When it comes to risk management, one of the most important tools in your toolbox is having a rockstar attorney. When I got started, I was fortunate to find a local attorney local who understands note investing. Brian Gallagher works at Council Baradel and has been instrumental in my companies growth and risk management strategies. Recently I had the opportunity to interview Brian and discuss creating a joint venture agreement. We have highlighted the key discussion topics below. For the full interview, we provide links at the bottom of this post.
While I focus on note investing, the topic of joint venture agreements is applicable with all types of real estate transactions. Whether you are doing a buy and hold, a fix and flip or as a note investor like myself. So whichever avenue of real estate you take, if you are looking to enter into an agreement with other investors, having a well-crafted, fair and compliant joint venture agreement. This is essential in the real estate and note investing business. so lets discuss.
Treat the Joint Venture Like a mini-operating agreement.
When creating a joint venture agreement, there are several components to consider at a high level. The best way to think about the agreement is to treat it as if it is a miniature operating agreement. An operating agreement defines how the members of an LLC are going to interact with each other. It also defines what their duties and obligations are with respect to that LLC. The same is true for a joint venture agreement. A good joint venture agreement should cover basic things of, “This is how much each is contributing. This is where what we are going to use the joint venture to accomplish.”. The agreement will also address the acquisition and disposition process.
Have Your Joint Venture Agreement Reviewed by YOUR Attorney
Whoever is drafting your agreement, it shouldn’t be you (unless you are an attorney). Nor should you just grab one off a website or another note investor. If you do, you will want YOUR attorney to review the agreement. Why? First and foremost you want to make sure you are not selling a security. You also want your attorney to review it because when deals go smoothly, the JV agreement is rarely referenced. But on deals when things take a turn for the worst, the document gets scrutinized. This is when you realize you did not cover all these caveats and contingencies in the agreement. Take it from me, I have had my JV agreement updated and edited at least a half-dozen times. Why? Because over time you have issues come up that were silent and not addressed in the agreement.
Is it The Sale of A Security?
The overarching point to understand when doing a JV deal is giving consideration to whether this is an investment. The SEC and the courts have defined what an investment is. The standard for determining whether something is an investment is whether you intend to make money solely off of the efforts of others. If you are going to give somebody $1,000 and you’re not going to do anything but in a year’s time, you expect to get back $1,500 based solely on their efforts, that is a security. With a lot of JV agreements, this is a problem. Another example taking money from somebody and then in the deal, you tell them you’re a silent partner. This again is a No-No.
Your attorney, when drafting a JV deal is to do everything they can to ensure you are not selling a security. Some key components of the JV are:
(a) saying this is not an investment;
(b) Give the person you’re JV-ing with a real, actual duty, obligation, and opportunity to participate meaningfully in the management of the asset. That means that they are not expecting to make money solely off of the effort of others.
The joint venture is over, but things don’t always go as planned, especially in the note investing world. There is a myriad of things that can happen to throw a wrench in the plans. When this occurs, the parties need to understand what their rights and obligations are. For example, what if somebody wants to get out of the joint venture. Do you allow them to get out of it? If they are allowed to get out of it, how does that go about happening? What if neither party wants to get out of it but they are stuck at an impasse? What if they can’t agree on a major decision to be made. These issues need to be thought about and addressed when drafting a joint venture.
When you’re in a JV deal, your JV partner should have the opportunity to ask questions. For example, “I understand this person is in default. They haven’t paid for a little while. What would a modification would look like and what we would accept as a modification or what we wouldn’t accept? What would a foreclosure look like? How long does it take, how much does it cost?.” If it’s going to foreclosure, that JV partner has to have the real and actual opportunity to discuss with you, “What’s going to be our starting bid? What’s going to be the bottom line that we’re going to allow this to sell for?”
How To Handle An Impasse
There should be language that deals with when you are at an impasse and typically that is what invokes a buy-sell provision. You hear a lot about buy-sell. What does that mean? When you reach a point with a partner where you can’t move forward because you’re at an impasse or a deadlock, are you going to sell your interest to them? Are you going to buy them out? It’s that whole process. This is also not something that should be cut an pasted from another agreement. How this is written is more of a business decision than it is a legal decision.
In order to understand how you want that to work and your joint venture agreement, it’s a business decision. Are you in a position that if you get to that point and there is an impasse, do you want to say, “We’re at an impasse. We’re refusing to move forward. We’re going to sell this entire asset to somebody else and we have to sell it to the highest and best bidder within 30 days. We’ll distribute the proceeds of that sale in such and such manner?” Does that work best for your business model? Does it work better for the business model that you have an opportunity to buy that person out?
Have The Appropriate Level of Experience
To enter into a JV agreement, you have to be an experienced note investor. Why? You need to understand how notes cash flow. Do you understand how realistically you can expect proceeds to come in? What is going to be paid out of those proceeds prior to you being paid? If you’ve never done it before or if you don’t understand how the cash flow of a note works, how are you going to successfully write a JV agreement? You need to determine your cashflow waterfall that accomplishes your business goals. That’s why I tell people I can give you some examples of how some waterfall distributions work but what works for me may not work for you.
The waterfall is a business decision. An example is I work full time and have a W-2 job. I do not rely on the profits from a note to put food on my table, therefore I can potentially be more flexible in how my distributions are made. If you work full time in notes and use these funds to put food on the table, your structure will be different than mine. You have to make sure your structure fits into your business plan.
Remember, the onus and the liability is on you. The liability is not on them. The liability for this being an actual investment is on you. As long as you are doing things that prove that your intent was not in taking an investment, that it is in having it partner to assist in the management of this deal, you’re doing the right thing.
To check out the full interview, click on the link below: