Episode 14 – Syndication Attorney Webinar – ‘Ask Me Anything’

All right. Thanks for joining us today. It is one o’clock in Raleigh where I am right now. And thanks for joining us, the syndication attorneys with the Moschetti Syndication Law Group. I’ve got a bunch of people in which is terrific. So we’re going to go through some questions that you have, feel free to use the Q&A portion that you’ll see in Zoom, and we will answer what is coming in as we go. Just let me know, I’ve scheduled about 45 minutes for this call.

First question that we have: Is there any support such as legal review of the acquired property, legal entity maintenance after finished drafting of the document?

That’s a good question. The answer is no. What we do at Moschetti Law Group is we’re primarily concerned with your security itself. So we’re concerned with how you deal with investors, how you present yourself, making sure you’re protected by the SEC. My license covers national things such as securities licenses, but it doesn’t necessarily go to different states. So I’m licensed in California, I’m licensed in Washington, DC. If you are outside of there, I can’t offer you specific legal advice as it relates to whatever state it is. If there was a legal issue about that acquired property, for example title, I’m not going to be able to give you legal advice on it. Many times for my clients, I can give them my opinion as a real estate professional or as a syndicator. But it’s not legal advice, and I will probably still refer you to an attorney if you have a specific legal issue. I hope that answers that question.

Another question: What LLCs do I need to start my syndication?

It’s probably one of the top three most common questions I get so happy to answer that for you. Let’s go to I have a whiteboard here that makes that a little bit easier to explain.

So there are two different LLCs typically that we form. It’s a service that we also offer – when you sign up for a package, we generally do the formations. It’s fine if you already have them set up, but we’ll also do them for you if you don’t. So there are two entities here. This is the building, so I’d say it’s a property. Generally, there are two entities we form. This is what I call the sponsor entity. And this is what I call the investment entity. The title is owned by that investment entity. This investment entity is managed by the sponsor entity. And then your investors all invest into that investment entity. So there’s typically two different entities. Now in cases where there are several different properties, we’ll normally set up SPVs or special purpose entities for each of those, which is then managed by the investment entity.

Another question is: How do I handle timing differences for different investors in a given fund when calculating returns? Great question. Also same issue with timing different projects/investments in the same fund.

George, good question. So, this is talking about two different kinds of funds in the world or two different kinds of syndications. There’s open ended funds, and there’s closed ended funds. About maybe 60-70% of our clients do closed ended funds. And that’s you’ve got a single asset, or a single group of assets, you have investors come over a limited time period. So you’re raising money for three months, six months, whatever it is, they all go in together, and they all come out together. That’s called a closed ended fund.

The difference is an open ended fund. In an open ended fund, it is open in time. So you may have investors coming in in month one, you may have them coming in in month nine, you may even have them coming in like a year later. So what George is asking about is this challenge here, where if we look at it on a timeline and this, let’s say Q1, Q2, Q3, Q4, etc., where you have an investor coming in here, and you’ve got for, say, 100k. And you’ve got an investor coming in here, for 100k.

The challenge comes up, because this 100k here is more valuable to you, at this point, than it is at this point. It’s time value of money, they’re coming in at different points. And if you’re saying at the end, we’re going to be paying you a return of 40%, or 30%, or whatever it is, this guy here, this guy who came in before the end of Q1 happened, he’s getting disadvantaged, so he is not getting the full benefit, because he would much rather wait till Q4 in order to put his money in.

So there’s really one main way to deal with it. And then there’s a couple kind of variations to deal with it. The main way is by calculating the net asset value at these different points in time. So you calculate the net asset value here, you calculate the net asset value here. And what that essentially does is you’d say, okay, the whole value of the entire portfolio, let’s say is 5 million here. And then in Q2, now, maybe it’s 5.2 million. And now maybe in Q3, maybe something slightly happened, where it’s now 5.1. But then it jumps up to 5.5 million. And then you divide out this amount by the total amount of membership units that there are. So basically, what you’re coming up with is the cost per membership unit. So you’re selling those membership units to this investor, for 100k, for 100k. And then each quarter, you’re doing a reassessment of what that net asset value is.

