Private Money: Terms You Should Know

Private money is key to successful real estate investing. And I’m not just talking about borrowing some dough from Uncle Bob for that rehab project and then returning it to him when the project is done.

That’s fine, but if you’re serious about the REI business, you need to be a bit more savvy about private money than that. The SEC has plenty of rules and regulations about it. Plus, the more you know, the more you can leverage private money to grow your business.

This lesson provides a quick overview of key terms, what a private money lender is and how to find lenders, and the paperwork you need when you bring a lender onto your team.

The Terms

Let’s begin by defining some key terms.

Private equity: In finance, private equity is an asset class consisting of equity securities and debt in operating companies that are not publicly traded on a stock exchange.

If you’re running a company, you are not publicly traded. You are a privately held company. A public company has what’s called a prospectus. And a prospectus gives a potential investor all the risks, information about the company, what do they invest in, etc.

Because we are not publicly traded companies, we don’t have a prospectus, but we still have to provide fair and adequate disclosure to our potential investors and what they’re getting into. This not only covers your investors but covers you too.

If you’re in this business long enough, chances are you’re going to get sued by a tenant, an investor, or a competitor. Don’t be surprised; just be prepared.

Debt or equity financing: Debt financing is what it sounds like: loans to cover expenses.

It guarantees someone repayment of principal plus interest. You tell an investor, if you invest with me, I will give you a mortgage and a note and I’ll pay you back 12% annual simple interest at day 365.

That’s debt financing. Your investor doesn’t own the company or have anything to do with your company or even the deed for the property. You’re just going to pay the investor back. This is more common for real estate investors than equity financing.

Equity financing happens when you give up ownership of your LLC to pay for those expenses. You tell an investor they will receive a 10% stake in the company, and whatever the company makes, the investor makes 10% of that.

Initial Public Offering (IPO): When a company decides to go public, its shares are publicly traded on the stock market. That initial offering when the company goes public is the IPO. Since your company is private, you don’t have an IPO.

Balloon: A balloon is when all interest plus all principals is due. So if you have a one year balloon, all your interest plus the original money that you borrowed is due after one year. Not sure how much interest to offer? I recommend 12% interest or 15% of the profits, whichever is higher due in 1 year. And you make zero monthly payments. All funds are due when the house sells or in 1 year, whichever comes first.

A secured loan has a mortgage. It involves collateral. An unsecured loan has no mortgage. A credit card is an unsecured loan. A promissory note issue can be an unsecured loan if it’s not tied to the mortgage or other collateral.

A line of credit is a bank loan with a revolving amount of money you can borrow back at will. I have a $150,000 line of credit I use to buy houses. I can write earnest money checks out of it.

Financial arbitrage is money the bank makes. It’s the difference between borrowing and lending. If you put $100,000 into a CD in the bank at 1% interest, the bank can loan that money out at 5%. Then the bank keeps the 4% difference. (By the way, don’t invest in CDs. You lose money on a CD.)

Public offering: Publicly traded companies (again, not us) can seek investors, for example to buy stocks, with a public offering. As a real estate entrepreneur, you would only seek investors if you have a 506c exemption that allows you to advertise for investors (but they need to be accredited investors).

What Is a Private Lender?

The key to private lending is personal relationships. If you see an advertisement for a private lender list, don’t buy into it. That list might include people who are on public record as holding a mortgage for someone else. But those people are often family members. And even if they are private lenders, if you try cold calling or mailing you’re probably not going to get a response.

The easiest way to get private money is to rely on your family, friends, coworkers, and all their family, friends, and coworkers. Your private lenders are not going to be people who have no idea who you are.

And if they ever ask for a credit check, an application, or your tax returns, they are hard money lenders and not private lenders. You don’t have to share your personal financials with your private lenders.

Private lenders are people. You meet them at Starbucks or Panera. For example, I had one private lender give me a referral. I set up a meeting with this guy (my lender’s boss) at Starbucks. We sat down, I was almost through my pitch, and he stopped me.

“I’m ready to invest. I want in now.”

He was an accredited investor, so I was able to bring him on right away, and he wrote me a check for $350,000. Yes, that really did happen with a guy I met once at Starbucks for 20 minutes.

