Forming and funding an LLC

A limited liability company (LLC)

is a hybrid business entity. It combines limited liability advantages of a corporation under state law with the federal income tax treatment of a partnership.

Like a limited partnership (LP), the LLC itself does not pay federal income taxes. Instead, all reportable income, profits and losses of the LLC are passed through to the members for individual tax reporting. The members, as individuals, pay federal and state income tax on their share of any LLC income and profits.

To form and fund an LLC, the real estate syndicator — a broker or agent who gathers investors into a group for the purpose of buying, operating and ultimately selling income-producing property — needs to provide four critical documents:

  • two to form the LLC itself; and
  • two to solicit investors to fund the LLC.

The documents needed to form an LLC include:

  • the Articles of Organization (LLC-1) form issued by the California Secretary of State (SOS) for use by the syndicator acting alone to establish and operate an LLC in California [See RPI e-book Forming Real Estate Syndicates, Chapter 16]; and
  • the operating agreement, similar to most co-ownership agreements in its management, income- and profit-sharing, voting and buyout provisions. [See RPI Form 372]

The two funding documents for an LLC include:

  • the investment circular (IC), a narrative disclosing all the material aspects of the investment to prospective co-owner members, prepared as the product of the syndicator’s due diligence investigation and analysis of property data [See RPI Form 371]; and
  • the subscription agreement, the investor’s agreement with the syndicator to contribute funds in exchange for an ownership share in the LLC. [See RPI Form 373]

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The operating agreement

The document that authorizes the operations of the LLC is the operating agreement. [See RPI Form 372]

The operating agreement also states the rights and duties of the syndicator, as manager, and the co-owner members. [See RPI e-book Forming Real Estate Syndicates, Chapter 19]

The operating agreement for an LLC needs to contain all the fundamental boilerplate provisions that establish the working relationships between the syndicator and the co-owners. Provisions include profit-sharing and buyout arrangements, comparable to those used in any other co-ownership agreement, such as:

  • limited partnerships;
  • tenants-in-common vestings; and
  • corporate stockholder co-ownership agreements.

All investors sign the operating agreement at the same time they sign the subscription agreement acknowledging their agreement to invest and provide membership in the LLC. [See RPI Form 373]

Technically, a written operating agreement is not required to evidence the agreement between the co-owners and the syndicator who forms the LLC. However, it is always the best practice to form a group investment program based on a written operating agreement, not an oral one. Further, title insurance companies require their review of a written operating agreement for any LLC receiving an insured interest in the property. [See RPI Form 372]

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Governing principles and designation of the manager and officers

The governing principles for the ongoing operations and co-ownership in the LLC as stated in the operating agreement include:

  • business purposes and objectives;
  • capital contributions and percentage ownership;
  • co-owners’ participation in the distribution of income and profit from operations, financing and sale;
  • establishment of different classes of members (i.e., Class A membership shares granting priority distributions to cash investors and Class B membership shares granting a subordinated right to earnings held by the syndicator);
  • officers, management, compensation and accounting;
  • assignment of interests, termination of a co-owner and buyout options; and
  • dissolution and termination of the LLC. [See RPI Form 372]

The operating agreement designates the syndicator as the manager of the LLC. The syndicator, as manager, may give themselves any title they want to use, such as:

  • president;
  • chief executive officer (CEO); or
  • general manager.

As the lone manager, they are solely responsible for conducting the business affairs of the LLC and operations of the property it owns.

In addition to the manager, the operating agreement may provide for the appointment of other officers, such as a secretary, treasurer and so on, as in a corporate management structure. The officers do not need to be co-owners.

For instance, an accountant who is not a co-owner may be named as treasurer when the syndicator deems the position appropriate to provide oversight for the cash flow resulting from the investment program. [Calif. Corporations Code §§17704.07(u), 17704.07(v)]

The operating agreement for an LLC is fundamentally a profit-sharing agreement. It spells out when and how all the co-owner members will participate in the rents and profits generated by the property acquired with the funds they invested in the LLC.

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The investment circular for solicitation

The syndicator prepares the investment circular (IC), also known as a prospectus or memorandum. [See RPI Form 371]

The IC is used to solicit prospective investors to buy a share of ownership in their LLC investment program. [See RPI e-book Forming Real Estate Syndicates, Chapter 20]

The purpose of the IC is to present investors with all material facts about the investment opportunity, giving as much breadth in scope of activities and as much detail as necessary for a prudent investor to be able to make a well-informed decision about whether to invest based on a review of its content. [See RPI Form 371]

Information provided in the IC includes:

  • the business and investment objectives of the LLC;
  • a full description of the property to be purchased, including the condition of the improvements, natural and man-made (environmental) hazards, location, title and operation of the property;
  • the proposed operating budget of the LLC;
  • projected earnings for the co-owner members;
  • a disclosure of the risks of loss involved;
  • the background and qualifications of the syndicator;
  • the compensation and duties of the syndicator as manager of the LLC; and
  • copies of the LLC-1 articles, operating agreement and subscription agreement.

The syndicator hands the IC to prospective investors to induce them to decide to contribute funds to the LLC. The investment amount is a non-negotiable, fixed sum for participating as a co-owner member.

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Goals of an investment circular

The IC needs to be user-friendly and visually attractive to a prospective investor in addition to being factually accurate.

The information contained in an IC has to allow a prospective investor to move effortlessly from page to page. The copy needs to have an open feeling, be clean in appearance and contain short sentences and short paragraphs. [See RPI Form 371]

A syndicator producing an IC takes efforts to avoid using encoded real estate industry jargon and arcane legalese. These are not easily comprehensible to a typical investor who is not active in the industry.

Instead, prudent syndicators use words of plan meaning and in common use that are easily understood and absorbed by all without the need for prior experience. When the copy puts the reader off or is needlessly obscure, investors immediately lose interest. When this occurs, these investors are not likely to finish reviewing the investment opportunity, let alone contribute cash to the investment.

Thus, an IC is presented in a chronological manner, instructive throughout and reasonable in its conclusion. Throughout the body of the IC, the syndicators avoid the use of hyperbole and excessive claims unsubstantiated by the syndicator’s review of the property. [See RPI e-book Forming Real Estate Syndicates, Chapter 21]

Then, in response to any question a prospective investor may pose, the syndicator and investor perform a mutual review of relevant section of the IC, discussing the answer to the satisfaction of the investor.

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The investment circular contents

A syndicator uses the Investment Circular — LLC form published by Realty Publications, Inc. (RPI) when soliciting cash investors to form a group structured as an LLC for the acquisition of a specific income property. The form allows the syndicator to thoroughly present their objectives, policies and property disclosures for review and consideration by potential investors. [See RPI Form 371]

The Investment Circular — LLC contains the following sections:

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The operating agreement contents

A syndicator uses the Operating Agreement — LLC form published by RPI when forming an LLC for a group investment in income-producing property. The form allows the syndicator to set all LLC operating terms and the rights and duties of its members. [See RPI Form 372]

The Operating Agreement — LLC contains the following sections:

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Want to learn more about real estate syndication? Click the image below to download the RPI book cited in this article.