Investing in Business as a Limited Partner

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Today, I want to introduce you to an income opportunity I got into years ago… that has proven to be one of my most lucrative.

The year was 1985. I was in an elevator in Boca Raton, Florida, on my way to a business meeting.

I was dressed in a new suit, feeling very grown up. At the second floor, the elevator stopped and another young man in a new suit stepped in. It was Jerry, a buddy of mine from high school.

“Hey, Jerry,” I said. “What are you doing here?”

Turns out he had moved to South Florida several years before I did.

“We’ve got a lot of catching up to do,” he said. “Are you free for lunch?”

“Sure,” I said. “I’ll meet you downstairs at one o’clock.”

Over lunch, Jerry told me that he was a real estate attorney. And he was now embarking on a new career as a property developer.

“This town is growing fast,” he told me. “There is big money to be made building houses for snowbirds.”

Jerry’s enthusiasm about what he was doing got me interested. So the next day, I asked my business partner what he thought about it. He agreed with Jerry. In fact, he was already invested in several developments in West Boca.

I called Jerry and asked whether there was “any way” for me to get involved in his project. And, yes, there was. His project – an upscale community of 200 homes – was structured as a limited partnership.

He explained that, as a general partner, he had to do all the work and take all the responsibility. But I could come in as a limited partner and make money by doing nothing.

That sounded good to me. For the first time in my life, I was making much more money than I needed, but I had no time. And I didn’t need any more responsibility.

Jerry had a business plan. And permits. And projections. According to those projections, I could make between 25% and 35% on my money.

I knew little about property development and even less about financial projections. But I was impressed by how detailed the plan was. I knew Jerry well enough to know that he wasn’t falsifying the numbers. And the numbers looked good.

“Even if I don’t get a 25% return,” I remember thinking, “I’ll still be happy. I’ll be happy with 20%.”

So I wrote Jerry a check for $50,000.

One of my main missions is to share with you what I’ve learned about creating extra income and building wealth. I’ve told you how you can build your wealth by running a side business online. I’ve told you how I gradually and timidly became an entrepreneur.

But so far, I haven’t said a word about that first investment with Jerry – and dozens of similar investments I’ve made since then. By “similar investments,” I mean direct investments in small business ventures. And for our purposes now, I’m going to limit our discussion to investing in those ventures as a minor shareholder or “limited partner.”

As a limited partner, you’re not buying into a business with the intent of running its daily operations. You’re not going to wield significant control or be the go-to decision maker. You’re just a “money guy.” You supply the business with cash in exchange for a small share of the profits.

All businesses of this type are structured in one of three ways: limited partnerships (LPs), limited liability partnerships (LLPs) or limited liability companies (LLCs).

This kind of investing can give you steady and substantial income plus equity growth. That amounts to a potentially big return on investment (ROI) with limited risk and virtually no work.

It is that last benefit – not having to do any work – that most appealed to me with that first investment with Jerry.

Since then, I’ve invested in more than a dozen real estate development projects. Also three natural resource companies, two startup technology companies, a private lending company, a furniture factory, a movie, a dozen publishing ventures, a dozen marketing companies and a local brewery.

Pros and Cons of Being a Limited Partner

The main benefit of being a limited partner, as I said, is the potentially high ROI. Higher than you can get with stocks and bonds… without having to do any work.

For example, when I invested $80,000 in a wood mill in Nicaragua years ago, I did so because I knew there was a fast-growing demand for its products. I also knew that an experienced person was running the business. The other limited partners and I didn’t have to build the plant, hire and train the employees, produce the products, or sell anything. Our only job was to write that first check and then cash profit-distribution checks when they arrived.

Another thing I like about being a limited partner is that, in most cases, your financial liability is limited to your initial investment. If the business fails completely, the general partner might have to dig into his pocket to bail it out. But not the limited partners. If, for example, the wood mill in Nicaragua had failed, my risk would have been limited to that $80,000.

A third benefit of investing in an LP/LLP/LLC is that you can take advantage of certain tax benefits. As a limited partner, you don’t have to pay self-employment taxes, as you would with your own business. And the profits are treated as pass-through income. So they are not subject to “double taxation,” as corporate profits are.

When you invest in an LP/LLP/LLC, the first cash you receive is usually return of capital, which is not taxable. Plus, any profits that follow are treated by the IRS as long-term capital gains. Long-term capital gains have a lower tax rate than ordinary income (unless you’re in the lowest tax bracket).

And there is another – intangible – benefit. I’m talking about the fun of being involved in a business outside of your normal sphere of expertise. That wood mill, for example. I really like owning it. Every time I’m in Nicaragua, I stop by to watch the hundreds of men and women working the machinery and admire the quality products they produce.

So those are the benefits. But there are drawbacks as well. You do have a certain sum of money at risk. If you invest in the wrong business, you can lose all of it. And if you’re a worrier, you will worry about your investment without being able to do anything about it. As a limited partner, you have no obligation – but also no right – to get involved in management.

My Batting Average

That first project I invested in with Jerry was successful. But it was not nearly as successful as he thought it would be. Since he was new to the business, he didn’t anticipate a significant increase in the cost of building materials and labor. Those increases – plus some construction delays – reduced my profit even below the “worst case” 20% that I expected. Still, I made 15%. A very good return.

