NUTS & BOLTS
JOINT VENTURES
CREATING A JOINT VENTURE–GOOD, BETTER, BEST
When evaluating a joint venture, I like to break it down into three categories, with each structure becoming progres- sively better, moving from a position with some protection into the ultimate joint venture scenario where you have security, protection from the unexpected and some degree of control. However, one must keep in mind that you may not be able to attain the best structure because the investor is not willing to accept your proposal. Therefore, if you must resort to Good or Better, then at least you can minimize the kinds of risks faced by George. ‘GOOD’ JOINT VENTURE George’s situation is fairly typical in the world of gap funding joint ventures. The investor presents the gap funder with a joint venture agreement he found online or was given at real estate workshop. These agreements, typically, are very rudimenta- ry and offer little to no protection for the gap funder. That is understandable, given that many investors are unwilling to spend money on an attorney to draft an acceptable agreement. So long as nothing goes wrong with the deal (since everyone stands to make some money) why bother? Well, things do go wrong, and investing a few thousand dollars up front to save you tens of thousands later on is a sound decision. Think on this: Have you ever met an investor who told you, “I sure regret spending money on a well-drafted agreement that protected me when the deal fell apart”? I am sure you have met a few that told you the opposite. So how can you prepare yourself if you are stuck at Good? Make sure you do the following: Enter into the joint venture as an entity, i.e., an LLC or corporation—never your personal name. This will provide you liability protection should something go wrong with the joint venture and a lawsuit is brought. The entity you use for the joint venture should not own a lot of assets. Again, if something goes wrong, everything owned by your entity will be at risk. Seek security. If the investor is unwilling or unable to pro- vide you security in the property in exchange for your fund- ing, then ask for a secured interest in his other assets, i.e., a personal residence or a rental property. If this is not available, then consider taking a lien against his ownership interest in the company he is using to develop the property. Many real estate investors are unaware you can lien a person’s ownership inter- est in their limited liability company or corporation. Thus, if the borrower defaults on the loan or does not perform, you can take over the company and, by extension, the property it owns. ‘BETTER’ JOINT VENTURE If presented with a joint venture agreement wherein the investor is willing and able to provide you a secured interest in the property, then consider skipping the joint venture agree-
Good, Better, Best BEWARE OF A ‘ONE-SIZE-FITS-ALL’ MINDSET IN STRUCTURING YOUR DEALS, WHICH COULD BACKFIRE IF YOUR JOINT VENTURE ENCOUNTERS ROUGH WATER.
by Clint Coons
F
lipping real estate requires access to capital. Most inves- tors fall into one of two categories: investor/deal spon- sor or lender/gap funder. Regardless of which side of the coin you are on, it is important to understand the various options available when using financing. The last thing you want to adopt is a “one-size-fits-all” mindset when it comes to structuring your deals. This type of planning will backfire when the joint ventures encounter rough water. Often joint ventures focus primarily on the money and not enough on the details of the deal itself and its implications, both short- and possibly long-term. George, a real estate inves- tor new to gap funding, paid dearly to learn this lesson. George met Ian at a real estate investor conference in Texas. Ian represented that he was an investor with a remarkable rehab property under contract in North Carolina. Ian was in need of $80,000 in gap funding and $120,000 in rehab money. In exchange for $200,000, Ian was offering 10 percent interest plus 50 percent of the profits when the property sold. To me- morialize the deal, Ian presented George with a “joint venture agreement” containing the following: • Financial term—profit split between the ventures, plus interest on money contributed. • Purpose of the joint venture—buy and rehab a property. • Name and term for the joint venture—take seven months to complete. • The funds would not be secured against the property be- cause the primary lender will not consent to any other liens. • It’s the investor’s duty to perform all of the rehab work. • Some various other clauses regarding dissolution, liquida- tion, etc. After some due diligence, George liked what he saw and told Ian he wanted in on the deal. After signing Ian’s joint venture agreement, George wired the money. Fourteen months later, George is served with a lawsuit by a person injured while working on the house, followed by a phone call from Ian in- forming George his projections were wrong and he is consid- ering walking away from the project unless George comes up
with another $75,000. George calls a local attorney, but he is unable to assist because the project and lawsuit are located in North Carolina and George lives in Texas. George’s investing comes to an immediate end. George’s situation may appear to be extreme, but it is closer to reality than most gap funders realize. I often tell gap funders to never enter into a joint venture agreement in your name. (I often recommend investors avoid them altogether unless engaging an attorney to draft the agreement.) At the very least, use an entity to be a partner in the joint venture, so you have some protection from lawsuits. Why do I bring up protection, you might ask? Well, it has to do with the fundamental nature of most joint venture agree- ments—they are lawsuit landmines waiting for unsuspecting gap funders like George to stumble across and end up with severe damage. A joint venture is essentially a general partnership that is limited in scope and duration. If you are not familiar with a general partnership, it is an endeavor taken on by individuals with an agreement to share in the profits or losses of the en- deavor. Both partners split the profits after the sale. Profit sharing is the first problem in joint venture agree- ments—they are disguised general partnerships with joint and several liability, i.e., both partners are fully liable for any claims made against the endeavor regardless of control by either partner. In George’s situation, even though the project was managed by Ian, in another state, George was a partner and, thus, the injured party has a legitimate claim against George for his injuries—all of them. The second problem with joint venture agreements is typi- cally the agreement itself. Very few joint venture agreements plan for the real contingencies typical in many real estate transactions. Here are some examples of issues ignored in many real estate joint ventures: THE LANDMINES IN JOINT VENTURE AGREEMENTS
• How is the sale price determined, and what is an acceptable reduction? • What happens if the property does not sell? • If the property is rented because it does not sell, how are rents divided? • What happens if the investor does not perform? • Limits on borrowing or expenditures? • Is the agreement to be recorded? • How is dispute resolution handled, and how are costs paid? • What happens if there is more project left at the end of the money? These are just a few of the areas typically ignored in joint venture agreements that quickly morph into a lawsuit because of violated expectations. The third problem with joint ventures is the lack of secu- rity. In many cases, the gap funder is not provided security for the loan. Far too often, the hard/private money lender will not consent to a second on the property. Thus, the gap funder has no recourse if the deal goes bad because the gap funder is an unsecured creditor. In George’s situation, Ian was considering walking away from the project. If Ian pulled out, the property risked foreclosure by the primary lender. George could lose his entire amount because he did not receive a security in the project.
110 | think realty magazine november :: december 2016
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