I frequently get asked the following questions: “Can I just use a promissory note for investors?” or, “Can I just use an LLC Operating Agreement?”
The answer is yes, but …
Notes and passive LLC interests are securities. To sell them legally, you still need to qualify for an exemption such as a Regulation D, Rule 506 or Intrastate Private Offering exemption.
Most exemptions require appropriate securities offering documents such as a Private Placement Memorandum (PPM) or other disclosure document, a Subscription Agreement or Purchase Agreement, filing securities notices with federal and/or state securities regulators, and a contractual agreement between you and your investors.
Additionally, securities exemptions typically have specific financial qualifications for investors. The burden is on the person selling the securities (you) to ensure that all investors meet the financial qualifications for the selected exemption.
While there is no requirement for a PPM in an offering that only accepts Accredited Investors, a PPM that explains all the risks of investing actually shifts the risk of loss from you to the investors. Why take on that risk if you don’t have to?
For your contract with investors in a real estate offering, you can choose either to sell interests in your company (LLC interests, Limited Partnership interests or corporate stock) or you can use a series of promissory notes.
Further, there is a legal distinction: In a promissory note, the borrower and lender are in an adversarial relationship. The lender typically has a remedy for default; e.g., if a borrower fails to pay as agreed, the lender can call the whole note due and payable, and if the note is secured, the lender may be able to foreclose on the collateral property.
Conversely, if you offer an investor a preferred return from a company, it means that you agree to pay the investors first, if—and only if—there is cash flow to distribute. If there is no cash flow, the investors’ preferred returns simply continue to accrue until such time there is cash to distribute. Much less risk for you.
Bottom line: You can use a promissory note or LLC Operating Agreement for investors, but you need more than that to comply with securities laws. The best way to follow securities laws is to hire an experienced securities attorney to help you figure out how to comply.