My team and I at SyndicationAttorneys.com have had the pleasure of helping over 500 real estate syndicators and fund managers create “securities offerings” that allow them to raise capital legally from passive, private investors. Our statistics show that our syndication clients (i.e., those who raise capital from passive investors for a specific real estate project) are 85% likely to close their deals. Syndicators who aren’t successful often fall prey to one of the common mistakes new syndicators make when raising capital.
This blog describes the top mistakes that are likely to: a) cause your offering to fail, b) get you sued by investors, or c) get you investigated by securities regulators, or just plain make your life uncomfortable for the duration of a deal. The purpose of this article is to help you avoid these common mistakes.
First, what do we mean by “cause your offering to fail?” It means you probably spent a ton of time, effort, and money to get a property under contract, and at some point along the way (even at the closing table) something happened (or didn’t happen) that prevented you from closing the deal.
Attorneys, just like doctors, usually focus their practice on a particular area of the law. You should plan to hire a “Corporate Securities Attorney” when you are creating a company to pool money from passive investors to buy multifamily real estate. A Corporate Securities Attorney will form the right entities for your syndicate, draft operating agreements that are fair for your investors, but also ensure that your syndication management team remains in control and gets properly compensated for all the time and effort spent finding, acquiring, and “asset managing” the deal. They will draft the disclosure documents and file notices with the Securities and Exchange Commission (SEC) and state securities agencies that are required when you are raising money from passive investors.
Real Estate Attorneys are not Corporate Securities Attorneys. Commercial real estate attorneys will help you draft purchase agreements, create vendor contracts, review loan docs, and work with title, escrow, and lender’s counsel to help get your deal to the closing table with a commercial loan, but they typically have nothing to do with private investors — and many of them don’t understand syndication deal structures or securities compliance (and I have talked to several in this category). Additionally, they might not have securities liability insurance to defend you if they advise you to do it wrong. Make sure you ask about this.
If you are purchasing commercial or multifamily real estate, you’ll need both — this is not a good time to seek a “jack of all trades.” Hire the right attorney for the right job, just like you would with a doctor who’s going to do brain surgery on you or your kid. If you hire the wrong attorney, you may end up with a structure that costs you or your investors extra taxes or that gives too much control to investors, preventing you from effectively financing or managing the project without getting their consent.
Other things to watch for:
Some attorneys charge way too much (usually big firms). We’ve seen $50,000 and $100,000 offering packages when they should be a fraction of that cost.
Some firms who don’t do securities offerings as a regular practice area may take too long — trying to learn a new practice area on your dime. We’ve heard of people waiting over a year for a fund offering package, which can be completed as quickly as 30–60 days.
A typical syndication offering package takes two to four weeks from engagement to final documents. First-time syndicators usually take the longest time as they are learning the process as they go, and having to read and understand more than 150 pages of legal documents; returning clients can often shorten the time from draft to final documents.
There are plenty of attorneys who will tell you they can deliver your offering documents within a week. That’s true — regarding your initial draft offering documents. But you, not the attorney, are responsible for making sure the documents are 100% accurate and that they don’t contain any information that could be deemed misleading or fraudulent by investors or a regulator.
This means you must review and correct the documents the attorney provides or provide additional information before your final offering documents can be issued. If you don’t do this, it’s at your peril as such mistakes could lead to litigation (and personal liability) if an investor sues or a securities regulator investigates your offering.
Based on our statistics and experience, we recommend that you hire your Corporate Securities Attorney when you: 1) have a signed purchase agreement, 2) have reviewed the property financials, and 3) someone from your team has been to the property.
Don’t wait until you complete your due diligence and then hire your Corporate Securities Attorney, or you likely won’t have enough time to raise the money and close the deal. The ideal timeframe to raise $1 million to $3 million is 30–45 days. If you are raising more, you’ll need a longer timeframe. Anything less will be stressful for you and your investors. You need a 90-day escrow period to syndicate a deal, with 30–45 days to complete due diligence and get your offering package prepared, and the remaining 45–60 days to raise capital and process the bank loan. Build this timeframe into your purchase agreement and include one or two 30-day extensions if you can. If the most you can get is a 60-day escrow, then make sure to include one or two 30-day extensions, and you should be all right.
Let’s start with a short step-by-step primer on securities compliance: When you are selling interests in a company to passive investors, you are selling “investment contracts,” which are securities. This means you must comply with securities laws. Syndicators typically choose to raise capital for real estate under a “private offering exemption” that allows them to raise capital without regulatory pre-approval (i.e., registration), providing they comply with the rules for the selected exemption and document how they complied. The exemption applies only to the “issuer” of the securities — that’s the company that is selling interests to investors (the syndicate).
Under the Securities Exchange Act of 1934 (15 U.S. Code § 78c(a)(4)(A)), a securities “broker means any person engaged in the business of effecting transactions in securities for the account of others.” You can sell your own securities without a license, but to sell securities for others requires that you have a securities broker-dealer license, which is very difficult to get and maintain. Further, the SEC (based on case law derived from multiple court opinions) has long viewed receipt of transaction-based compensation as a hallmark of being a broker. Transaction-based compensation has been interpreted to mean any compensation that takes into account the amount of capital raised.
