There’s a lot of focus on debt financing. That’s to be expected, as the financial industry tends to promote debt as the most effective way of obtaining capital. Need to build a stronger business? Take out a loan. Want to invest in new equipment for your organization? A line of credit can do that for you.
Debt can be a powerful tool for growth, certainly. However, equity trumps debt every time. With equity, you have a tool that does not put you further into the hole – you’re not mortgaging your future earnings to spend them today. Instead, you’re using a current asset and leveraging it to its fullest advantage.
First, a Caveat
Equity trumps debt every time, and that’s what we’ll explore in this series of posts. However, we first need to cover an important caveat. In order for equity to work on your behalf, it’s important to develop a smart financial and legal strategy. As an entrepreneur, you need effective ways to raise capital for your deals, but that effectiveness must be balanced with legality. Therefore, it’s essential that all your fundraising efforts follow the letter of the law.
Currently, it’s a time of anxiety for many in our industry. Why is that, though? The economy is surging, and the real estate industry has exploded. Everyone seems to be out there raising money without a problem.
Here’s the thing – the current environment is reminiscent of2016, making it easy for people to be tempted to take unreasonable risks. Don’t do that. Avoid investing in deals that won’t work. And, most importantly, don’t skirt around the rules trying to avoid some law that seems like it’s unfair.
Remember that when you break the law, even to avoid a rule that may feel unfair, it can have a ripple effect. Once the authorities get involved, then attorneys enter the mix, subpoenas are issued, investor inquiries are made, other attorneys get involved, and so on. The entire situation snowballs. So, how do you ensure that you’re able to follow the law and raise capital effectively?
- Follow the rules (we’ll come back to this in just a moment).
- Have the right documentation for your investors.
- Vet your investors.
- Work with licensed and reputable broker-dealers.
With that caveat out of the way, let’s move on to the topic at hand: equity. We’ll begin by talking about equity rules.
What Are Equity Rules?
What are equity rules? How do they work compared to what equity is? Here, we’re discussing equity in terms of how it compares to debt. Many people assume that to get started in real estate investing, you need to work with private money lenders. Or maybe you’re creating a new biotech company or a tech firm, and you’ve borrowed money from friends and family to get it up and running.
Those are both viable paths. However, things become different when you sell private securities and approach banks for debt financing. Banks don’t like any other debt beyond their own claim on your future finances. And, they will shy away from a great deal simply because there is another outstanding debt associated with it.
The challenge is that if you’re selling unsecured promissory notes instead of secured promissory notes with a trusted mortgage company, there could be a misunderstanding with investors and issuers. Ultimately, the issuer may assume that the debt is secured with real estate when it is actually not secured.
When looking at a balance sheet, equity and debt are on the same side, right? Assets = liabilities + stockholders’ equity (often referenced as simply + equity). You're either selling to investors equity when raising private capital, or you’re seeking debt from a bank or private lenders. And when equity holders are involved, this is something that they owe the owners in the company, whereas debt is something that is owed to them. So, they don't have any ownership in the company, but they do have a debt instrument where there's an obligation to pay them.
In discussing debt, banks don’t like seeing debts on your ledger as it effects the debt-equity ratios for their underwriting. Also, it’s important if there are any priority debt holders to have a client on repayment, either. They see every debt that’s beyond their claim as another drain on your resources, which they have a vested interest in.
However, you have obligations as an issuer, as a company, and as a fundraiser. What is your duty to those who have debt versus equity? With debt, the company promises to pay a certain interest rate, then the company is obligated to pay it. Even if the money is not there, the company is legally obligated to pay and maybe in default if any payments are missed. It’s a contractual obligation.
Regarding equity, you’re only obligated to pay dividends/distributions if the cash is there. If profits exist, then you can make the payment. However, there are no profits to report, then you’re not contractually obligated to find the money to make the payment. In other words, you don’t necessarily pay a return on investment if there is no return on that investment.
What About Stated Rates of Return and Prioritized Payments?
