Structuring Real Estate Joint Ventures

Real estate investors work together all the time.  More and more, we see combinations of brokers, money investors, contractors and other folks flipping or developing properties.  As members of a real estate venture, these folks need a formal structure to govern their relationships within the venture.  In this presentation, I hope to give you a brief but condensed outline of the issues to think about when forming joint ventures for real estate investments.

There are three key concepts in structuring your joint venture: control, splitting up the profits, and exit.  First, you need to think about who will control the venture, including the votes needed to make decisions, and day-to-day operational control.  Second, think about how you will split the profits of the venture, including how you compensate those members who contribute their time (for example, contractors).  Third, think about your exit – before you enter any business relationship, you need to have your exit locked down.

One last introductory thought: At a later stage in their evolution, to handle more projects and bigger projects, real estate investors and developers start looking for money, that is, for passive investors.  Essentially they start to build real estate funds for the purpose of raising capital.  This will be the topic of a later presentation – the building of real estate funds.

1. Legal Entity.  You should always operate a joint venture through a legal entity, whether a corporation or an LLC.  Without a legal entity, the members will be partners in a general partnership.  A partnership is about the worst structure possible, because it makes all partners personally liable for the partnership’s debts.  I have addressed this topic at length in prior presentations, so I will not discuss it here.  Check out my website, mattdickstein.com, for some articles on the subject.  

2. Control.  The concept of control generally includes board / member voting, and veto rights.   

        2.1. Voting Power.  Generally, you make decisions about projects and other matters based on a vote of members.  In a corporation, this is done through the board of directors.  It is very important that you think through who will be on the board and how the directors will get along and ultimately line up in voting coalitions.  An LLC works about the same, except you count member votes instead of director votes.  LLCs also can have managers, who are given varying degrees of operational control. 

        2.2. Veto Rights.  For specified operating decisions, the parties can require a certain percentage (e.g. 75% or 100%) of the votes.  These decisions can include purchasing or selling properties; budgets; hiring contractors; salaries & bonuses; affiliate transactions; bringing in new members; distributions; loans; etc.  Veto rights generally help minority owners, because a minority can use a veto right to block company action.  This can lead to deadlock.

3. Distributions.  A venture throws off money in various ways, including the sale of properties, lease rentals, interest payments to lenders, compensation to contractors, and compensation to the venture’s employees.  You need to clearly provide for the splitting of profits among the members based on such factors as money invested, time and labor spent in fixing up properties, and time spent in management.

Remember that managing owners can siphon off substantial salaries and perks, but absent mandatory distributions, passive owners might get no return on their investment.  Consider how salaries and related party contracts will pull pre-distribution income out of the venture.

4. Exit.  Before you enter, always know how you will exit a business venture.  You need a structure that permits an economic divorce among the members in a venture.  Essentially, if the venture or the relationship among the members falls apart, all members should receive their fair share of the venture.  No one should be able to short-change anyone else.  

        4.1. Trigger Events.  The precondition for the economic divorce is some bad event.  Examples of bad events are irreconcilable dispute among the members, the need to remove a member from the venture, or the death of a member.  These bad events trigger the economic divorce.  The economic divorce can either be a complete liquidation of the venture, or for individual members, the buy-back of the member’s shares.

                4.1.1.  Liquidation of the Venture.  The value in most real estate ventures is the real estate itself.  There is little goodwill value in the venture, in contrast to other types of business.  Nor is there much sentimental value in the real estate – the venture holds the real estate on a short-term basis with an eye to flipping it for profit as soon as possible.  With this in mind, if the members cannot get along, it is very easy to liquidate the venture’s assets, distribute the profits and let the members go their separate ways.  This is the economic divorce.

                4.1.2.  Buy-out of Individual Members.  Sometimes you only need to deal with one member and don’t want to liquidate the whole venture.  For example, an individual member might get a better job and stop putting time into the venture.  This member becomes a freeloader, and the other members might decide to remove the freeloader to prevent him from benefiting from their hard work in building up the venture.  Or for example, a member might be such an irritating malcontent that the other members decide to be rid of him.  Or a member might die, in which case the venture will want to distribute cash to the deceased member’s estate in a fair amount equivalent to the deceased member’s stake in the venture.  Or a member might go bankrupt, and the other members will want to protect the venture from his creditors.  In all these cases and other cases, the venture needs a structure for the orderly and fair removal of members.

                 4.1.3.  Note Regarding Disputes.   Sometimes two members just can’t get along.  To deal with this situation, you can use “shotgun” procedures.  This means that, between the two warring members, the first member offers to buy out the second member, and the second member has the choice, either accept being bought out, or turn around and buy out the first member on identical terms (i.e. I cut, you choose).  Either way, a price is fixed for the buy-out, and one of the warring members leaves the venture.

        4.2. Buy-out Price.  The buy-out price is crucial.  A high buy-out price gives the exiting member a windfall.  A low buy-out price is unfair and leads to litigation.  The trick is finding a procedure that ensures a fair price – for example, using a neutral appraisal process to fix a price.  Further, deciding to buy out a member is the easy part – paying the purchase price is harder.  You will need cash to pay off the member.  There are many methods to handle these problems, and ultimately all methods derive from the specific structure of the venture.  Here are some general concepts, however:

                4.2.1.  Liquidation of the Venture.  A straight liquidation of the venture can be clean and simple, because the real estate will sell at its fair market value and thereby produce cash profits.  The members will distribute the cash profits per their ownership percentages and dissolve the venture.  That’s the end of it.

                4.2.2.  Buy-out of Individual Members.  If you only want to buy out a single member without liquidating the venture, you will need a source of funds.  From whence the money?  One structure that I use is to make the buy-out price the net equity value of a member’s interest in the venture.  The other members then finance this amount.  As another example, for buy-outs upon death, the venture can put in place life insurance on the life of the deceased member, then use the proceeds to fund the buy-out.  This is classic buy/sell work.  In any case, your structure will have to handle these issues down to the last detail.

        4.3. Personal Guaranties.  Be very careful regarding personal guaranties.  These are the wild cards in an exit structure.  An effective exit structure must fairly compensate and/or protect members for their guaranties.

This presentation only gives a brief outline of some issues involved in a real estate joint venture.  There are a lot more issues and details to worry about.  I strongly urge you to get competent legal and tax counsel when you set up a venture.

Call me to schedule a legal consultation: 510-796-9144