According to the Pew Research Center, less than half (46%) of US kids under the age of 18 live in a traditional American household: with both of their parents who are married to each other. And this percentage continues to decline. Whatever you think about this trend, one conclusion is obvious: traditional marriage is not the only possible way to raise children.
Similarly, 50/50 partnership is not the only possible way to collaborate on a real estate project. In fact, it is often the worst of the possible setups. Yet, many investors automatically choose the 50/50 partnership, giving little to no thought to the consequences of this critical decision. So let’s give it some thought, shall we?
Why do we partner up?
No, I’m not talking about marriages here. I’m talking about real estate. We met Gloria couple months ago. Being a new investor, only several months into it, she decided to partner with another woman. When I asked Gloria about her partner, she confirmed what I feared was the case. Gloria met her partner Ann while taking one of the real estate seminars. Both women were learning this business, and neither one had prior experience with real estate. They both had limited funds, limited connections and similar skills.
In other words, they were not combining their strengths or their resources for some synergy. They were jointly fighting the same fears and inexperience. This is not called partnering. This is called support group. Nothing wrong with it, but support groups do not need to be structured as LLCs. Starbucks was specifically created for this need. Or Spec’s if you prefer.
Partnering would make much more sense under one of these scenarios:
- Gloria found an attractive deal, and Ann is providing funding for the project
- Gloria has sales and marketing skills, using it for acquisition and selling, while Ann contributes her construction skills
- Gloria has extensive knowledge but very little time, with Ann being in the opposite situation: plenty of time but no experience
You need a partner when your partner brings to the table something that you do not have.
The common theme in these examples is simple: you need a partner when your partner brings to the table something that you do not have.
You won’t have a very enjoyable potluck dinner if everyone brings mac-n-cheese. Now that I think about it, my youngest son would not mind.
So let’s do the partnership, then! Why not?
I can’t help bringing back the marriage analogy. Easy to get into, a nightmare to get out of. The same applies to partnerships.
Divorcing out of a partnership can be as much a nightmare as divorcing out of a marriage. Or so I heard. The conflicts can (and do) get very intense and personal. A lot of money can be at stake. Even custody battles have their partnership equivalent: deciding who ends up with the jointly owned properties. Someone may be stuck with “child support” of sorts. I have seen it.
So, you are saying that you’re tight with your partner, and there is no chance you two will be fighting? I hear you. How is it different from marital wows, again? I have witnessed some very bitter business divorces between childhood friends, between sorority sisters, even between brothers in arms. I could show you my collection of some very emotional emails along the lines of “how could you do this to me after all we’ve been thru together?” Yes, in real estate business.
A Russian comedian once quipped that people get married to jointly solve the problems that single people never encounter. If you list the most common reasons for spousal conflicts (and, ultimately, divorces), you will see that partnerships deal with the same exact risks:
- money
- control
- division of responsibilities
- incompatible personalities
- substance abuse
- infidelity
You wonder what infidelity has to do with business? Then google “partnership fiduciary duties” for some eye-opening reading.
Bottom like: not unlike marriages, business partnerships are complex commitments that create not only benefits but also multiple risks and complications.
Partnerships are complex commitments that create multiple risks and complications.
Jump in at your own risk.
Why 50/50 partnerships are the worst
Actually, they are the second worst. “Handshake partnerships” take the dishonorable top spot on the business disaster list. 50/50 partnerships are the close second.
Surprised? You should not be. Let’s specify what we usually mean when saying 50/50. You get 50% of the profit, and I get the other 50%, of course! That sounds simple and fair. And many investors stop right there, while they should be asking at least two more questions:
- Who takes us there? and
- What happens if there is no profit?
Let’s not forget that 50/50 reward assumes a 50/50 effort. Can you see a problem here? I do. Even if in the early days of the business both partners bust their behinds shoulder-to-shoulder, life inevitably happens. Will you be happy to give your partner 50% of the profit if he was sidelined by a demanding job, illness or family emergency for a good stretch of time? Or if you had to repeatedly drop everything and rush to your project site to take care of crises while he was vacationing with his family? I don’t think so. But you agreed to 50/50 – so here you go. Or rather, here goes your business relationship.
Now, the elephant in the room, foolishly ignored until it’s too late. What if there’s no profit on the deal? Who eats the loss? 50/50, right? You wish.
Imagine a rather common situation: your rehab is in its final stages, and your GC just called you to report that he found some termite damage requiring another $2k to fix. Since you’re 50/50, you bring a $1k check, and your partner will cover the other half, right? Not so fast. His car or his AC broke this morning, so he is short on cash. Guess who is going to shell out the entire $2k?
Not too concerned about $2k? Then how about $20k over repair budget plus $10k for hard money extensions? I know, it will never happen to you, but what if? Where is your 50% partner now?
Of course, nothing to worry about, because you can always recover your temporary cash infusion from the profit when you sell. If you end up with enough profit, that is. Or any profit for that matter. Do I have to tell you what happens when there is no profit? I hope not. Remember this very simple truth: when things go south, the only one who suffers is the one who invested the money. The other party just walks away. Google the European Union for a good illustration.
When things go south, the only one who suffers is the one who invested the money.
Some problems with 50/50 partnerships do not involve money directly. Take decision making, for example. What if your partner wants to hold on to a property, but you think it is time to sell? Who wins, since you’re 50/50? The correct answer is: nobody wins. You both lose.
If not 50/50, then what?
Then 60/40. Or 75/25. Or 51/49. Anything that gives one person the power to break a standstill. If you have the 51%, you get to decide. I may be unhappy, even mad, but I have no choice but live with your decision. It’s not like we are not used to this system. Every recent presidential election in the US has been pretty close to the 51/49 ratio, and looks like we may have another close one in 2016.
By the way, one of the powers you should have as a majority owner, even though 51% barely qualifies as majority, is the power to fire me as your partner. This is a rather dramatic but nevertheless an effective method to resolve our differences. Would be nice to have this option in some marriages.
And what if your egos preclude any other percentage except the democratic 50/50? If you have two Batmans, and neither one is willing to play Robin? Then you need a 3rd party to resolve any deadlock. The decision of this 3rd party arbiter must be binding for both partners. It does not matter who this referee is, as long as his decisions are accepted. And if no such person exists – then the NFL-style coin toss is another option. If you can agree on who is doing the tossing.
As you noticed, the 51/49 or the arbitration arrangements resolve only part of the problems with 50/50: decision power. They do nothing to prevent problems with distribution of duties and with business losses. Those problems are part of the deal whenever you create any variation of a partnership. Which brings us to the next question.
Can we partner without partnership problems?
Yes! You can have your cake and eat it, too. All it takes is think outside the box. In this case, outside the partnership idea. A lot of arrangements that are traditionally structured as partnerships would be simpler, more efficient and less risky if reorganized as one of the two alternatives:
- Investor-Lender
- Investor-Contractor
Both concepts have their respective pros and cons, and they may not be suitable for your particular situation. However, whenever available, they are superior to the conventional partnership.
These two structures, as well as many other legal and tax aspects of partnering in real estate business were covered by myself and real estate attorney Steven Newsom during our 4-hour advanced seminar “Mastering REI Partnerships”.