Forming a business entity with partners for real estate or other purposes requires careful thought. There are many factors to consider. We have written about some of the important considerations before (see prior posts HERE and HERE). One consideration that deserves particular attention is the exit strategy if the business doesn’t go as planned or, more specifically, if one partner doesn’t perform as expected. This is extremely important for the money partner where the minority or sweat partner is given equity up front without making a cash contribution or with only a small cash contribution or has options to acquire equity for little to no investment other than “sweat”.

Two years ago, I drafted such an Operating Agreement for a client. My client, the money partner, who would also be taking an active role in the company. The client was funding 100% of the initial cash needs of the company. As such, he would receive 99% of the membership interests in the newly formed LLC. The minority partner was to provide only sweat for a 1% stake. We treated the client’s investment as a loan. The minority partner had an option to receive up to 49% of the interest in the company if he made a $100,000 contribution to the company in the first 2 years. That contribution would be used to pay down the client’s loan. Upon making the contribution, the client would immediately transfer 10% of his shares to the minority partner. If the partner did not make the contribution on time, the option to acquire a larger share of the company was reduced to 30% and either way, transfers of membership interests to the minority shareholder would occur going forward only when the company was able to generate sufficient revenue to pay down the debt owed to the client. Transfers would occur at certain benchmarks.

The partner did not make the capital contribution and the company was unable to generate revenue so the loan was not repaid at all. Instead, the client made additional loans to the company. The client recently decided that he wanted a way to change the deal. Fortunately, we planned for that.   We added provision to the Operating Agreement allowing the client, as the manager, to terminate the minority partner’s employment with the company without cause. Upon such termination, the company was obligated to buyout the partner at an agreed price of 150% of the value of the partner’s interest in the company. The company value would be determined by the company’s accountant.

This provision is very clear and the partner had a decision to make. He either had to renegotiate the option provision, which the client felt was necessary in order to attract new investors to the company. Or, the partner could allow the termination provision to kick in. That would, in effect force the partner to pay his share of the company debt to the client because the company debt is currently greater than its assets.

Planning for the worst can help to avoid protracted disagreements. While the partner, in this case, was initially uncooperative, after further thought and conversation, the parties did, in fact, come to a satisfactory conclusion. The client’s position was protected and he will be able to attract new investors to the company in the future and hopefully, grow the company and recover his investment.

Forming an entity to purchase, develop and operate real estate is generally a good idea for many reasons. There are tax considerations and liability implications that should always be at the forefront of any discussion when investing in real estate.  These are primary questions whether there are multiple partners or only a single investor involved in the deal.  But, when there will be more than 1 partner in a project, some sort of entity will need to be formed, whether a corporation, general or limited partnership, or a limited liability company or similar limited liability entity.  The “partners” (I am using this term generically to cover all  possible entities) should enter into an agreement carefully to set forth the rights and obligations of each partner so that there are not any questions about what happens in the future if/when certain problems arise.

Every relationship starts out with the best of intentions. Friends and family members, even acquaintances, generally trust each other to do the right thing.  But when money is involved or deals turn side ways, all bets are off.  Here are 6 provisions that should be considered in every shareholders, partnership or operating agreement, particularly when real estate is involved:

  1. Management Authority and Major Decisions – going into a real estate deal, 1 or 2 people might be the sponsors, or, 1 partner might have certain expertise and another might have a different expertise. Very likely, 1 partner might be the real estate guy and the other or others might be providing the capital.  It is important to determine who will make the day to day decisions and what decisions constitute “major decisions” requiring a vote of the partners.  Will  major decisions require a majority vote or a super majority?  Perhaps even a unanimous vote?

 

  1. Admission of New Partners – it is important to determine whether there will be spelled out criteria for admission of new partners and whether a vote of the partners is required to admit new partner or if the managing partner may admit new partners on his/her own. More importantly, will the admission of new partners dilute the voting interest or equity interest of the existing partners?

 

  1. Transfer of Ownership Interests – there are 2 concerns here, voluntary transfers and involuntary transfers. A voluntary transfer is the ability of a partner to freely transfer or sell his/her interest to 3rd parties.  Should this be permitted?  Or, should voluntary transfers be tightly controlled or absolutely restricted?  Involuntary transfers include transfers due to bankruptcy, divorce and death or a partner.  These are of concern to the partners because often, the non-transferring partners don’t want to be partners with the ex-spouse or surviving spouse, or be forced to deal with the bankruptcy trustee.  Therefore, it is important to provide mechanism for dealing with involuntary transfers.

 

  1. Capital Calls – the partners must determine the procedures for dealing with the need for additional capital and what happens when a partner does not fund.

 

  1. Buy/Sell Provisions – often, partners want to add provisions allowing for a partner to buy out the other partners. Sometimes, these mechanisms allow for “put and call”, requiring a potentially purchasing partner to sell his interest instead so that the financially stronger partner can’t force out the weaker partner any time he/she desires.  These provisions also can include rights of first refusal.

 

  1. Exit Strategy and Other Obligations – what is the partnership’s overall exit strategy? Have the partners agreed to sell the property at a fixed benchmark such as the exercise of a purchase option by a major tenant? What about other obligations like loan guaranties?  Are any of the partners obligated to provide guaranties for financing for the project?  These kind of provisions must be included in the partnership agreement.

 

These 6 provisions might only scratch the surface of issues relative to real estate deals. Every partnership and real estate transaction is unique.  If there are deal specific provisions, they should be added to the partnership agreement so that no questions or expectations are left unanswered.

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