AMA - Lender Asks For Additional Security

This question came up on Saturday where it was part of a lunch discussion with a group of investors over the weekend.

This particular sponsor was trying to figure out how to work with a private lender who would be lending funds that the project sponsor would ultimately use to fund the earnest money deposit and the equity for the project. The lender wants a 10% rate of return on their money. He’s also asking which property will be used to secure his loan. But the property has not been purchased yet. How can the sponsor convince the lender to keep money available until it’s needed so the 10% interest isn’t being spent on money that I can’t put to work yet.

This is a terrific question. The first thing to pay attention to is the fact that money is not all green. Money always has an agenda.

When I wrote the book Magnetic Capital, I found that raising money was straightforward when there is a perfect fit between the goals for the money and the goals for the project. In fact, there are 5 elements to raising money and if one or more of these elements are missing, then raising money becomes problematic.

The 5 principles are:

• Relationship
• Trust
• Results
• Compelling Opportunity
• Alignment

Where you’re having trouble is in the last element called alignment.

It’s very important to match goals for the money and the goals for the project. If you don’t have a perfect match between those objectives, don’t take the money because you’re trying to force a square peg into a round hole.

Alignment covers the structure and the terms of the transaction. These are things like the

Size of the investment

The length of time the money will be tied up

The rate of return

Are the funds secured on title?

What’s the tax consequence?

What’s the control structure?

What’s the risk?

The first thing to be aware of is that you are proposing a structure that might be governed by securities laws. Now let me say that it’s not my role to provide legal advice. I’m not a lawyer, and I’m definitely not a securities lawyer. I definitely recommend you get legal advice from a securities lawyer.

Any time you have a situation where there is an active party who brings effort, and a passive party who brings money, you could be walking in securities territory. You may qualify for one or more exemptions. A mortgage exemption is one of the securities exemptions that could apply. But if you’re going to be using the funds for the earnest money deposit, those funds are needed prior to closing the land purchase. Unless you’re prepared to cross-collateralize another property it’s not going to be possible to use the mortgage exemption.

It seems to me like you have a fundamental mismatch between the goals for this particular lender and the goals for the project.

There should never be anything in the process of raising capital that feels forced.

It seems to me like you are ideally looking for an equity partner. An equity investment is not a secured investment. It is an ownership investment, not a loan. You can get a loan for the rest of the project, but you will need some equity in the project.

If you bring an investor into a project to co-invest with you, then you might also consider a joint venture partnership. This could involve you investing a small amount of your own cash, and involving the investor directly in the decision making. That way, you are both contributing money to the project, and all the partners are active in venture. They become a full partner in the joint venture, and then you don’t have to worry about compliance with securities laws, because a joint venture where all the members are active is not a security.