The Difference Between a Partner and an Investor

By Jarom Bergeson, Esq.

 

If you’re reading this, then there is an excellent chance you are aware of at least one outstanding real estate investment/development opportunity right now – or at least you believe there could be such an opportunity out there.

You might be a realtor or a real estate investor – or maybe you just run in the same circles with people who are.  Maybe it’s a piece of property you pass on the way to work every day. You look at it and think: “Man if I just had the resources, I could buy and develop/rehab/market the heck out of that property and make a fortune!”

However, most of us don’t have the cash available to take down large and/or attractive pieces of real estate, and the process of getting traditional financing can sometimes honestly make you question your will to live.  Just when you think all is lost, there enters a “money partner”. (Queue the chorus of angels!)

You all know the money partner.  He (or she) is the person with tens or hundreds of thousands in extra capital ready to deploy in a good real estate deal.  Maybe’s he’s self-made, or maybe he’s a trust fund baby – you don’t really care either way.  He isn’t happy with his returns in the stock market and he’s ready to put his money in something he can go touch and feel and have the pride of being able to say “I built that.”  You love the money partner.  He’s is the answer to your prayers – right?  Maybe.  The answer (as it always is when it comes from the mouth of a lawyer) is “it depends”.

Let’s say you have the connections.  You find and negotiate the deal.  You know exactly what needs to be done to improve the property and maximize its value.  You convince the money partner to put his cash into the deal and let you handle the rest.  After all, he probably doesn’t know much about real estate and he doesn’t really want to be involved anyway.

You oversee the improvements and keep the contractors in line, on time and on budget.  You know the local market like no one else, and you know precisely what to do to extract the top dollar when it comes time to sell.

The money partner brings what?  The money of course, and not much else!  You and the money partner agree to split the profits from the sale of the property 50/50.

What could possibly go wrong?

Well, I’m glad you asked!  As an attorney, doing my best to figure out how things could blow up is sort of my thing.  As in all partnerships, you want to make sure you and the money partner have a written agreement that clearly spells out the rights and responsibilities of all the parties, as well as how disputes will be resolved.  You also want to make sure you think through taxation issues.  Being thoughtful and proactive in your tax structuring can help you limit the amount of profit you’ll be handing over to Uncle Sam.

But what about securities issues?  You may be thinking, “Which securities issues?  There’s no security here.  It’s just a partnership!”  You may be right.  But then again, you may not.  The statutory definition of a security under federal law is really long and not all that helpful.   However, one of the items specified in that definition is something called an “investment contract.”  The U.S. Supreme Court, in a famous 1946 case called the SEC v. W.J. Howey Co. the decision held that an investment contract is “a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.”

So, in the example above, did the money partner enter into a transaction where he invested his money in a common enterprise (the real estate investment) and was led to expect profits solely from the efforts of the promoter or a third party (i.e. you)?  I don’t think it’s a huge stretch to make that argument, and if the argument is made successfully then it will be determined that you have sold the money partner security.

What’s the big deal about selling securities?

Well, if this “deal” qualifies as security it puts you under the purview of the Securities and Exchange Commission (SEC) and state securities regulators. I am fond of saying that the SEC will ruin your weekend even quicker than the IRS.  Selling unregistered securities will get you in hot water, and failing to make material disclosures and/or committing fraud in connection with the sale of a security might just land you in Club Fed.  So, how do you protect yourself when working with a money partner?

  • Option 1: Make sure your money partner is really a partner, not just an investor.  A key part of the Howey definition of an investment contract is that the profits are solely from the efforts of a third party.  This part of the definition goes away if the money partner brings some sort of expertise or effort to the table – in addition to his cash.  You can also argue that it isn’t satisfied if your money partner must agree to major decisions in the life of the partnership (such as the purchase and sale or rent of the property, major structural changes, and purchases over a certain dollar amount).  However, Option 1 does put you in a gray area.  There is no bright-line here.
  • Option 2: Embrace that the situation involves the sale of a security, look for securities exemptions, and make sure you jump through the hoops to qualify for those exemptions.  Solutions here are things like Regulation D Rule 506 and Rule 504 offerings, Intrastate Offerings under Rules 147 and 147A (and the applicable State Blue Sky Laws), and exemptions for equity crowdfunding.  Option 2 will almost certainly cost you more to comply. However, it will allow you to bring on “silent partner” investors while losing a minimum of sleep over SEC compliance.

Neither option is right 100% of the time.  Taking the time to speak with a qualified and experienced securities attorney can be a HUGE HELP in knowing which way to go, as well as how to break down the costs involved.  Don’t bury your head in the sand when it comes to the potential securities issues of hooking up with your friendly local money partner.

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