Most watchers of the home building industry believe that friends and family networks are an important part of the future of builder financing. The phrase makes it all sound so cozy and informal. It’s anything but. The mechanism for pursuing investment money from individuals is called a private placement memorandum, or PPM.
Houston-based attorney Warren A. Hoffman has done “a lot of these.” Setting one up is complicated, time-consuming and expensive. “It takes longer than doing a bank loan,” says Hoffman, adding that it’s not uncommon to spend $50,000 to $75,000 on the paperwork.
“Even though it’s still a lot of money, the whole purpose is to eliminate the risk of doing it wrong,” he says. “If you do it wrong, you’ve got nothing for your money. That buys you the protection that you want. If you don’t do it, you’re at risk. Authorities can come back, years later, and they can make you buy everybody out. You don’t want to go through that.”
Among the decisions to make is the kind of investment entity that will be used. Historically, companies have used limited liability partnerships because they’re cheaper and easier to set up than corporations and limited liability corporations, but those are options as well.
You also need to decide the type of investment security you want to issue. It’s usually some type of equity — people will own an interest in the deal — or a debt offering. Or both.
You need to decide on the proposed investors. Will they be what securities laws call accredited investors or non-accredited investors? Accredited investors are wealthy enough to be allowed to invest in certain high-risk ventures. “As long as you have accredited investors, you can get away with an easy federal filing,” Hoffman says.
You’ll also need to put together a business plan with information on the company’s history, its reputation in the market and bios of the principals, as well as a summary of the deal points of the partnership.
“Hopefully, the client has versions of that they used in marketing materials or used for banks,” he says. “To the extent we have to write all that for them takes a lot of additional time.”
You’ll need to decide on management fees. “The people putting it together take fees,” Hoffman says. “They don’t do this generally just for nothing because they have to take care of this thing for years.”
You need to decide the term of the deal — is it a few years or longer? Investors will want to know when they’re likely to get their money back or their profit out. They’ll also want to know if you’re putting any of your own money into the deal. (“Yes” is the correct answer.)
Next, you need to decide the types of properties to be acquired with the funds.
You also need to determine the fund’s size, the minimum needed to go forward, if you’ll close it after raising a certain dollar amount, and if you’ll shut if down if you don’t raise the minimum.
Finally, what’s the minimum investment commitment?
With all those decisions made, then it’s time to file all the paperwork with the U.S. Securities and Exchange Commission and the regulatory agencies in all the states in which your investors live. The process usually takes a couple of months — less if everyone knows what they’re doing, says Hoffman.
Once all the paperwork is done, you then have to sell the fund to prospective investors. That can take several weeks. Then, when the fund is closed out, filings need to be made with the SEC and state agencies.
The most common mistake in setting up a PPM, he says, is in overestimating the amount of money they’ll be able to raise.
“Everybody is optimistic at the beginning, which is a natural trait,” he says. “People who think they’ll raise $25 million raise $10 million. I caution people on the front end to put very conservative numbers out there. Think about who you really know, can you raise this kind of money, and is it worth it? They have to spend a lot of time doing presentations. It’s not an easy, cheap way to raise money.”
So, what’s the point of trying? PPM’s do have advantages, Hoffman says.
It’s your deal and you can put in it what you want and what you think you can sell to the investors. You set the rates you’re going to pay your investors and the fees you’re going to make. Sometimes, you can raise more money through a PPM at more favorable rate than you can get from a bank.
Bottom line: It could be worth a shot as long as you understand what you’re getting yourself into.
“It is done, it is done successfully and, in hard times when banks are not giving money away, a lot of people are trying it,” Hoffman says. “I just try to be conservative and make them think hard about it first.”