy.
Of course some of them then buzz off to other creators and guess what, they get burned as they are used to having me do everything. Then they come back and want to resume the relationship. By that time we have moved on and are no longer interested. Crazy world. Go figure.
Cheers Lucius
My "other investors" are never (as of yet) equity, I just find people that want a ROI greater than what they are getting on their money market fund, or CD.
If I was in your shoes, I'd simply split the LLC based on the weighted average of the money invested. If you are the only one involved in the day-to-day operations of the propertie(s) then I'd pay myself a management fee and just compensation for any maintenance work I did.
just my 2 cents.
everything is negotiable.
I think the easiest was if for them to play bank and lend you the money.
Next this to consider is having him contrib to the LLC but not 50-50.
OK, in my experience there are essentially four ways to structure such a transaction.
1) you split according to the amount of cash contributed and the hands-on guy usually feels like he got screwed. (I have done deals like this, and didn't really feel to bad about it because I didn't have enough solo cash to do the deal)
2) You structure a loan from the investor, he gets some rate of return and he walks. The problem is that the investor usually ends up feeling like he got the short end of the stick because he's always suspicious that you are making a lot more money than he is.
3) You modify #1 by the inclusion of a management fee which compensates the managing partner. Here both sides usually feel like the othe side got the better deal. The managing partner feels like the management fee is not enough to actually compensate for the work and the silent partner feels like he paid too much.
4) The investor partner gets some rate of return before the managing partner gets any money above that amount they split. Personally I like this structure best. the "base rate" of return can be relatively low. In this market as low as 5-6 % but I usually go 10%. above this relatively low base rate you split.
This lets the investor feel like he got a good deal (he got paid first) and short-changes the working partner a litle (since his manament fee is paid only after the investor partner has the base rate).
I agree with commercial on this one but any agreement that both parties are happy with is a good situation. As long as everything is outlined and everyone knows there role it should work. Win-Win
Mark,
Quote:4) The investor partner gets some rate of return before the managing partner gets any money above that amount they split. Personally I like this structure best. the "base rate" of return can be relatively low. In this market as low as 5-6 % but I usually go 10%. above this relatively low base rate you split.
Do you mind giving an example of this?
Thanks,
Robert
PS-You know, you nad Lucius should get together and write some articles about things like this. You have some unique experiences that I know I appreciate. Thanks.
commercialking,
Could you give an example (using some real world numbers that you've used) of specifically how to structure a deal like #4 in your reply? Experience is the best teacher...
Thanks,
look2thehorizon
A quick example for #4...
Cash investor gets 5% interest.
Then the managing partner gets paid their fee.
Then what ever is remaining is split.
If there is very little then the order above indicates who gets paid first and who might miss out. The incentive is there for the managing partner to only do profitable deals or they will be making very little for their time.
John
[addsig]
A specific comment on the LLC structure.
If you have a 1 person LLC, the tax status is treated as if the LLC does not exist. All the income, etc flows through to the individual and the tax ID can be the individual's SSN.
Once you add a second member to the LLC you have created a partnership and there needs to be a bit more process to deal with the taxes. A tax ID is required. The rules for managing the LLC are slightly different.
No reason not to add a second person if that is what makes the most sense. Just a warning to watch out for the structural changes implied when you do add a second member.
John
[addsig]
Well, look2 and Robert, an example:
This method tends to work best on short-term deals because otherwise the management issue starts to loom large. I'm currently looking for a partner in a renovation project: 10,000 square feet that I have under contract to buy at $25 per foot. The renovation will probably cost another $25 per foot so lets figure a total project budget of $500,000.
I can rent the space for $10 per foot after the renovation so the GOI is $100,000. Assuming operating expenses of 20% (probably high, based on another similar building that I have with similar use) that leaves a net of $80,000 for an ARV of $800,000 (a .10 cap).
The investor puts up $100,000 and signs on the note. Now in my world that makes him at risk for $500,000 and so we'd figure the base rate of return on that number. I'll use 10% for an assumption here although I might be willing to go a little higher on the base for a good buy-out provision at the end.
So the first $50,000 of income per year goes to the mortgage (say $35,000) and to the investor ($15,000). Now on his down-payment that looks like a 15% ROI but again, I think ROI should be calculated on all the money you are at risk for. That leaves about $30,000 per year cash flow to split.
So now we get to negotiate the split. Since the investor has now gotten a rate of return which reflects the value of his capital I could attempt to negotiate a higher split for me (say 75/25) or I could attempt to put in a management fee to reflect the value of my time. (Say 10% of GOI).
Or I might be willing to waive any such fee for a buy-out agreement at between $550,000 and $600,000.
Assuming that we agreed to the low end of that range ($550,000) and that this was a two year deal the investor makes another 5% ROI annually on the total at-risk for a return of 15% over all or about a 40% annual rate on his downstroke. Much better than letting it sit in CD's in the bank.
Meanwhile I have a deal done with none of my cash or credit. Where I make $10,000 per year to do the renovation and lease up and have $250,000 of equity at the end of the day.
The point is that by agreeing to a base rate up front and paying it on all the money the Investor is at risk for I have very much comforted my investor that he gets paid first and it is in his best interest to sign on the note. In this example I assumed the bank rate to be 7% so he's making 3 points annually for lending his credit to the deal. I have, on occasion, structured no-money down deals for investors along these lines where they actually had no cash in the deal and were making decent money just on the difference between the base rate and the bank rate.
Hope those real-world numbers are helpful.