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Transcript

Why Structure Matters in Syndications and Funds

Many clients have questions about how to structure their syndication or fund. So I thought we’d do a blast from the past for today’s video to take a look at just what goes into that thought process. It’s a blast from the past because it’s a video I recorded about three years ago when I was working with people who are becoming real estate syndicators and real estate fund managers. But the information in it is absolutely up to date. It’s timely, and I know you’ll find it useful.

We are talking through the core right now, specifically about company foundation. In this segment, we are going through structure. Now, why are we going through structure? Well, structure is obviously kind of like the foundation. It’s what everything is based on. If you structure it right, it makes it much easier to grow and do what you want to do. It also can protect you, as we’ll talk about soon.

Member-Managed vs. Manager-Managed LLCs

First, before we get started, I’m going to use a couple of terms here that we may not have gone through yet. You may not have seen the segments on LLCs versus corporations. We need to go through specifically two terms: member-managed LLCs vs. manager-managed LLCs.

A member-managed LLC basically means you’ve got people who are all part of the same LLC. So this is a property LLC, and each person gets their own vote, and they all have control equal to the amount of shares or membership units that they own in that LLC. This becomes very hard to manage, as you’re basically going to be ceding control to all of your investors in order to get things done. It makes it hard for you to get paid and is kind of defeatist in how you want to do things.

You may use member-managed in one particular context, and that’s the joint venture. We’ll talk through what joint ventures look like. But most of the time, you are not going to do this. Instead, you’re going to do a manager-managed LLC, which basically means that you or your entity have control over the LLC itself. Your investors have only the voting rights that you give them in the operating agreement.

The Most Common (and Risky) Syndication Structure

I set that out because I’m going to talk specifically about member-managed or manager-managed in the first way that you could do this. The way you can structure a syndication, and the way a lot of people do (these are people who have not gone through our core, they are not members of the Altitude Syndication Founders Club), is the way that most syndications take place. There’s actually a very big mistake that goes on when you set it up this way, and we’ll talk about why.

Let’s say you have identified a terrific building. You think this is just perfect for investing. It’s going to make you and all of your investors a lot of money. So you go, you put a down payment on it, and then you call up your friends – call up Bob, call up Joe, and maybe three or four other people. They all contribute money into the property as well.

You smartly decided, “Okay, well, I’m going to create an LLC and that’s what’s going to own the property.” So we’re going to call that property LLC. When you were setting this up, one of the decisions you made was whether it was going to be manager-managed or member-managed. Hopefully, most of the time you will choose manager-managed after we had this discussion, because then at least you have some control over the property itself and over your actions.

Litigation Risk in Simplistic Structures

But here’s the problem with this very simplistic form of structure for syndication. Let’s say there’s Bob over here, and Bob has decided he just doesn’t like you. He thinks you sold him a bill of goods, and he doesn’t like this property. Joe’s totally thrilled with it, and so are your other investors. But for whatever reason, Bob’s gone off his rocker and just doesn’t like it anymore. So now he’s mad.

What’s Bob do? Well, we’re in the United States, and I’m a lawyer, so I always see it this way: he is going to file a lawsuit against you and the property.

The problem with the way the structure is set up in this instance is that you now have exposure to this lawsuit. There’s an indemnity clause, no doubt here, but it’s not as effective as you probably would like because ultimately, what is your choice to do? You can’t just bankrupt this property LLC because you’ve got all these other investors out here.

The Preferred Structure: Separate Management Entity

So how are sophisticated ones done instead? We still got this, we’ve still got you obviously, and we’ve got this terrific looking building here that you know is going to make a ton of money. You’ve got your investors, and this time, this is a whole new one – you’ve learned your lesson.

But now you’ve learned your lesson. You know that if you were just to put your money and put the deposit in on that property, you know that you’re being exposed. So what do you do instead? You create another entity here that is You Management Inc.

So you contribute your deposit money into You Management Inc., and then through You Management Inc., you make the down payment on the property, start gathering up the investors, and things like that. Now Property 2 LLC pays management fees and other fees to You Management Inc.

If Sue suddenly decides that she’s mad at you, she can sue the property, she can sue You Management Inc., and she can sue you personally. So what have you gotten out of this? Well, because you’ve done it through this company, as long as there isn’t fraud, you’re actually not liable, and the court’s not going to really recognize that as a lawsuit that’s meritorious.

Scaling With Multiple Properties and Investment LLCs

This isn’t the only structure. One other structure that’s a little more advanced is basically you have – you’re still here – and now you’ve identified not only one really amazing building, we’ve actually identified two really amazing buildings.

So what do you do here in this case? These are all different properties. So let’s leave this Property A LLC, Property B LLC, and after you find it, it will be Property C LLC.

So we actually build another LLC or corporation here, and this we could call Investment LLC. Your investors go there, Investment LLC buys and manages these properties. Investment LLC is managed by you and pays fees that way.

Why Each Property Needs Its Own LLC

A great example of this exact situation is the Ghost Ship. I encourage you to look it up on Wikipedia.

What happened in the Ghost Ship – the Ghost Ship was an office building in Oakland, California. Some of the tenants decided to convert it to live-in lofts and a dance hall of sorts. There was a fire that broke out. Now, the Ghost Ship was owned by a trust, which was owned by one person. But the trust didn’t only own the Ghost Ship; it owned something like 13 other buildings.

Ghost Ship fire breaks out, 20 people died, families sue against the trust, who’s the owner of the building. And now, because there’s one entity that’s being sued, all of these other buildings are suddenly vulnerable to losing everything.

Joint Ventures as a Separate Structure

The last way that you may encounter putting together a syndication would be something like this: You have identified a terrific building, an apartment building that’s worth – that’s on the market for $2 million.

So rather than seeking investors for this property, you seek a different kind of investor – you seek a joint venture.

So you have now contributed $2 million into this building, and they are contributing, say, their time and materials into improving it into what it is. And then when it comes time for receiving money, it goes according to however your joint venture agreement has been written.

Recap and Practical Guidance

So let’s just recap for a minute. This way of doing things here, where you’ve got everybody investing into the same LLC, including you, is just not going to work. It doesn’t protect you from litigation.

This is the structure to keep in mind. Now I encourage you to actually draw out what structure you think is going to fit your needs the most.

I hope that was helpful. Draw out your diagrams, and we’ll see you in the next segment. I hope that was helpful for you. My name is Tilden Moschetti. I am a syndication attorney with the Moschetti Syndication Law Group.