I continued to invest in just about every project Jerry brought to me. I doubled my money on one project in Aspen and made 15% to 25% on several more. But I lost my entire investment in a development in Miami. (They found Native American bones while digging the foundation!) And I lost a big chunk on a project that ran into Chinese drywall problems.

Overall, I’ve done well with Jerry. I’d say my average ROI has been about 12%.

My experience with other investments as a limited partner has been mixed.

I made 10 times my money on an overseas development project. The project was (and is) a great success. But the general partner has yet to get all his money out.

I made good money with two of my investments in natural resource companies. But I lost half my money in the third one. And I lost all of the money I invested in the movie and the first high-tech startup. (The second one could still be profitable.)

Along the way, I learned three important lessons… and now follow three simple rules…

The Lessons I Learned

Lesson 1: The best deals are in businesses you understand.

When I wrote Jerry that check for $50,000, neither one of us knew as much about property development as we should have. But as time passed, our knowledge increased. And as it did, so did our ability to pick good deals and walk away from bad ones.

My worst investment was the first high-tech company I invested in. I knew absolutely nothing about the industry. I couldn’t even explain what they did, despite having heard the CEO explain it a dozen times. The goal of the business (and this is true for many businesses) was to make some noise in the market and then cash out big-time in some leveraged deal. That is exactly the kind of thinking I railed against in all my essays and books about entrepreneurship.

Why did I do it? I liked the CEO. That is, he seemed like the kind of guy that could pull off a trick like that. And I gave into my greed. Something I promised myself I’d never do again.

Lesson 2: There are advantages to being a limited partner instead of a general partner.

As a limited partner, you can decide beforehand – based on how strongly you believe in a project – how much money you will invest. General partners do not have this option. Jerry, for example, had to back every deal with most of his net worth. The banks required it. And that hurt him in the end.

You see, for 20 years, Jerry had made truckloads of money on property development deals.

But as the real estate market topped in 2008, he had most of his net worth tied up in that project with the Chinese drywall problems. (Between 2004 and 2008, many contractors had unwittingly imported drywall from China that was defective and toxic.)

As a general partner, he was liable for the settlements on the Chinese drywall suits. He was also liable for the debt that accumulated as sales slowed.

Another advantage of being a limited partner is how quickly you can recover your initial investment. I didn’t know anything about natural resources when I invested in those businesses. I did it because the owners were people I had helped in the past. They felt obliged to make sure I did well. They couldn’t ultimately guarantee their success, of course. But they could (and did) structure their deals so that I got my capital investment out before they did.

Lesson 3: It’s important to go with general partners who are open to your ideas.

Because of my experience as a marketer and entrepreneur, I was able to help several of the general partners I invested with make smart business decisions. For example, I persuaded Jerry to use direct-marketing techniques to sell the million-dollar homes we were building. At that time, developers used nothing but space ads in newspapers to bring in potential buyers. Sending out carefully crafted letters to high-income addresses proved to be much more effective.

Actually, my best deals were the limited positions I took in marketing and publishing businesses. I made out very well on almost every single one. In retrospect, this is not surprising. I had a deep understanding of these businesses. I didn’t manage the partnerships. I didn’t spend nights worrying about them. But I was able to provide useful suggestions.

Three Rules I Follow as a Limited Partner

There are just three rules. They are simple. They are easy to understand. And they should be very easy to follow unless you let greed blind you…

1. Invest in businesses you know something about.

The best opportunities are in the industry you have worked in all your life. You should know the marketing side of that business: what it costs to create products and what consumers are willing to pay for them. You should be aware of the bad ideas that have caused most of the failures in the past. You should also know enough to evaluate the competence of the general partners.

2. Invest with people you trust.

There are many ways for general partners to screw limited partners. You can protect yourself from most of them by having a good lawyer review any contracts or agreements before you sign. But paperwork can’t protect you completely. You should invest only in people who you know – from experience – have integrity.

3. Bring more than money to the table.

As a limited investor, you cannot control the business in any way. (If you do, you might be subject to general liability.) But you can influence the general partners if you think they are heading in the wrong direction. General partners will listen to you only if they think your suggestions have merit. And the only way your suggestions will have merit is if you have knowledge – either industry knowledge or general business knowledge – that they respect.

Best,

Mark

Do you have questions for Mark about becoming a limited partner? Shoot us an email here.

The Difference Between a Limited Partnership, a Limited Liability Partnership, and a Liability Company

A limited partnership (LP) is a business owned by two or more people. It has two classes of partners:

· General partners run the business and assume liability for its debts.

· Limited partners contribute capital and share in the profits. But they normally do not participate in the management of the business. And they have no liability for expenses beyond their capital contributions.

A limited liability partnership (LLP) is similar to an LP. But it has no general partners. All of the owners of an LLP have limited personal liability for business debts.

A limited liability company (LLC) is the same as an LP in terms of having two classes of partners (general and limited). It also enjoys the same benefits. But an LLC has an additional benefit: The general partners, like the limited partners, are not liable for expenses beyond their capital contributions.

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