I’ve got the knowledge, you’ve got the cash, let’s make lots of money … er but wait! How do we structure this deal so everyone’s expectations are met and our new business venture does not end up in the hands of attorneys looking to profit from our misery? Simple. Slow down and explore your options. In a past post I discussed the problems with poorly drafted joint ventures structured as limited liability companies. (Read the post here: Poorly Drafted Joint Venture) However, for certain short-term investors with many deals and money partners, a limited liability company may be to complex, expensive, and overly burdensome. (I typically recommend the use of a limited liability company when the joint venture parties can expect an ongoing relationship.) For the investor looking to flip properties and use different money sources, an alternative approach might be appropriate.
Consider the case of Josh and Ben who want to flip properties together. Josh has the knowledge and connections while Ben has the financing. Josh approaches Ben with the following offer: If Ben agrees to invest $200,000 with Josh in a short term real estate deal, Josh will pay Ben simple interest of 8% on his money plus 6% of the appreciation when the project sells. This deal could be structured several different ways.
Option 1 – Participating Note
Josh could offer Ben an equity participation note secured against the project. Equity participation notes give the lender interest plus a piece of the appreciation when the project sells. The strength of this arrangement is its simplicity. Josh would provide Ben a deed of trust against the property to secure a note. Ben will receive his payment when Josh sells the house. However, such a situation gives Ben indirect control over the project via his note. If the project takes longer than expected and Ben’s note matures, he could demand his money and foreclose on the property.
Option 2 – Limited Liability Company
As stated earlier, complexity is key when using a limited liability company with structured payments. Here, Josh would create an operating agreement with two classes of interest. Ben, a Class B Member, would receive his interest plus a stated percentage of the company profits. Josh, a Class A Member, will receive the remainder. These percentages could change. After the deal is complete the company would be dissolved. If Josh is engaged in several projects, he could keep a solo practitioner attorney busy for months filing, drafting, and dissolving limited liability companies.
Option 3 – Joint Venture Trust
A trust could solve the issues presented by scenarios #1 and #2. Josh could structure his trust similar to a limited liability company with a primary and secondary beneficiary. As the primary beneficiary, Ben will receive his $200,000 back plus the interest (note: if there is more than one source of money you can have multiple primary beneficiaries). Josh and Ben would each be secondary beneficiaries with different percentages for the sharing of profits; Ben has 6% and Josh holds 94%. Distributions would be set in the trust agreement to occur immediately after the sale of the property.
Joint Venture Trust Details
The typical joint venture trust is set up with all the joint venture parties as Grantors. Like the personal property trust or land trust, the Grantor is the person who initially transfers assets into the trust. One of the Grantors is appointed as the Trustee. Typically, the Trustee will be the real estate investor who is putting the deal together e.g., Josh. The Trustee will have complete control over the investment of the trust’s assets which, would be outlined in the trust agreement, e.g., to purchase and rehab the property located at…
All of the Grantors will be trust beneficiaries. Depending on how the joint venture trust is structured, you could have differing payouts for the Beneficiaries based on contribution amounts, past investments, etc. The flexibility of this business form is in its execution. The trust can be created as needed without the necessity for any state filings. When a deal is complete, the trust is shut down and the funds are distributed per the beneficiary schedule (this information is private and does not get filed with any state agency). As with the land trust or personal property trust, this trust can be used over and over again with changes only being made to the trust name, date, and parties on each deal.
The following is a chart of the above 3 options:
For more information on creating a trust agreement for your next real estate joint venture contact me directly with this link: Schedule a Conference Call with Clint