Private Placement Memorandum Must Knows for Passive Investors

Why do we have to have all of this, these legal documents and all that sort of stuff? And so the main reason is that essentially the SEC says if you are selling a security, then you either must register that security or have an exemption. And so if we're thinking of registration, typically we're talking about public companies. It's a very expensive and somewhat long process to go through. And particularly with the timeline that real estate deals go for, trying to register each syndication you do just wouldn't work. So your other option is to have an exemption. And so that's where PPMs come in. And essentially what an exemption is, it's saying, hey, for whatever reason, because how your deal is structured, the SEC says, we're not requiring you to register that security and that investment. However, there are certain things that you might be required to do in, in order to make sure that you still fit that exemption. And so that's where the PPM comes in. And essentially what it is for most exemptions, there's some sort of disclosure that we have to give. Because if we think about a publicly traded company, part of the reason that it costs so much to get it publicly traded, and part of the reasons that the SEC allows them to be publicly traded, it's because if they're publicly traded, there's going to be certain information that they're required to share with all investors. They're going to have to have audited financials in most cases, for instance, whereas a private company typically is not going to be required to have that same level of disclosure or the same type of document keeping. But the SEC says, okay, we know you're private, and we know that there aren't especially any laws that say you have to be that formalized. But if you're going to be taking other people's money, we want to make sure that it's a kind of even footing to where we're going to make you disclose certain things so that that investor can evaluate the deal. Because with a publicly traded company, you get a prospectus that gives you all the information. And so with a private company that's selling securities, they're trying to somewhat mimic that. So that's the role that the PPM plays, that it fulfills that disclosure requirement for the issuers, but then on the other side, it also serves as warnings for the investor. And so a lot of times I have clients that they'll look at the PPM and they'll say, oh, this sounds scary, or, you know, can we soften up some of that language? And, you know, There are times where we might soften some of it, but typically I'll say, no, we don't want to do that because we want to scare them before they have their. Before we have their money. Because, you know, if we say something like, you could lose your money, which is the truth, if it ultimately happens, we don't want that investor to say, I didn't know I was going to lose my money. If we, if that happens, we can point to the PPM and say, no, we told you that. So on that same token, when I'm reviewing PPMs for clients, kind of the scarier that it is, the more that I'm like, yes, go forward. Because if they're, if it seems a little scary, then to me it says, okay, they're disclosing the types of things that they should be disclosing, and they're giving us seemingly a full picture of that. So just wanted to give that big blurb about a ppm. A PPM is not a marketing document. It might somewhat help sell your deal, but that's not its purpose. Its purpose is to warn investors of issues that they may not be privy to. So that's the big introduction. So exemptions, there's multiple different exemptions. And with ppms, depending on your exemption, your PPM might look a little bit different. Also, because we're dealing with non publicly traded securities, there are some guidelines, there are a few requirements, but there's no somewhat uniform way it has to be. So there's certain things that you should generally see in all PPMs, but there's. Most PPMs will probably look a little bit different. So one of the first things you should see is kind of a big picture. Look at what are they raising, how much money are they raising? What, what is the price per unit or share? Another big one is, are they taking any, are they giving any commissions or finder's fees and things like that? We want to know because we want to know how much money is the deal ultimately, does it need, how much are they anticipating to raise? And if we are giving an investment and they're paying commissions, as an investor, we want to know that too. Because I'd want to know that if I give them 100 bucks, all 100 of those dollars are not going directly to work in the project. Some of it's going to a commission or a finder's fee. And so if they are doing a finder's fee, we want to make sure right here is where we would disclose that and say, hey, you know what? If we're charging $5,000 per unit, and we might be paying $100 per unit. Sold. We would put that in this area so that investor knows, I'm giving you 5,000, but really only 4,900 of that is going to actually be going to work. So that's kind of what the initial page should have. It should have when the offering is open, when it closes, perhaps. And then another thing that it would have, and modernly I kind of do this as a link, is you'd have what's called Blue sky disclosures. What those are is that if you're doing, typically real estate, my real estate clients do a Regulation D offering. So that means 506B or 506C, if you've heard of those before. So with Regulation D, we're following federal law, so we are not required to follow each individual state's securities laws. However, with the Blue sky disclosures, essentially each state might have certain warnings that say, okay, you know what, you're following federal law, so you don't have to follow our law, but you do have to notify them of these certain rules or requirements that are in our state. And so what, that's what the Blue sky