What you don’t want to have happen is basically to be saying that this person is getting diluted at the same time. And that’s why we do it this way. Because we also don’t want to be just adding shares, or membership units here and here in order to make up the difference, because that just dilutes that person.

So that’s kind of the main way we deal with it. The second way to deal with it, is by doing an accounting. So what we can do is get rid of the idea of net asset value and come up with accounts for each one of your investors and build a ledger for each one of them. So let’s say I have investor one who comes in here. And let’s say this is investor 17. Just for sake of argument, I’m doing deals and this is really for a portfolio not for a single asset. So I know that here I’ve got these properties here. And I allocate as evenly as I can at the time of the person investing, or at the time of acquisition, I’m allocating percentage of ownership of each one of those assets, almost like its own little mini fund. It’s a little account that you’re keeping track of. And then as those get disposed of, it gets rolled off.

This is probably the harder way to keep track of it in a lot of senses, especially if there’s a lot of transactions coming in, but it’s probably the only way to do it if you’ve got large gaps of time between acquisitions and dispositions and when your investors are trickling in. So kind of a complicated question. That’s how it’s dealt with, most almost always is one of those two ways. But we can go through and come up with some other ideas about whatever meets your particular need as well.

Sure, Tom, we can talk about fees. My fees – we charge flat fees, we’re very competitive about what we charge. So we charge for a closed ended fund, we charge $15,000 as a flat fee. And for an open ended fund, we charge $25,000 as a flat fee. Now, that’s only for the first deal. Once you become one of my clients, we give a guarantee that for the next three years, it’s going to be discounted by 50%. So if you’re doing closed ended funds, which most people are, those get discounted to $7,500. That’s just the fees.

I do not finance or do monthly payment plans. It’s a one time upfront charge. Because our time to produce these is really quick, I devote a lot of time to it. And then we get you the paperwork out. So you’re generally getting the paperwork in two weeks. So financing just generally doesn’t work.

Is there software that I use to keep track of individual accounts or ledgers? Yes. I personally use AppFolio. AppFolio is a good solution. I recommend it, I have a discount code with them. When they pay that affiliate fee, I pass that directly on to whoever got it. So I don’t keep any of that affiliate money myself. And it winds up being about 10% of the cost. I think the cost is about $600 a month, because it is a very industrial grade solution. There are other products out there. I know that some people are using a product called Groundbreaker. I haven’t used them myself, but you could check them out. Maybe they’re very good, I have no idea.

Can I get my friends to invest in my Reg D if I am advertising?

Let’s start from a bigger picture, it might make a little more sense. There are two types of syndications generally under 506 under Reg D: 506(b) and 506(c). There is also 504 but it is hardly ever used now, it’s overly complicated, so nearly no one is using it.

506(b) – yes, you can have non-accredited investors, there’s up to 35 per 90 days.
506(c) – you can advertise, you can make a general solicitation.

With 506(b) though, no advertising. And with 506(c) no non-accredited investors.

So to answer your question, the problem is, if you’re doing a 506(b), you’re not allowed to advertise it really at all. And you said that you needed to advertise. So the short answer is probably not as long as those friends and family are non-accredited investors.

How do you do a 506(b) and basically be able to get people into your fund and find investors? There are a few ways. What the SEC’s main concern is between 506(b) and 506(c), and why they have this rule setup, is they don’t want people just going out and making general solicitations to the entire world of “hey, come into this fund”, and basically taking advantage of people. So people coming up with some very large mechanisms to, you know, make – “you’re gonna make a billion dollars if you invest $5 into this fund”, and we’re gonna make all this money and basically, the syndicator walking away with it. None of you are obviously going to be doing that. But that’s what the SEC’s concern is.

And so they use this toggle point between accredited investors versus advertising as their mechanism to regulate that. So non-accredited investors are not necessarily less sophisticated, but they have less means to be able to adapt to a very bad thing happening where somebody walks away with all the invested money.

