OFFERING DIFFERENT CLASSES OF SECURITIES
Can I Offer Different Classes of Securities?
The short answer is obviously yes, as an issuer of securities you are completely free to offer different classes of securities if the company’s governing documents allow for it (for example, an LLC’s operating agreement or a corporation’s bylaws must be written so that the company can issue multiple classes of securities). A more important question issuers should be asking is why they would want to issue multiple classes of securities.
Anytime a company raises capital by bringing in more investors, the company should be concerned with whether or not these new investors will have voting rights and what those voting rights are. The company should want to retain control over managing the day-to-day business of the company and not allow a single investor, or a small group of investors, too much control over the business. Having multiple classes of investors helps solve this issue. A company could create a class of shares (or units if talking about an LLC) that has limited or no voting rights. Now depending on what state the company is organized in, it might be impermissible to completely take away all voting power of an investor so check with a business attorney in your state before deciding on removing all voting power from investors for a specific class.
Having multiple classes of investors solves the issue of how to grant manager rights to profits without requiring them to invest as much as a passive investor.
Reserving Interests for Insiders/Management
Another issue that faces companies raising private capital is making sure the people running the company are adequately compensated. Sometimes this can take the form of simply giving the
management team salaries or a flat fee. However, in the realm of real estate syndications, the manager of the syndication often takes a portion of the net profits as part of the compensation. This makes sense in real estate because it incentivizes the manager to maximize profits for both the investor and themselves. However, the manager in a real estate syndication might not want to invest as much capital as a passive investor for the right to their portion of profits; after all, the manager is investing their time, resources, and manpower and should be compensated for that in some way. Having multiple classes of investors solves the issue of how to grant manager rights to profits without requiring them to invest as much as a passive investor. For example, an LLC has two classes of members: Class A and Class B. Class A would be all the passive investors from the offering that are all paying proportionate amounts for their respective interests in the company (e.g. $1,000 per Unit). Class B would be all the people involved in management of the company. Class A would own 80% of the interests in the LLC and in total all the Class A members paid $1 million for that 80%. The Class B members pay $1,000 for their 20% since they are investing other things besides money (time and effort). Cash distributions could be split 80/20 between the Class A and Class B members (Class A would get 80% and Class B would get 20%). If there were only one class of members, the company would not be able to create the incentivized distribution split since all members would be entitled to a pro rata share of any profits.
There is obviously a multitude of different ways on how to structure a profit-sharing split that adequately and fairly compensates the management team. The above was merely an example to highlight how having multiple classes of investors can help do so. If you are thinking about conducting an offering to raise money from private investors and you have questions on whether having multiple classes of securities is right for you, you should talk to a securities attorney.