disclosures are. One thing related to that, and this is something that we won't specifically go over today, but since I'm kind of touching on it, I'll bring this up now, is that with your, the issuer, that's the operator, the person who's doing the deal, the sponsor, the GP, within 15 days of the first day they receive capital, they're required to file what's called Form D with the sec. And so if you're trying to look into your, your issuer, particularly if the deal is already going, one thing that you can do is look for the Form D through the sec. And that's one thing that I do. And I ask a client, if I have an investor client that's giving me a PPM to review, I'll say, hey, you know, have they started taking money? And if so, have they filed Form D? And if the investor doesn't know or they say, yeah, they've taken, they started taking money two weeks ago, but I don't know what a Form D is. Well, we know how to look that up. And if they have taken money and they haven't filed the Form D, that's going to be a big red flag for me because that's a requirement. And so for me as an attorney looking through this for my investor clients, I am looking to make sure that the issuer's attorney has followed the rules, has crossed their T's and dotted their eyes. And so one of them is filing that Form D. One of them is going to be some of the stuff or some other things are going to be the things we talk about today, which are the things that should be included in a ppm. So another thing that you should have, and this is I say a requirement, but again, the SEC is a little loose here, but for me it's a requirement. You should have basically an executive summary that gives you a big picture view of the deal. And I would as your, not as your attorney, but as an attorney, I would say read the all the document, read every single thing. But as a human being and an attorney that has clients, I know that you're probably not necessarily reading all of it or maybe not understanding all of it, but one area where you definitely want to look at is that initial executive summary. Because this should, if you're saying tell me about the deal, what's the main points, what's kind of going on? You should have that generally contained within this area. And so you'll see here we have the general company information. So we have the address. Again, I've kind of changed the information so that I to protect the clients. But you have the addresses. If there's multiple classes, you'd have what those classes are. We talk about the sponsors. One question I get often is kind of what is the sponsor? Exactly. This is another area where there's not a hard and fast definition, but essentially oftentimes when you're creating a raise or doing a syndication, at least with my clients, we will create brand new entities. And so if an investor is trying to vet the company and get an understanding of the history and background, these entities typically were created within the last month or two. And so there's no history or background to have. And so the sponsors are essentially who is really running this deal? Who do we look at to try to vet and see the backgrounds of the owners and operators? They're the sponsors are essentially those parties that we'd be looking at. So we have that information in here. We'd have the investor qualifications. So we would know whether we're dealing with accredited investors or sophisticated investors and what those requirements are. We have the general terms of the offering. So how many units are we selling? What's the minimums, how much do does it cost? And so if you are thinking about this, you're like, wait a minute, didn't we just see all that above? Yes, you did. And a lot, a lot of a PPM is going to be very redundant. Part of it is just to make it part of its redundancies that I put in just to be extra, crystal clear part of it, it's redundancies that the SEC kind of requires based upon the, the formatting and where they want certain information. There are many times where it makes sense to have it in one certain place. But then the SEC also requires that you have it in a different place. And so you essentially just have it in both of those places. So at the very beginning, within the first couple of pages, we should have know how much the units cost, how much money is being raised overall, the name of the company, who's kind of behind the scenes running the company. I think I mentioned the amount of money raised as well. In the summary we also typically will include the property, so where is it located, the unit amount, the mix, that sort of stuff and then the owner's plans because they're going to buy the property. Typically there's some sort of plan involved to create more value. So a lot of my clients do value add, but there are other techniques as well. And so we, whatever the plan is, sometimes you might just have a good lead on a good deal that's under market and the plan might just be to manage it because you're getting in on a good deal and based upon how you buy in, if you just manage it well, it's going to perform well. But in any case, we have a project summary that explains what the operators plan to do. Then you're going to have some more warnings. And these warnings here are, you would see in a couple of different places. Some of them include, this is security, there's risks. You may not get the returns that we projected. There are no returns required at all. You could lose your investment. You've got to be accredited or sophisticated, what have you. So again we're having some, some repetition here and let me take a quick look because I see some questions popping up. Just want to make sure I'm not missing anything. All right, continuing on. So now we get to what I consider actually the ppm. All that was kind of introductory stuff that essentially it's quick summary information that is again provided in the PPM and expounded upon even more. So again here we'd have our general company information. So we, so