I took that check and invested it. 9 months later I had his check for $400,000 (the principal plus $50,000 of interest) and went to meet him at Starbucks. But I realized I didn’t remember what he looked like, because we had only met the one time.

Thankfully he was sitting in the same spot as he did at our first meeting, so I recognized him and dropped off his check. Whew.

But that’s the great thing about private lending. Rely on networking and people you know to find those crucial private investors.

What’s an Accredited Investor?

So that Starbucks guy was an accredited investor. Accredited investors meet one of a series of qualifications:

  • Million dollar net worth (not including their principal residence)
  • Income of $200,000 each year over the past two years (for a single) or $300,000 each year over the past two years (for a married couple)

There are a few other possibilities we’ll get to later, but these two are the most common for our purposes. The SEC likes these investors. You can work with non-accredited investors who have a lower net worth or income, but the SEC keeps a closer eye on those non-accredited investors because of fraud and Ponzi schemes.

Finding Private Lenders

There’s really no exact way to find private lenders. But the key is to always be networking. You should have your elevator speech down pat, and you should set goals on how many people you’re going to tell about your business.

This is so easy. If you start a conversation by asking what the other person does for a living, they will usually reciprocate. And that’s your opportunity to give that elevator speech. I usually say something like, “Thanks so much for asking. I am a real estate entrepreneur and I actually raise money from individuals like yourself. Our investors have a fixed double-digit rate of return.”

Remember, you’re not just an investor, a flipper, or a rehabber. You’re an entrepreneur, and you raise money. You’ll be blown away by the reaction you get, and you’ll often be able to cultivate that into a meeting.

I would recommend that you start your own Project 100. Identify 100 people you can pitch this to. Start with family and friends, coworkers, your dentist, your kid’s dentist, and the guy who owns the gas station up the street. Never exclude anyone from that list by thinking they don’t have any money or they have too much money to want to invest with you. Everyone wants to make more money, so everyone will be interested in your pitch.

And never get desperate. You don’t want to plead or beg. Don’t tell people you only need $200,000 more dollars so you can make some money to buy your dream boat.

Instead, remember that you’re offering an opportunity to invest. There are plenty of potential investors, so if someone isn’t interested that’s fine. You can keep looking for other investors. Remember, this is a relationship, and you need to be able to work with these investors too. I’ve fired private lenders because they were a pain to work with. It needs to be a good fit for both of you.

Advertising for Investors

Advertising for investors is actually a little tricky because it is tied to exceptions.

When you issue any type of mortgage or notes, this is a security. You need to have a license to issue or sells securities, or, in our case, you need to have an exemption. You can get either a 506b or a 506c exemption.

With a 506b exemption, you can have up to 35 non-accredited investors and an unlimited number of accredited investors, but you can’t solicit anyone. That means you need to have some kind of relationship with your investors and you can’t just post an ad on Facebook or Craigslist.

With a 506c exemption you can have an unlimited number of accredited investors, but you can’t have any non-accredited investors. And you can’t have both exceptions and convert them from one to the other. But with a 506c exemption you can generally solicit for investors.

Remember, though, that people invest in people. If you don’t have a relationship with people, chances are they’re not going to invest with you. So this is not an avenue that I promote. Build up trust with people you know and then they choose to invest with you and give you referrals.

Paperwork to Close the Deal

So you meet with your new potential private lender. You give them your polished pitch. And then you need to show them some paperwork. There are four components to a winning private investor pitch:

  • Executive summary
  • Private placement memorandum (PPM)
  • Mortgage
  • Note

I’m not going to go through these word-for-word; I’m just going to highlight some key points for you so you have an understanding of what each of these documents does.

Can you close with a private lender without some of these documents? Yes, but this paperwork is all about CYA—covering your ass. The goal is to be able to prove that the investor is fully informed about the investment he or she is making. That way if something ever happens and an investor decides to sue, you can show a judge proof that the investor was fully informed about your business and business practices. So it’s important that these documents are complete and forthright.

Executive Summary

Your executive summary should be prepared by an SEC attorney. It’s typically about 4 pages, and the goal is to provide an overview for your potential investor. It includes a few key sections.

About the Company

This section explains what your company does and how you invest your money. It also tells your story and helps the investor understand your history and experience.