So the turning point, really, and this is my interpretation, reading between the lines of what the code says, is that it comes down to trust. They want the investor to be able to have some relationship, some sort of trust that’s based in something real with the syndicator. And so what needs to happen is dialogue and communication that is outside of what the investment is needs to take place first.

What used to happen in the very early days, syndicators would put together a seminar, they’d get everybody packed into a room, they talk about the investment, and they get a list of things and they’d start talking about what their investment was immediately and saying, “Okay, come invest, come invest, come invest in this. It’s great, it’s great, it’s great.” And there was concern that there was a lot of pressure that was being put onto investors by syndicators in order to invest. And so what they have done by doing this is they’ve actually specifically said in the code, you can’t do that.

What you can do, and what this code does not prohibit, is putting together the same seminar. You put together a seminar of how to invest in real estate, you never talk about your investment at all. And then you basically invite people to say, “hey, if you’d like to talk some more about real estate and talk with me one on one, love to do it, let’s set up a coffee or whatever to do that.” So that’s really kind of the main mechanism that people are doing in order to build their investor base – by still setting up seminars or webinars or things like that, inviting people into those communications and those dialogues, and then going from there to build that trust and then doing a 506(b).

What services do I provide in setting up a closed end fund?

Good question. So we are basically your back office, your support team to get that fund set up. What we do is we put together the PPM, the operating agreement, subscription agreement, investor questionnaires, and then package those all together so that it meets what investors would be expecting to see. We can do reviews of your marketing material. We don’t do the marketing material ourselves, but we do reviews. And then you can put it out there into the marketplace.

Once you’ve put that all together, we look at what the offering is. And then we put together the Form D which is what gets filed with the SEC. And then we put together the blue sky filings.

Now, a lot of my competitors do exactly that same thing in terms of the actual documents we put together. What I think sets us apart and my firm is I’m an active syndicator myself. I’m putting together my own deals. And so what we try to do, the difference that we make, is I take that expertise, and I’m available to you in order to make sure that ultimately you’re successful. The reason that we cut our rate once you’re a client of ours is because our whole goal here is to have you be successful. So you keep hiring me over and over. That’s my goal.

Generally, once you’re one of my clients, I’m available to you, we set up meetings. I see some of my clients are on this call. And so they can probably attest to it as well, that I really do try to make myself as available as possible. Probably the easiest way is to set up a meeting with me, I try and make it so that I can meet with people as quickly as possible. And then we can discuss whatever it is, if it’s about your syndication specifically, we can talk about that. Or if it’s a question about an issue that you’re having, I’m happy to have those conversations as well. So that’s what we provide, in order to set up a closed end fund.

Is it okay to have both a 506(b) and a 506(c) for the LLC?

Great question. I do get that a lot, too. The answer is no. So you choose one and then sometimes you can go to the other. Generally, if you need to do a raise from friends and family and to advertise, what you can do is you can put together a 506(b) offering, offer that to friends and family. And then once that’s closed, then you can put together a 506(c), and then advertise that. Specifically, they need to be two separate different offerings, though.

We have a fair number of people that do that, probably not nowhere near a majority, but some people definitely do that. And it works fine. What you cannot do is do a 506(c) offering, where you’re advertising it to the world and then do a 506(b) offering just to pull in those people because at that point, they’ve pretty much seen the offer that’s there. And that may be out there in the marketplace that you’ve advertised.

What we don’t want to ever have happen would be a complaint gets filed, the SEC is called in to investigate, the investor says, “Well, I had no idea who these people were, I saw an ad on TV, I gave them money, and I’m definitely not an accredited investor.” That’s what we’re trying to prevent. By making sure that it doesn’t go C then B. But if it goes B then C, you know, that’s fine. You’ve brought in all the friends and family that you know, and then close that off and then do the 506(c) offer.

How do I let friends and family know if I’m doing a 506(b) and can’t advertise?

