Paying for the Private Placement Memorandum

A Private Placement Memorandum (PPM) is a legal document that is required for syndications when you are managing someone else’s equity investment. The PPM must be reviewed by a securities attorney for compliance, completeness, and efficacy for your project. The PPM can be very expensive, costing thousands of dollars.

I understand the frustration with the legal cost for preparing a PPM. I tried to cut corners with PPMFast.net and I was overwhelmed with the size and complexity, plus the cost of “state specific caveats” grows quickly. The caveat is one or two paragraphs that are specific to a state in which either the property is situated or a potential investor resides. You’ll need to buy a caveat paragraph for each state in which your investors reside plus the state for the subject property. However, the original template document is yours plus the purchased caveats. Over time after investing in several properties (reusing the PPM template), the cost will amortize and seem cheap. It’s just not cheap at the outset.

My attorney quotes about $8K to draft a PPM. The higher the quote, the more they are saying, “We really don’t want to do this work and be liable for it.”

I can negotiate for a payment schedule (maybe half now and the remainder spread out over a few months), and for a “fill-in the blanks” form so I can do most of the work and then let my attorney review the document (much less expensive).

Reviewing a “complete” document for compliance, completeness, and efficacy is cheaper than drafting a new document. (Even though I know that they have the document on their computer database and they just “fill in the blanks” too.) ALWAYS have a securities attorney review your PPM, especially when you use “off the shelf” forms.

You’ll also need to be sure that the escrow agent or title company has a very strong reputation and experience in processing syndication deals. It’s very different from simply buying a house. Your attorney will likely be needed at the closing table to be sure that the paperwork is correctly accounting for all of the monies and the legal documentation is perfected.

I doubt that you’ll have much success negotiating a “piece of the action” with your attorney in exchange for a PPM. Most law firms have zillions of pieces of action on worthless projects that never saw the light of day. They’ve learned their lesson the hard way. A quick nickel is better than a slow dime. It wouldn’t hurt to ask, anyway.

This is another situation where an equity partner financier can help with offsetting the cost of getting started as a syndicator. That’s one of the reasons that I suggest retaining 40% of the deal, so you have negotiating room and so that you can offer some of that percentage to your private financier to pay your upfront costs. This is my preferred method of handling the costs of due diligence, including inspections, legal and accounting costs, surveys, environmental site assessments,  earnest money deposits, etc. I don’t mind other people making money as long as I am adequately compensated for my sweat equity. I give up a piece of my action in exchange for covering my overhead costs.

Another alternative is when syndicating “small deals”, that you include all of the investors as LLC managing members with voting rights relative to their percentage investment. Your membership position must be subordinated to theirs; otherwise you may be subject to immediate income tax on your syndication premium, as well as your equity position. (It would look like they gave money to you to buy your equity position.)

The subordination is relative to an agreed minimum yield on their investment before you receive any cash flow or the exit strategy. They get paid before you get paid. When they are all managing their investment, then it’s not a security. They can delegate the management to a 3rd party professional management company, which you can be responsible for managing. You just manage the managers. That is all expressed in the LLC Operating Agreement. You will receive an administrative fee for managing the professional management company. I suggest that in this instance you vet and retain a 3rd party management company, rather than your own management company to avoid the appearance of managing other people’s equity (which is then viewed as an investment security).

Another alternative is to borrow the common equity investment, rather than ask the investors to take an equity position. When properly documented, the investors are lenders holding a promissory note and secured by a fractionalized trust deed (lien on the property or a Uniform Commercial Code lien on the LLC). With private lenders, rather than equity investors, they don’t have much say, if any, in how you manage the property and they are secured by a lien. The downside is when it’s time to clear the lien from the title and redeem the note. All payees on the note must sign off (notarized) on both the note and the lien.

If there is a default on the debt, then it gets worse. That’s why it’s best used for “small deals” to reduce the complexity and hassles. I recommend that the promissory note is non-recourse, which means that the subject property is the only security for the note. They must foreclose on the lien, auction the property or take title subject to any senior liens on the property. They cannot sue you for recovery of any deficiency.

If you borrow the common equity investment, then you must qualify for the senior financing tranche. Your private investors are lenders, not equity members. That’s another reason to apply this financing technique to small deals that you can qualify on your own capacity. I recommend trying for seller financing for the senior financing tranche. In your negotiations with the seller, point out that in the event of default your junior tranche lenders may decide to take over the property subject to the seller financing. In that way, your private lenders are essentially qualifying for the seller financing and they’ve already qualified you for their junior debt financing. That is over 100% financing and the seller gets some upfront cash.

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