Just as private investment is not for everyone, raising private capital is not for every company. However, compared to other financing options, raising private capital is attractive to many small businesses looking to take their business to the next level.
Here are a few reasons for this. Private capital does not cost as much or last as long as a public offering. It also doesn’t have the pressure of immediate repayments like debt, and it gives more access to more important, higher quality assets than self-financing.
If you are considering raising capital from passive investors for your real estate ventures, you need to ask yourself some tough questions. Getting private capital right or wrong can mean the difference between taking your business to the next level or dealing with potential legal troubles — not just from investors, but also from the SEC and state securities regulators.
Let’s start with those for whom raising capital from private investors is not appropriate.
Are you ready to invest?
One of the most frequently asked questions on the Pyjama People forums is “How can I start investing in real estate with no money and bad credit?” The answer? You should not. You need to resolve your situation and invest from a financial position.
1. This is your first rodeo
Never start in a new investment class or industry with investment capital. And you should definitely not take investor capital if you are not prepared or organized. You should already have experience in the industry and asset class you are trying to raise money in, and have a clear business goal and plan for achieving that goal.
If you are unsure about any of the following key elements of the potential asset or investment, do not take private capital.
- You are unsure of current market trends related to your target assets.
- You are unsure of the demographics or key economic metrics of the area or neighborhood you are targeting. If there are fundamental market movements that you miss, such as a workers’ exodus, you could be putting yourself at risk.
- You have no experience with math, and you are not good at estimating, spreadsheets or accounting.
- You don’t have a team to make up for your shortcomings with numbers, organizing, marketing, networking, etc.
- You have not performed due diligence on or even inspected your target asset. Your investors will do due diligence on the asset. If you are not willing to answer questions based on your due diligence, do not bring in investors.
2. You covet investment capital, but do not understand the true cost of that capital
Attracting private capital is not free or labour-free. If you don’t understand all the ins and outs or don’t want to learn about what it takes to launch a private listing, don’t go down this road. Here are some of the costs and time requirements to consider.
- Professional fees and costs from third party vendors to prepare legal documents, financial statements and marketing materials.
- Personal time needed to prospect and engage investors.
- Time and expense required to prepare supporting materials to pitch to investors, including a summary (offer memorandum) and financial statements
3. Like your investors, you are looking for a passive solution
There is no ready-made solution for private offering. Raising private capital requires experience, knowledge and expertise on your part and at the very least oversight to lead the capital raising process towards its end goal. You can hire the best professionals and third-party vendors to help you with your venture, but if you’re not willing to oversee their work, raising private capital is wrong for you. This is why.
- If you’re unwilling to review attorney’s listing materials, mistakes can cost you dearly. Lawyers can provide the legal framework for your offering material, but they cannot describe your business or the terms of your offering as you intend. The only way to ensure accuracy is to review the documents.
- If you hire licensed brokers, you can be guided by their fees and commissions if you are not vigilant. Did you know that the NASAA and FINRA 10% limits on underwriting fees and 15% limits on front-end tax do not apply to private placements?
- Only take accredited investors. If you are lax with this requirement, not only will you run into legal trouble, but history has shown that unaccredited investors are the first to file a complaint with the SEC when they get impatient. Accredited investors understand risk, are patient and have the financial resources to withstand investment losses. Nobody likes losing money, but accredited investors are sophisticated and experienced and know how to give sponsors the breathing room they need to grow the business.
4. You want to get paid whether your business is successful or not
The successful capital raisers are the ones that get paid only when the business is profitable. Front-loaded compensation is a turn-off for experienced investors.
5. You like your space and don’t like to be annoyed by partners who ask you questions
If you like investor money but not investor inquiries, private capital is the wrong way for you. Sophisticated investors prefer private investment because of transparency and access to management. If you don’t want to be open, don’t hire investors.
Who is private capital suitable for?
Now that you’ve asked yourself the hard questions of whether raising private capital is for you, let’s take a look at who private capital is right for. If this describes you, raising capital from passive investors should be a viable option for you.
- You rely on your experience and knowledge.
- You follow market trends and have a finger on the economic pulse of the neighbourhood, area and region in which you want to invest.
- You have the infrastructure, staff and processes to execute your business objective and vision.
- You have meticulously calculated your financial forecasts and went through them with a fine-toothed comb. You are good at executing figures, projecting estimates and justifying unforeseen situations and worst-case scenarios.
- You understand the risks of your investment and are confident that you will limit these risks. You’re not afraid to risk everything and reveal those risks to like-minded investors.
- You are thorough and willing to assess the work of professionals and external service providers.
- You are willing to give input, but prefer to avoid the experts and let them do their job and rely on the expertise of professionals. In other words, you are not a micromanager.
- You take your stewardship of investors’ capital and their trust in you seriously. You are willing to defer compensation to give them preference in terms of cash flow and profit distribution.
- You are willing to be open and transparent with your investors. You are willing to always keep the line of communication with them open – good or bad.
Only you can decide if you want to pursue private investors, but hopefully this will give you some essential questions to think about before taking this crucial step. Taking private capital is serious business, but if you do it right, have a plan, and have the staff and processes to execute your plan, it can be a satisfying venture for both you and your investors.