Great question. You can’t advertise in terms of a general solicitation under 506(b). But you can certainly let friends and family know. I think you probably could even post on Facebook or on whatever your social media is, “hey, here’s what I’m working on.” And you could bring people in that way. But you’d have to be very diligent that the only people that you’re letting into that investment are people you actually know.

So I wouldn’t go like trying to test the gray area when you’re putting together seminars and getting to know them for a week and then talking to them about the investment and do that mechanism. But otherwise, you could certainly say put it out there to the world, “hey, I’m doing this. You know, if you’re one of my buddies, give me a call.” And that should be okay because it’s not then a general solicitation where anybody can come in.

Who is an accredited investor?

An accredited investor as defined in Rule 501 – what it basically says is there’s two tests, there’s an income test or there is a net wealth test. You do not need to pass both of them in order to be considered an accredited investor, you only need to pass one of them.

For the net income test, if it’s a person applying on their own, so without their spouse, they need to have $200,000 a year in income for the past two years and expectation of that for the third year. And for the income test, if it’s with a spouse, it’s $300,000 a year for the last two years with the expectation of the current year being $300,000 a year.

The wealth test is for a net wealth of $1 million. And that’s not counting any positive equity for primary residence. So if a house is underwater, that does bring down that personal net worth. But if your house is worth a million, and you owe, you know, $5 on it, you don’t get to count that additional income as that primary. That big spread, that $995,000 – you don’t get to count that as your wealth. That needs to be separate from that primary.

Can we do a 1031 Exchange?

Common question. The simple answer is no. If you mean can people 1031 Exchange into a property into your property and give you the money from there? The answer is probably no, that money itself would be counted as boot and they’re going to be paying their taxes on it outside of that 1031 Exchange. If they want to pay taxes on it, then absolutely they can. But it is counted as boot.

The only exception to that, and I’m hesitant to say it, is in the case of a Delaware Statutory Trust, which is a very complicated mechanism. And it’s so technically you can set up a fund in order to raise money with 1031 money. But it can only be in the specific shell of a Delaware Statutory Trust, which are very, very complicated, expensive and very challenging to put together.

Can you 1031 out? Probably not. Here it gets kind of state specific, because a lot of times what happens is under the IRS rules, it’s 98% not a problem. Under local state rules, it depends. So in California, for example, if you were to try and do a 1031 exchange out of a property that’s being syndicated, and one of your investors doesn’t want to go along, but everybody else does, the Franchise Tax Board in California will come after you and disallow it and they don’t have any problems filing a lawsuit against you, no matter what, despite whatever the IRS rulings are. They want their money immediately. So they will disallow it. I’ve heard New York is also equally challenging. I’m not keeping track of which states like it and which don’t.

Now, if everybody wants to 1031 Exchange, that’s not going to be a problem. So you certainly can 1031 out, as long as every investor doesn’t have a problem with it. Or if your fund is just set up automatically to do that, then it will be okay. But everybody has to come along, you can’t split out fractional shares in some states. So I’d be very careful about that. We have some clients who are doing it very successfully. But they’re also not letting in people from New York or California in order to be able to do it without a problem.

Which is easier an open ended fund or a closed ended fund?

It depends what you mean by easier. Easier in terms of raising capital – I think most of the time, it is much easier to raise money for a closed ended fund. In my experience, most investors like to have concrete start dates and an expectation of this money is going to be held and doing whatever it’s doing for five years, seven years, three years, whatever that time period is and they kind of know what that is going in. So raising money, in my experience, closed ended is much easier. Open ended is more vague. And the more vague it is, the more challenging it is.

What’s easier about open ended funds is open ended funds are easier in terms of strategic decisions. If you’ve got a pool of money and you’re able to place it, an open ended fund, you’re able to do that. You just need to make sure you’re complying with whatever rules are in your operating agreement that are set up. So the specific plan of an open ended fund can be easier. But a closed ended fund is much easier to get investors for and much easier to maintain. Because we’re not dealing with what we answered before about funds where we’re having to keep track of either separate ledgers or keep track of net asset value along the way. That gets overly complicated.