we talk about how much are we raising, when was the company created, the contact address, that sort of thing. Then below that we have an organization chart. Now if you're. This doesn't apply so much to investors. But if there are any operators or issuers in here, the org chart that I typically put here is a little bit different than the org chart that you would need if you're on the operator side and to actually acquire the property. So again, as I mentioned, the PPM is about disclosures and providing information and trying to give the clients a picture of kind of what's going on. And so the org chart that we need here typically is not going to be quite as comprehensive as the org chart that a lender is going to need. So I'll typically, we'll have the sponsors, the manager, the main entity itself, and that usually will be about it. Whereas if you're on the operator side, you probably see very long, very complex org charts because a lender is going to want to know, you know, the tax ID or ein or Social Security number of anybody, any owners, they're going to want to know the names, addresses. And so the org chart there's going to be a lot more involved, but that's for the lender. And so typically on a pbm, I don't have a org chart that's quite that detailed because the SEC doesn't require it. And a lot of times it's information that's not absolutely needed for the investors. One thing to keep in mind for the investor perspective is I kind of glossed over this. But typically a lender is going to want to vet any investor that owns. Usually it's 20%. I have some lenders that do 25%, but there's usually some sort of threshold where the lender says, hey, I don't care if they're a passive investor or lp if they own X percentage, we want to vet them because they have a good chunk of the deal. And so the lenders are going to want want to vet them. So typically it's 20%. And so usually I'll set the, with the client's permission, I'll set the maximum investment at 19% so that we can avoid having to the investor have to go through that vetting. Now if you say, hey, I really like this deal and I want to get a bigger chunk and I'm okay with the bank or the lender that vetting me further, then there's nothing legally that prevents you from owning more. But that's typically a lender requirement that would prevent you from owning more. Or it's maybe your own preference. Because a lot of the reason that many people invest in these types of deals is because they want to be passive. And kind of left alone. But if you say, you know what, I'm fine submitting my financials and whatnot and having the bank vet me, then there's no legal thing that, that says you can't own more than 20%. So here again we have another table kind of explaining the financials. How many units are we selling? What's the price per unit? How much do we think we're going to raise overall? When do we think we'll make distributions? Can I sell this? And with most unregistered securities, the answer is going to be no. The term legended or that, or if we say that the securities have a legend, that means they have a restriction on their sale. And so with regulation D in most situations there's going to be a minimum 12 month hold period. So even if your issuer allows you to sell, typically you're going to be required to hold it for a minimum of 12 months before you could sell. And a lot of times issuers will just say, we're not allowing people to sell. It becomes, sometimes it becomes complicated. It also becomes a cost for the issuer and it's a cost that they're taking on that really only benefits the one person who's actually getting out. So that's why most of my clients don't allow people to sell, or it's at least not advertised that they allow people to sell. So the risk factors, this is where, when I'm looking at a ppm, where I look the most, this is where I tell my clients, I'll go through it, I will review it, I'll give them notes, but I will say, hey, read this part. This is typically one of the longer chunks, at least in my ppms. And this really gets to me as the heart of it. This gets into those risks that we're talking about, that disclosure, that transparency that the issuer has to have. So when I do a ppm, one of the questions that I ask at the end is I say to the issuer, what keeps you up at night? What are the things you're worried about? What are you afraid that could go wrong about this deal? And the reason that I asked that is that's going to help inform me of the types of risk factors that we need to include. Because those things that keep the issuer up at night, that's a risk. And we want to make sure that we disclose that because the issuer knows that and the issuer knows the nightmares they're having about that. And we want to make sure that the investor knows hey, you know what? The issuer has a plan in place. They think this deal is still good because they're moving forward. But here's some of the things where they're like, I'm not too sure I or this, this gives me concern. And so we want to make sure that the investors are, have knowledge about that concern. And so the risk factors is where we do that. For a real estate deal, we'll typically have general real estate risks, so ones that will kind of apply to most properties. Then we will also have some entity operating risks. A couple that I will highlight that are newer is, you know, you know, in the past year or so, I had to add in a COVID 19 risk because that's something that anybody who's working in real estate knows that that had a major, major effect. You know, I had a lot of clients that even as they were getting into a deal would think that it's, you know, 90% rent payments. And then when they start doing their due diligence, they realize it's 70%. Or I had some clients, unfortunately, that purchased assets that at the time were legitimately bringing in, you know, 90% of the rent or so. But Covid hit and now that number dropped dramatically. And so it threw all of their numbers