Example:

THE COMPANY

MILLENNIUM CAPITAL INVESTMENTS, LLC (“Company”) is a limited liability company (“LLC”) being organized in the State of Ohio. Its principal office is located at 7102 Brookside Drive, Cleveland, OH 44144, and its telephone number is (216) 233-5448.

MILLENNIUM CAPITAL INVESTMENTS, LLC is being created solely for the purpose of attracting Private Lenders’ funds for investment in the form of Promissory Notes.

Josh Cantwell graduated from Baldwin Wallace College in 1998 with a major in Business Administration and a minor in communications. Although a full-time student and college athlete, Josh was already driven to succeed in his career. After graduation he obtained his Series 6, 63, 66 and life and health insurance licenses, and worked as a Financial Advisor from 1999–2004….

What if you don’t have any investing experience?

Don’t forget that people invest in people. Show that you are trustworthy and know what you’re talking about. Use solid referrals. Everybody’s got to start somewhere.

Risks of Investment

This is key. You need to provide fair and adequate disclosure. Private lenders should know where their money is going, how long their money is going to be out, and what they’re investing in. They should know everything. You don’t want them to be surprised.

Example:

As a real-estate investment company, the Company is subject to risks including, but not limited to:

  • Availability of investment capital from Private Lenders
  • Local real estate markets
  • Competition from other real-estate investment companies, which may offer competitive interest rates or terms and/or conditions to Private Lenders
  • Potential vacancies
  • Potential damage caused by tenants
  • Unanticipated repair costs….

This section should also state that if the company engages in other business activities, all interested parties will be notified. For example, if you are investing in apartments and then decide to invest in storage units, you need to make investors aware of the risks of the new storage unit investment. Again, they should never be surprised.

Management

Tell potential investors who is in charge, how much they are paid, and who the property manager is. Explain that investors don’t have voting rights.

Company Operations

Explain what kind of business the company will do and how decisions will be made.

Example:

COMPANY OPERATIONS

The Company will invest in residential and commercial properties based upon the decision making and investment analysis to be done by the Company’s management. The Company’s management will rely upon the best available market information in those markets where it intends to invest, as well as upon the Manger’s own years of experience as a real estate investor, conducted in separate businesses. The Company will use funds to acquire real estate in multiple states, focused in the states of Ohio, Illinois, and California, although properties may also be purchased in other states….

Use of Funds

This section lists different ways funds are used. For example, they are used to invest in properties in specific states, make loans to other investing companies referred to as borrowers, or cover offering expenses.

Financial Information

This section should make the investor aware that financial information on the company will be provided upon request and is treated as confidential.

Securities Counsel

This section describes who provides legal services for the company.

Litigation

This section explains to the investor that the company may need to engage in litigation, for example to evict a tenant. Our goal here is to fully inform the potential lender.

Disclaimers

The executive summary will also include disclaimers; this is all the legal mumbo-jumbo that helps you make sure you’re covered.

Private Placement Memorandum (PPM)

The PPM is very different from the executive summary. It’s much longer. One PPM I worked on recently was 30 pages. This is the specific offer you are making to a private investor.

The PPM is also required IF you are:

  • raising over a million dollars (from various lenders, not all at once)
  • crossing state lines (if you live in one state but invest in another or have investors in another)
  • advertising or completing a federal registration intrastate offering within your state

Now on to a few highlights of the PPM.

Introduction

The PPM is a specific offer for a specific investor, so on the first page it should include your investor’s name. It should also list your company name, the amount of debt being offered, and the minimum investment.

The amount of debt offered is the cap for your LLC. You can raise whatever you want to raise; one recent example of a PPM I did had a cap of $5 million.

You should also set a minimum investment amount. I have a $50,000 minimum because anything less than that really doesn’t get you very far.

The introduction should also summarize what you are offering and who you are offering it to. Specifically, you are offering units (shares) in your company in amounts exceeding your minimum investment amount, and you are offering those units to accredited investors who complete the paperwork you are providing.

This introduction also needs to explain that these investors should not be relying on the funds they are providing and would be able to economically handle their personal situation if they lost the money they are investing.

Confidentiality

All these documents are confidential and should say this is the case. Investors shouldn’t be sharing your PPM with anyone because that could be misconstrued as general advertising.