You might be wondering, what about investors who need a stated rate of return? These investors need to know exactly what they are going to earn and they want to be prioritized in payments. In other words, these investors want to be paid first.
The good news is that you can still pay them first without creating untenable contractual obligations that require you to pay even if there is no return. So, how do you do that? Through what’s called a preferred return.
Understanding Preferred Returns
To understand preferred returns and prioritized payments better, let’s look at an example of a single-family flip example. A single-family property flip has the profit potential either through, first, the remodel and, second, resale or rental. But during that rehab period, there is no money being made. And if the project runs over and the promissory note becomes due, there's a contractual obligation to repay the lenders. If you are a personal guarantor of the debt, then you may be personally obligated as well.
So, how can we provide the investors with the stated return without getting stuck in a contractual obligation increasing your risk? We do this with what we call a preferred return. Investors like preferred returns because it prioritizes their returns over that of the sponsors of the investment. The sponsors of the investment like the preferred returns since they generally can’t go into default. Banks like preferred returns since the investors are part of the equity stack and are not secured by the property. These are owners, not people who are owed money.
Let’s use another example to illustrate what a preferred return might look like. Let’s say that , based on the terms of the agreement, you’re expected to earn an 8% return on your money before anyone else is paid. The investment sponsor basically treats it as a debt in terms of a stated return being paid but the company is not in default if payment is not timely.
If I have a project that has a 30% ROI, and I split it 75% with my investors, they’ll receive a gross 21% return. There are other options to only offer a preferred return, like 10%+ annualized preferred return. This incorporates the time value of money and unless the project required 2 years or more, the sponsor of the investment should receive a higher return. We’ll often use this strategy when a quick refinance or sale is anticipated.
The example above is easy to understand. However, in some cases, we can take that preferred return and move it to another level. For instance, you might decide to offer a smaller preferred return of between 6% and 8%. You tell your investors, “I’m going to pay you 6-8% on your money, then I’m going to get 6-8%, and then we’re going to split the remaining distributions.”
Of course, there are other ways to do this. For instance, you could pay the preferred return to investors and then split whatever’s leftover. You can pay a preferred return to investors and then together with a preferred return split anything remaining. However you structure it, these options give investors an opportunity to make a little more than just a preferred return.
When Investors Hold Out for Equity
With that being said, you may encounter situations where your business partner or investor doesn’t want a preferred return. Instead, they want straight equity. In this case, you would just split the equity with your investors.
For instance, let’s say you agree to split the profits with an investor, giving them 75% and you receiving 25%. The point of all this is that you can get returns to your investors without creating contractual obligations for yourself. Banks on the other hand are only going to offer you leverage or debt. And you also create it so that you only pay these returns when the money is available to pay the returns. You don't pay it because you have some kind of contractual obligation.
What Do Investors Actually Receive?
You might be wondering how to determine what your investors should receive. Should you tell them they’ll earn 12% on their money? 18%? More? Less?
Here’s the thing – it really doesn’t matter. Let’s pause for a moment so you can process that. The percentage offered doesn’t really make a difference.
Why doesn’t it matter? Simply put, what investors want is irrelevant. If the deal doesn’t work, then you can’t deliver on your promise.
Let’s break this down a little bit more. First, it makes no sense to offer your investors a 50% return on investment for a deal that is only possible if all you’re going to do is add your investors. At the end of the day, investors are going to invest now because they’re excited about an opportunity but also because you’ve provided them with a solution to their problem.
It’s your job to determine what that problem is so that you can solve it. For instance, maybe they’re trying to save for their child’s college education, and you have a way for them to do that. Perhaps they want to invest in a self-directed IRA, and you’ve got the right option for them. Maybe they want to find deals in Western Europe, and you know where to look. You get the idea – you’re not selling a return. You’re selling an answer to their problems, which is priceless. The return itself is secondary.
We hope that you found this information helpful and look forward to sharing part two in the series in an upcoming post. We’ll answer some of the most frequently asked questions on the debt vs. equity topic and explain the value of equity to your business investments
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