Entrepreneurs have long wrestled with the question of whether or not they should use their own money to fund a project, raise capital through multiple investors using a fund, use a lender, or a combination of these approaches. This article will discuss the pros and cons of each, and discuss why one approach may be more beneficial than the others.
This discussion begins with the assumption that the entrepreneur is able to bring enough personal money to the table to satisfy any credibility questions. Now, let’s look at how best to get the rest of the money.
THE TALE OF THE TAPE
Number of “Dance” Partners
With a private lender, you usually have to answer to just one entity and one voice throughout the life of the project. With investors, since there tends to be multiple people involved in the funding, you might find yourself answering what seems like endless phone calls, explaining what is happening to their investment. Having only one party to appease makes it easier – both time- and focus-wise – when things go a little sideways. Big Edge to the Private Lender.
Duties to Partners
The general partner of a partnership (for our purposes, usually the entrepreneur or its entity) owes a duty to its partners. Often, this rises to the level of a fiduciary duty, which, in non-legal terms, means the general partner must watch out for the best interests of its partners. Should the project sour, the existence of the fiduciary duty and breach thereof could be a separate cause of action that an investor can bring against the entrepreneur. With a private lender, the entrepreneur has no fiduciary duty. Big Edge to the Private Lender.
Ability to Take a Punch
Most private lenders have experienced defaulted and delayed loans many times. They understand how to work out of them and their expectations are usually reasonable. On the other hand, unless the investors are institutionalized money, they may never have experienced a project that has gone sideways and their expectations of a return on their investment (whether it’s less than expected or perhaps nothing at all) may be unrealistic. Additionally, private lenders understand the time it takes to complete a project and the many factors that can cause delays. Your typical investor will likely get antsy when a project becomes sidetracked, even if only for a short while. Edge to the Private Lender.
The Relationship
The private lender is really just looking to be a temporary partner. Their goal is to make the loan, get paid some interest, and get paid back the principal. A fund investor, on the other hand, has the expectation they are in for all 12 rounds, or however long it takes to monetize the project. They expect to act and be treated like an owner during this time. So, unless you are looking for long-term partners…. Edge to the Private Lender.
Maintaining Control
A private lender absolutely does not want to control its borrower. In fact, it will go out of its way to make sure the loan documents leave the element of control out of its hands to avoid claims by the borrower of lender liability. Lender liability claims usually arise from failed projects where lenders take an aggressive position in managing the borrower and the borrower claims that but for the management imposed by the lender, the business would have succeeded. So, with the private lender, the developer is always in control. Investors almost always want to have some level of control (see “Relationship” above). The most often negotiated provision of an operating agreement is the provision that limits the decisions a sponsor can make without first obtaining the consent of the investors. These are often referred to as the major decisions sections of the operating agreement. Typically, major decisions that require consent of some percentage of the investors will be a decision to sell the property, bring on additional investors, borrow money, etc. If you are not looking to cede control…Big Edge to the Private Lender.
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Initial Expenses
The out of pocket expenses involved in using a private lender are limited to the usual third party-reports (for real estate deals – environmental, title, soil, survey, etc.) and legal fees of the lender and the borrower. These costs can be controlled by requesting a cap on lender’s legal fees and by instructing borrower’s counsel to keep fees to a minimum. Using a fund to raise money can be very expensive. First, there is the cost of producing a private placement memorandum in order to avoid violating securities laws. Legal fees can run between $15,000 for the very simplest of deals with investors of only family and close friends, to $25,000 for the most common types of real estate investing, to upwards of $100,000 for highly-complex or riskier deals. In addition to the legal fees for the private placement memorandum, once investors are located, each investor may want to negotiate and revise the proposed operating agreement in some fashion. This means dealing with multiple lawyers, with multiple clients, all trying to win their client the best possible position. Big Edge to the Private Lender.
Interest/Rate of Return
The private lender may charge a few points for originating the loan, and then a reasonable rate of interest depending on the risk level of the developer and the project. The all-in return to the private lender is typically between 10 and 18 percent. While the return to investors is typically bifurcated into a preferred return (usually between 8 and 12 percent) and then a split of all funds after the preferred return has been returned to the investor. This means there is a sharing of the profits in the deal with all investors. In other words, the upside to the investor is usually unlimited and the developer will have to share the profits no matter how big. The private lender will never share in the profits and its upside is limited to the interest and points it charges. So, while the percentages are lower if you go the investor route, the private lender’s fees are capped proportionate to their investment, not the overall gain. As long as your calculations include the profit, this one might be a…. Draw.
Your Reputation Should You Lose
If a project turns upside down, the reputation of the developer may be ruined with that particular private lender. On the other hand, the bad reputation of the failed developer will circulate among the many investors in the deal, their peers, their friends and their families. In many cases, the investors could be your friends and family, making family gatherings uncomfortable should the deal capsize or go sideways. If you are concerned about showing your face at the next Thanksgiving dinner or stopping by the club after a deal fails, consider staying away from the investor-funded deal. Edge to the Private Lender.
Recourse: A loan can be either recourse to the sponsor or non-recourse. If it is a recourse loan, or even a non-recourse loan with a limited guaranty, there is risk to the sponsor that if the project fails, the sponsor could become personally liable for any loss the lender has on the loan. If there is a loss and there is no lender, the sponsor is generally not liable to any investors. Big Edge to the Investor.
Move Like a Butterfly
The private lender will have some very specific requirements for collateral, funding, monitoring and servicing the loan. There will be financial and non-financial covenants to maintain and a very specific timeline by which to perform. Failure to perform may end up in a lawsuit. Investors, while their expectations will be set by the deal terms, usually place no hard deadlines for performance, do not require financial or non-financial covenants and the end result for not performing is usually not a lawsuit. Big Edge to the Investor.
THE DECISION
While the above seems to indicate that the private lender route is the odds-on favorite in the decision (that is, the best way to raise money for a deal), there are certainly plenty of circumstances where the investor route is the better choice. For instance, poor credit history of the sponsor may limit the sponsor’s ability to obtain a loan. Institutions that have invested together for long periods of time, may also favor the investor route, having worked out the kinks described above.
All that being said, for those who have not considered private lending as a “real” option or are venturing into this ring for the first time. If you are looking to raise money for your project, a private lender should definitely be a contender in your funding planning process.
This article originally appeared in the May/June 2017 edition of Private Lender magazine.
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