Does documentation for 506(c) accept investments from self-directed IRAs?

Yeah, basically, almost every syndicator does allow accepting funds from self-directed IRAs. To backup just so everybody knows, a self-directed IRA is basically an IRA where the administrator of that IRA allows the account holder to basically dictate where their funds are going to go. And that can be into a syndication.

There’s quite a few companies that are self-directed IRA companies, probably the biggest is Entrust (E-N-T-R-U-S-T), but they’re by far not the only ones. I’ve dealt with probably about six different ones. And they’re generally pretty easy. I haven’t had a situation where I’ve had an administrator of a self-directed IRA ask for any changes to a PPM or to an operating agreement. Their main concern, in order to stay compliant for the benefit of the IRA holder, is that the IRA holder doesn’t have access to touch the money themselves.

So it’s nearly impossible to set up a self-directed IRA where the syndicator themselves gets to go into the investment. But it’s almost always the case that you can generally have investors who have self-directed IRAs. And that’s a great talking point to finding investors, to having those conversations, because now they can put their IRA money to use in your syndications as well. It’s a good thing to talk about.

And the only administrative burden that it adds to you is two things: First, you have to submit it to the administrator for their review before you can get the money. And the second thing is every year, the administrator is going to ask – really they’re going to ask the IRA holder, who then will ask you – they want to get a general assessment of what the current value of that IRA is, or what that asset is in their IRA, for reporting purposes. They need it. So they will ask for it. But it’s really not that big of a deal. I basically have a template for it. If ever you’re working on one and you’re a client of mine, you just tell me that, you know, how does this work? And I’ll send you over what my template is, and you can fill it out and it’s pretty simple.

We have some situations where after signing the PPM we’re wanting to provide a discount on our fee and commissions. What tax formality or documentation do we need to have?

Okay, yeah, you absolutely can do that. This is where most of the time we’ll talk about side letters. So, and we talk about side letters in our PPM and I think we talk about it a little bit in the operating agreement, just that these things exist. What a side letter basically is, is it’s an agreement outside of what your normal investors get.

So you’ve got your agreement with your investors, and then you’ve got this guy here, who’s also an investor. And you want to give him a little bit better deal. Say you’ve got it on that investment is paying, and I’m making stuff up here, it’s paying an 8% preferred return, and then a 70/30 split. So 70% to the investor and a 30% to the manager. This guy is coming in with a lot of money, and you really want him as an investor, and you want to incentivize him in order to finish off your investment and bring him in. So what you want to offer him is an 8% pref and an 80/20 split.

So that is no problem at all. What you’d basically do is have him sign the fee agreement, and then do this separate side letter just for him, that says, “okay, and for you, we’re going to do an 80/20.” So that’s one way to do it.

What the caution is that we’re looking at whenever we’re doing side letters, is I don’t want there to be a situation where instead of this 8% pref, you are suddenly doing a 12% pref, and you’ve told your investors that this is an 8% pref. Now why is that the case? Because all these are getting the 8%, and then after that are getting that 70/30 split. So after all that money’s paid out, then they’re getting a 70/30 split. Well, that 8% is driving down the amount of available cash for distribution. Because they’re getting that right off the top. So now if I’m giving somebody this 12% right off the top, that’s taking more than the investors are expecting, and so you’re diluting them without telling them and so that’s a big no-no. So whenever we’re talking about those, that’s what I’m on the lookout for – dilutions that are unintended.

In terms of fees, what you can do is, because I think that was your question, is can you give them some fees? The answer is, yeah, you can give them some fees. And sometimes we’ll do those, especially in the case of like a kicker for a guarantor on a loan. Like if somebody is investing a large amount, you’ll give them maybe 1% of the amount financed just for the act of signing on the loan. That’s okay to do.

In terms of what there is now, in terms of tax formality, the documentation is simple, it’s a side letter, it’s the agreement between the fund and the investor. That’s the documentation you need. As it relates to taxes, what will happen is you’ll need to just basically explain what the situation is to your tax preparer, your CPA, when they’re preparing the K-1s to make sure that they get notified.