off. And so those are the types of things that we're talking about with risk factors. What are some things that you can predict and maybe if you're not thinking it's going to happen, but just some things where you're saying, oh, you know what, maybe I should have a plan for this, or if that happens, that's not going to be too good for us. Those are the things that the issuer needs to be disclosed and share. So we have some that are related just to real estate generally. As I mentioned, a lot of my clients do value add, and so they're almost always doing renovations. That's a risk costs. Again, anybody who was working in real estate knows, particularly last year, lumber was, you know, three, four times what it normally was. And so if your costs are going to be three or four times what you anticipated, that's going to throw your returns off a bit. And so we want to let the investors know about that. Typically, I structure syndications as LLCs. The typical way that we'll do it is we'll have one LLC that serves as the where the investors are pulling their money into. Within that, we'll have multiple classes. And one of those classes will be the management class. And many times my clients will own that management class as a second LLC for both for accounting and liability purposes. So with LLCs, they have pass through taxation, so they're taxed like a partnership. So we give warnings about that. You do have limited liabilities, so we do talk about that. But with that limited liability, the manager also typically has limited liability. And so that's a warning that we need to disclose because say that I'm an investor and I think that the manager of the deal has been making bad management decisions and, and I want to sue them. Well, if I, as an investor, if I sue them, typically the entity will be paying for the manager's legal fees. And so if I'm suing my, the company I invested in in some way, I'm kind of suing myself. And so we give a warning about that that says, hey, you got a manager here, they've got limited liability or indemnification. And so we give warnings like that. We have these warnings I mentioned before about restrictions and limitations on transferability, lack of liquidity, because you'll be locked in here. So as you can see, there is a long, long list of warnings and people usually roll their eyes over at that. But that's really the area where you want to be, I would say you want to be paying the most attention. I'd say the warnings and then looking at their underwriting, that's the areas where I would focus. But all this just warnings, disclosures of things that could possibly go wrong, that might go wrong, hopefully won't. But we're letting the investor know so that they can review it and say, you know what, I don't think that I like the risk of the manager being having indemnification. If I want to sue the manager, I want to be able to sue them and not kind of be suing myself. And that might be the thing that turns me away from investing. And that's fine because the setup of this deal didn't work with the risk that I was willing to take. And we'd want the investor to know that in advance versus me finding that out later after I already sent my money in or already invested. Another area you want to focus on is use of proceeds. This basically tells how they plan to use the money. And so I've taken it out here, but I all but require my clients to at least give a big picture, five year pro forma. What is the money we plan on that we think is going to be coming in? What is the money that we think is going to be coming out? And how much do we think is going to be left over and the more detailed, the least better for the investors. But I do realize that underwriting is a bit of an art form, and some issuers don't like sharing their underwriting. But one thing I'd say to you guys as investors is that you're giving them your money. And if you want to see the underwriting or if you're not sure about their assumptions, I ask about that. And if they say, yeah, you know, we don't share our underwriting, say, look, I'm interested in this deal, but I need to see your underwriting in order for me to invest in it, if that's what your risk tolerance says. So just because an issuer might say, we don't do this or we don't do that, if they want you to invest and you still want to invest, make sure that you get the information that you want, whatever it might be, and if their answer is, no, we don't give that information, then this might not be the investment for you or you need to evaluate, is this information important to me, or do I trust them enough or know them well enough, or are there other things that make it to where I can forego having that information? But please don't be pushed off by an issuer saying, I'm not giving this or not giving that because it's your money at the end of the end of the day. And they, at least in some forms, are beholden to you. So you want to make sure that you're comfortable with them and you giving your investment to them. So we look at the proceeds, the financing, the financial types of issues, and then say, this is probably the last major issue. There's still lots more. But I'd say probably one of the last major issues is the description of the business. This is going to be some repetition from what we saw above in the executive summary, because it's just a summary of everything below. But it should talk about the classes of ownership, if there are multiple classes. It should talk about the project, what they plan to do, how they plan to use the money, how they plan to make value and provide a return. Any management scenarios with real estate, you usually are going to want to talk about your property manager and disclose what those costs are going to be as well. And so these kind of goes through the business talking about all that sort of stuff. Talking about the executive team has their biographies above. It talked about the securities, the classes, and that sort of stuff. Again