Prohibition 1: You can’t hire people outside the syndicate (such as a consultant, independent contractor, or placement agent) to solicit investors on your behalf unless they have a securities broker-dealer license, as they are not entitled to the issuer exemption.
Prohibition 2: You cannot compensate anyone (including people inside your syndicate) based on the amount of capital they raise unless they have a securities license.
What can you do? The consensus among securities agencies (SEC and state) is that you can compensate people in your management team by giving them a share of management fees and profits, but they must have a job in management other than raising capital and no one gets separately compensated for just raising capital; the compensation cannot take into account how much capital they raise. This is the “co-GP” model you may have heard bandied about.
Our opinion is that too many people in management of a syndicate is litigation waiting to happen. I’ve seen a deal where litigation began immediately after closing. Too many members typically can’t agree on management decisions or even show up for meetings.
The magic number we’ve seen is less than five people in any joint venture — whether its purpose is to manage a syndicate or to buy real estate with active partners. Any more than this in the management of a syndicate means the management compensation gets spread too thin so that no one is happy. The ideal structure is to have one or two people in control. If you bring in others, they should be able to fill jobs without having a deciding vote in managerial decisions. In reality, only two or three people end up doing all the work; the others end up being dead weight.
Everyone in your syndication management team should each have a clearly defined job description attached to the syndication management operating agreement. The agreement should allow you to terminate or reduce compensation for anyone who doesn’t perform their job. Carrying dead weight will drag you down, cause drama, and may prevent you from achieving your syndication goals.
The most common syndication model for multifamily real estate is to buy value-add properties that can be improved through upgrades, increasing rents, and decreasing expenses. You will need to raise capital to fund the down payment, and capital improvements (renovations), reimburse yourself for pre-closing expenses fronted by your syndication management team, operating capital, and reserves, and to pay your acquisition fee. Many times, a syndicate will set a minimum dollar amount for their offering that is just enough to close on the property. You can continue to raise capital after closing, but it’s easy to get the deal closed and then let your capital-raising efforts slow down.
If you don’t raise enough money to execute your plan of operation for the property, you will have the same property (and problems) that the seller had. You may end up with unreimbursed personal funds tied up in the deal, no acquisition fee for efforts, and you could be operating the property for a very long time before you see any distributions for investors or yourself (if ever). You won’t be able to complete the capital improvements or increase rents, and it is likely the property will fall into decline. Worst case — we saw a situation where the property made the news as a “slumlord-run” property. The property will become a burden that you can’t wait to sell, and your only option may be to sell it at a loss to your investors and probably at great cost to yourself in terms of time, reputation, and money. If you only raise enough to close, don’t take your foot off the gas post-closing. Continue to raise as vigilantly as before until you reach your target, and you’ll be in good shape.
Whales (just like in Vegas) are individual investors who claim they can fund your whole deal. While that may be true, the truth is that they won’t. Every new syndicator tries this at least once, erroneously thinking, “I don’t have enough smaller investors; I only need one and I’m good to go.” However, 95% of the time, they don’t come through.
Whale investors are notorious for disappearing right before the close, claiming, “Something came up and I can’t do the deal,” or they just stop answering the phone, without ever having invested a dime. Another common issue is they renegotiate their terms right before closing — knowing that you don’t have any other options, and effectively squeezing you out of the deal.
The reality is that some larger investors, while they may be able to do your deal, simply won’t. They may be too polite to say “no,” so you pin your hopes on them, and they string you along, but they won’t usually invest until you have demonstrated a significant track record with similar properties. Further, if they do invest, they will likely impose a bunch of reporting and operational requirements on your team — you essentially just bought yourself a job working for them. If you do get into negotiations with a single investor, hire a Corporate Securities Attorney to help you negotiate your side of the transaction.
Some private equity companies are predatory — they get into the deal and look for technical violations of their required conditions so they can exercise takeover rights that they’ve reserved for themselves. This usually allows them to purchase the property for the amount of their investment, stripping you, and any other investors you brought, of your equity.
In the worst case, they’ll string you along, and then simply won’t show up at the closing table. We saw this happen to a deal where more than $100,000 had been spent by the syndicator and a $400,000 investor simply didn’t show up. The deal was lost, along with the pre-closing expenses shelled out by the syndication management team and a lot of credibility with the investors that did come through.
Your favorite football team didn’t get to the Super Bowl without having a coach, and you are unlikely to achieve your syndication goals without having a coach or mentor for your early deals. All of our first-time clients who have gone on to do more deals and bigger deals have started with a coach. Clients who try to go it alone end up doing one or two deals, and often make mistakes that cost them time, effort, and money along the way. Don’t risk making hundred-thousand-dollar mistakes with other people’s money. It’s easy to do if you make some of the mistakes we’ve described along the way. If you do go it alone, you may be short-lived as a syndicator, and you may end up having to resume your previous profession.
Syndication is not a DIY area of the law. You need a real estate coach, and a Corporate Securities Attorney who will actually invest time in your education — to make sure you succeed from your first syndicate and as your syndication business grows. Getting a coach will keep you on track and streamline building your syndication business. Make the investment. You’ll ultimately be glad you did.
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Disclaimer:
The views and opinions expressed in this blog post are provided for informational purposes only and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.