Now, if they’re getting paid a portion of fees, that’s basically coming from the manager is how you would want to structure it, not from the fund itself. So it’s the manager paying the fees. So a fee gets paid to the manager, and the manager then kicks that back to the investor. So let’s just make sure it’s real clear because it could be a problem otherwise. So you have the investor. So it’s paying regular distributions. And this is the investment. You have the sponsor LLC, getting paid fees, and then the sponsor LLC paying some subset of fees. So it’s going to reduce the amount of taxes that the sponsor LLC pays. And then what this investor is going to basically get is a K-1. They’ll get a K-1 on that distribution, and they’ll get a 1099 on the subset of fees. So from a tax perspective, that’s what would happen.

In a real estate fund, could an investor invest funds into a property’s equity through a note between the fund LLC and the sponsor?

Yes, you could. You just would want to, again, make sure that the investors are still getting what they’re expecting, who are not a party to that specific investor. And then document that investment through the note.

Is there any difference in the document preparation if the syndication invests in residential or commercial property?

Not a substantial difference, no. In your private placement memorandum, there’s documentation about different risk levels, there’s documentation about what your overall strategy is. So those things are going to be different in what those syndication documents look like, but the structure of those documents or, you know, there’s not anything that’s substantially different, except for risks or whatever is going on with that particular investment.

Is there any minimum or maximum amount of money that can be raised?

No. So under Regulation D, you could raise $1, you could raise $20 trillion. There are no maximums under Regulation D and no minimums, either. It’s probably not economically viable to do a minimum raise. Typically, when I was coaching people, when people would ask what the minimum would be that I would look at, I probably would say a minimum of a million dollars of equity raised. The amount of money that you’re making at less than a million dollars is probably lower than would make it make sense for the amount of work that you do as a syndicator.

How does Form D work?

Form D is basically the notification to the SEC. So Regulation D is basically an exception to the general security rule that all securities must be registered. That’s the key word – registered with the SEC. As an exception to it, it doesn’t need to be registered, but some documentation needs to be filed. And that’s through the Form D.

What the rule is, is generally the SEC wants the Form D filed within 15 days of the first sale of the security, but it further defines that the sale, the first day of the sale of the security is the date basically at which point the investor isn’t going to get their money back. So if you’ve raised all this money, you get it to the finish line, it’s just not going to happen, that property is not going to transact, you give them their money back, no Form D is owed. It’s just not a relevant piece of paper anymore to being filed. You still could file it if you want. But you’ve already given the money back. So you don’t have a filing date, really until there’s no time to get it back.

Now, if you miss that time period, it’s very far from the end of the world. The SEC does not have a penalty. There’s no fee in filing the Form D, there’s no penalty associated with the SEC on late files. Occasionally, some of the blue sky states have a late fee filing. But they also don’t have – I don’t know of any state that has a prohibition of, you know, you won’t get this protection under Form D because that would be outside of their jurisdiction anyway. Because as a matter of federal law, the federal rule wins.

Regulation D says, yeah, you need to file it within 15 days. Probably you need to have it filed to be protected by Regulation D in case of a lawsuit. But there’s never been an opinion. There’s been one opinion letter that opined that it was possible. But in that one particular opinion letter, it said in this case, it doesn’t change the standing that Regulation D still applies, even though the Form D wasn’t filed.

Okay. So we hit the amount of time that we’ve got allocated for this. So I hope that was helpful. Again, if you’re ready to move forward on putting a syndication together, if you’ve identified properties, or you’re ready to get started right away, give us a call and we will get you going. We’ll set up a time to talk. But otherwise, feel free to – we’ll be putting these webinars together fairly regularly or I’m sure you’re getting our email blasts, and I hope you find those useful. Feel free to check in. If you’re not a client, I will try to make time to answer questions. If you are a client, I will definitely find time to answer any questions. So I hope you found that helpful. Thanks and have a great day.