with that company business finances, you want to understand what the executive fees are going to be. It's very Common for issuers to charge some sort of executive fee. Now if anybody's looked at deals before, you might have also heard of the term of preferential payment or pref or preferred return. One thing to note is that executive fees come out before preferred returns. They are company expenses. So what a preferred return is is basically it's the issuer saying, hey, before I take any dime as in my investment or any dime kind of as back end participation, I'm going to give you X percentage return before I take $1. Well, with a preferred return, again that's after all expenses are paid. So executive fees are expenses that are paid to the executive team in some form before you get your prep payment. So you want to look at those and see one do they fit your risk satisfaction or your risk tolerance and do you personally think they're reasonable for an investment that you would make? It's very typical to have asset management fees that are anywhere from about usually see 1 to maybe 4% of the gross receipts. Typically it's again it's market based, so different areas had different ones. But I typically see more about a 2 or 3% is what I usually see. Again, I'm just one attorney, so don't take that as the law or the standard. But that's what I typically see. You'll also see acquisition fees kind of in the same range as the asset management fee as well. And what these fees are is that these are essentially ways for the issuer to keep the lights on. You know, when you're running the show on a monthly basis, that's time that staff that the issuer might have. And so these fees goes towards that or the acquisition fee. They're doing due diligence, they're meeting with the real estate transaction attorney, they're talking with the brokers, they're working with the lender. And so the acquisition fee is their compensation to work for them and their staff, that sort of thing. So you just want to look at these and say do I think these are reasonable or am I, am I okay with the operator taking all these different fees out before I get any return? You are going to see some fees. It's rare that you're going to see a deal. I've never done one where there are no fees. But you just want to look at what are these fees and am I okay and comfortable with them. And if you're not or you have questions, talk to the issuers and operators about that and let's see what else. I think we've gone through a lot of the big stuff. I guess this is another area, the description of the securities. This basically tells you the returns that they're projecting for you or that you can potentially receive. And so if they're describing the securities, they might say class a, it's a 10% pref plus 70% or share and 70% of backend. Class B might get a 12% pref plus a share of 70% of back end as well, or something of that nature. But it would describe the different, it would describe what it is that you are purchasing and what you can expect to receive, assuming that the deal goes well. And so this example that I pulled from was a more complex deal that had classes A through F, usually. Something most deals that I deal with typically will maybe have usually not more than three investor classes plus the management class. But again, it depends on the deal and the issuer. And there's no, there's no maximum or minimum really that there needs to be. So yeah, when we're describing the securities, we talk about what they are and what you can plan, what you should be receiving as well. I think we're getting towards the end. Yeah. And then what's left is just the glossary. So that's, that's a quick, quick review of a ppm. And I realized that it was quick. You know, if I've been talking to this with a client, I will have probably spent a couple hours reviewing it and then I'll talk through it with them for another half hour, hour as well. So this was a very, very quick review of that. But I do think we have a little bit of time left for some questions. A couple other things that you might see as part of a PPM that we didn't go over. You should have the operating agreement or the partnership agreement because that's what governs the entity itself. And then you'll probably have what's called a subscription agreement. Subscription agreements could be, or they might vary how I do mine is that I actually always attach the operating agreement to the ppm and, and then my subscription agreement is very short and it basically says it's you as the investor saying, I've read the ppm, I've read the operating agreement and my signature on the subscription agreement is as if I signed the operating agreement. So you're binding yourself to the term and agreeing to the terms of the operating agreement. Some that you might see. Instead they'll have a very long subscription agreement that basically echoes all the terms of the operating agreement. And, and you just sign the subscription agreement directly instead so you'll see. Those are two variations that I've seen. You probably could see other ones as well, but those are the two that I mainly see. So again, in addition to the ppm, you'll likely have a subscription agreement and. Or an operating agreement as well. That's what I've got for now, but definitely happy to answer some questions. I know we were running through that at a pretty good clip.

That was perfect. Cause it allows time for questions. Thanks for giving the high level of the ppm. So with that, any questions, if you aren't comfortable talking, you know, put it.

In the chat box and you watch this. Sorry, Bob.

Yeah, I've got it. I did record it, so I will send that out if that's okay with Nick.

Yep, yep, that's fine.

Yeah, Bob, I saw that you're doing a little later, so no worries. We'll send that out.

Hey, Nick. Sean Griffith in the DFW area. Where do you practice? I'm located in Inglewood, California. So for real estate transactions, I wouldn't be able to.