Instructions for Purchasing Units

Provide investors with a checklist of tasks to purchase units. Include a deadline.

Have investors electronically sign documents (I use DocuSign, which is a paid service). This will make the whole process much smoother.

Consulting Counsel or Financial Planners

This section should explain to the investor that you are not a lawyer, and the investor is free to consult a lawyer or financial planner before investing.

International Investors

You can work with international investors, but the investor needs to abide by their own country’s laws and regulations. It’s the investor’s responsibility to observe those laws, as your PPM should explain.

Subscription Agreement

The investor should fill this out to tell you how much they want to invest.

Acknowledgement of Risk

The PPM needs to state that the investor understands that the investment involves a high degree of risk, including the risk of total loss of the investment.

This is important in the event that something goes wrong and an investor sues. You should be able to take this to a judge to say that the investor acknowledged the risk and signed the document.

Securities Subscription Agreement

This section provides instructions for a wire transfer of funds. The investor should fill in the amount they are investing, and you provide the information about where they wire the money, including the name of the bank, the account number, etc.

Provide instructions for a cashier’s check as well.

Accredited Investor Status

Investors basically self-accredit with this form. All the investor needs to do is check the box that applies to them and then sign the form:

  • individual whose net worth (not including their primary residence) exceeds $1 million
  • individual whose income exceeds $200,000 in each of the two most recent years OR income of a married couple that exceeds $300,000 in each of the two most recent years
  • a trust with total assets in excess of $5 million
  • an equity in which all equity owners are accredited investors
  • non-accredited investors who are sophisticated investors or are working with the assistance of a purchase representative

Execution Page

You fill out this page and they sign. This asks for their taxpayer ID (social security number). It also asks for signatures from spouses or co-owners.

So that’s the PPM. There are different versions of the PPM. Your SEC attorney might make some changes to make sure it fits for your business.

Mortgage

At this point we’re turning to specific paperwork for the investment property. First, the mortgage is what is securing the investment. You’re providing the private lender with collateral so that if you walk away they can foreclose on you and get the property back.

When you buy stock in Apple or Google, you don’t get a guarantee like that. You don’t get that level of control or peace of mind.

Now the mortgage document doesn’t say anything about the repayment plan or the terms. It doesn’t list interest rates. That’s in the note, which gets attached to the mortgage. This doc is usually just a couple of pages.

The mortgage lists your company, the mortgagee, and the property address. The mortgage states that the mortgage is based on the attached note, which does include the repayment terms.

The mortgage also states that the mortgagor (you) will maintain fire and extended coverage insurance. You should give a copy of the insurance to your investor as well, and they should be listed on the insurance.

You sign the mortgage (your investor doesn’t need to sign). Then get the mortgage notarized.

Promissory Note

The promissory note is an IOU. It includes the terms of a loan. It states who is borrowing and who is lending, how much principal is involved, the interest rate, the date the borrower will be paid back.

This document is not recorded. And, although it can be attached to a mortgage, it doesn’t have to be attached to a mortgage. I have a note with an investor who gave me $35,000 that I use for revolving funds. I send her a check every quarter for $875, and she’s as happy as can be.

When I write notes, I never include a monthly payment. I set up my notes so that all my payments occur at the end when the property is sold. If you’re doing a rehab, you don’t want to be making payments every month. That’s what a hard money lender requires, but this is private money.

I typically use a balloon for a year or 18 months. If you need to extend that loan beyond 18 months, give the investor another percent interest. Or if you need a note with longer terms, for example 3 years for a residential assisted living property, the investor knows that up front and is not expecting the return until the end of 3 years.

The note should also state that you can prepay some or all of the money early.

And the note should say that if payment is defaulted and the note is given to an attorney for collection you will pay reasonable attorney fees.

Again, you, not your investor, signs off on this form.

Until Next Time

This is truly the way that I run and operate my business, and I’ve raised millions and millions of dollars at this point. If you are in this business for the long haul, it’s critical that you take the time to set up these four documents.

And don’t forget about Project 100. Get out there and start looking for those investors; they’re out there, and you’ve got a great offer they won’t want to refuse.

If you want to hear more about how we find private lenders, how we “buy” houses using 100% Invisible Bank Funding… and flip ’em for big profits FAST, join me for my latest masterclass.

Be Daring,
Josh

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