Now that you’ve learned all the ins and outs of marketing and understand how to best harness the power it can have, it’s time to make a deal! There are a couple of main points you’ll need to keep in mind when you’re considering how to structure your deal, like what people are finding in the marketplace and what you should consider when setting up your investment opportunity and business. Below, you’ll find a breakdown of two major components – distribution and fees (how they’re paid and how they’re allocated) and some related terms you might run into.
Profits Split
This concept is simple enough to grasp. In essence, investors get some percentage of the profits and some percentage of the distributions. It can break down as easily as a 50/50 split where investors get half and sponsors get half, but there are scenarios where it gets a little more complicated.
Dilution
This term will typically only pop up when dealing with a corporation. To better understand what it means, picture this – you set up a corporation and start selling stock. When you begin, you have 100% ownership, but that ownership starts decreasing while the shares held by investors and shareholders’ shares are increasing. That’s called “dilution” and affects the profits you’re going to see.
Preferred Returns
When you’re talking about a profits split, one of the major concepts to understand is a preferred return. A preferred return is essentially a percentage interest rate on the cash and investments that came into the company. As an example, imagine that you raise a million dollars and you’re offering a 5% cumulative preferred return. Every year, you’ll owe all investors $50,000 before the profit split comes into play. Why does that make a difference? It’s reflecting the time value of money rather than just saying that cash needs to earn something. This works in the investor’s favor, and because of that, it is often expected in real estate dealings.
The preferred return is paid out before any profit split occurs. Remember that example with the 5% cumulative return? Let’s take it a little further. You’re developing a property, but the cash flow isn’t immediate. It takes two years to see the cash flow or to sell. In this case, “cumulative” means if you cannot afford to pay out for the preferred return, no profit will accrue until the company can pay the preferred return.
Legal Issues
Sticking with the idea of preferred returns, there’s a fairly routine (yet frowned upon) thing you might see happen: paying a preferred return before there are any profits. The SEC doesn’t condone it, and FINRA has just restricted it from broker-dealers. It still happens, and moves get made to over-capitalize a property. The preferred return gets paid from the current capital before there’s enough profitability to continue profit distribution.
Why is that a problem? Doing it is misleading. Because it’s a preferred return, you’re just returning the investors’ own money, reducing their capital basis with their own money in the process. The return on their investment is just an illusion. There have been plenty of lawsuits and enforcement actions around this issue, too.
Moving Levers
When you look at a preferred return in a profit split, think of them like levers. Consider the following scenario – you have a 6% preferred return 50/50 profit split. These are your levers. If you increase that share of the investors’ profits, you can reduce that preferred return. You could give the investors 75% or 80% of the profits and do away with the preferred return entirely. On the flip side, you can let the investors get 10%, 11%, and 12% preferred returns, but they don’t get any profits besides that.
Differing Strategies
Sometimes, one strategy makes more sense than the others. Do your due diligence, talk to someone who has been there and is familiar with the markets, and figure out what works. Below are a couple of examples where opposite strategies make sense, and knowing the difference can make or break the way you structure your deal.
High Preferred Return & No Split
You might find yourself in a situation where offering a high preferred return without a profit split is the best method.
For example, maybe you’re able to buy a “diamond in the rough” property or a business at 50% below the fair market value, but you know that in the next three to six months you can refinance it and pull out a huge amount of that money. In that scenario, you might have the opportunity to own 100% of that real estate. By paying off the investors, you’re reducing that preferred return, because they don’t have their capital in the deal. In that case, congratulations! The property is entirely yours. That is one situation where it makes a lot of sense to have a high preferred return with no profits split.
No Preferred Return & Higher Split
On the other hand, the opposite strategy sometimes makes the most sense. This often happens in multifamily transactions or real estate transactions that are cash-flowing. Those scenarios can be challenging from the sponsor’s side. When you have a small cash flow, you expect a big capital gain.
Unfortunately, that big capital gain might mean that the sponsors don’t receive anything except for their management fees and that they don’t get any share of the profits during the operational stage. That’s not sustainable. If you’re trying to limit management fees to be able to maximize returns, that’s when a structure with no preferred return but a higher profit split makes much more sense.
For another possible scenario where this strategy is preferred, picture the following. You have a 7% preferred return, but its cash flow is only 5%. On the sponsor side, the management side never gets any of the cash flow until you get to a sale point. That is a difficult prospect. What if you just gave 75% of the profits to the investors and the management receives 25% of the profits throughout the opportunity? At that point, it’s completely reasonable to receive a nominal or no preferred return for the sake of a much higher profit share.
Investors’ Best Interest
It should be noted that not having a preferred return is less in the best interest of the investors. If your goal is to provide an amazing experience for investors and arrange things so that they receive a fantastic return on their investment, this strategy might be slightly less aligned with that goal. You do still want to make sure they’re happy at the end of the project.
Performance Hurdle
While a preferred return is charged before the profits split, a performance hurdle occurs after the split and operations. It happens when you get to a capital transaction, which means you’re either refinancing or selling a property. There’s often a different set of terms for capital transactions compared to the operations or distributions. This is an essential component and something you’ll want to think about.
Suppose you were to offer your investors 70% or 75% of the profit without giving them any preferred return. At the end of the day, that means you can provide investors with a less-than-stellar return if the project doesn’t go to plan. Here’s where the performance hurdle can come into play to help.
In this situation, imagine 8% and a 70/30 split during the investment operations. You’re splitting the profits 70% to the investors and taking 30% of the profits for yourself. The investors get their money back, to the extent that it hasn’t been returned, and they receive 70% of the profits.
At that point, do a bit of evaluation. What is their return on investment (ROI) or IRR? Those are just two different ways to calculate somebody’s return. If based on ROI, they received an annualized 6%, then they didn’t hit the performance hurdle of 8%. That’s not a problem. At that point, you can reduce the 30% that’s being received by your management side. Share that to make up the 2% difference and get the investor the 8% return they were expecting. With that scenario, you’re still receiving an excellent return on your time, effort, and risk while going through the project.
Cumulative vs. Non-Cumulative
Cumulative and non-cumulative are both different types of preferred returns. In basic terms, non-cumulative means that if you can’t pay someone, they simply lose the opportunity to be paid, but you’ll pay if you have the ability. Cumulative, on the other hand, means that if you can’t pay someone then you’ll continue adding up what you owe them until it can be paid.
A cumulative return can offer assurance that you’re valuing your investors, their time, and their money. It helps build up the trust of your investors, too. Cumulative returns understandably encompass a large percentage of deals.
You’ll typically only use noncumulative returns in a few specific cases. When something is ground-up construction where you might see delays and other issues, for example, you can try to get a capitalized, non-cumulative preferred return. That sets the stage for using the preferred return, performance hurdles, and profit splits.
Waterfall
Another term to be aware of is “waterfall”. A distribution waterfall involves pouring the profits on top and letting the legal terms filter out who receives what until it reaches the bottom of the waterfall. By that point, all of the profits should have been paid out.
When you’re talking about preferred returns, it goes out to investors before the profit splits come into play and the investors get their percentage share. Then the management sponsors and the operators are getting their percentage share.
Add a secondary waterfall specifically dealing with capital transactions, which, as explained earlier, is a sale or refinance of an asset. With that waterfall, you’re getting investors their money back. If lawsuits happen, it’s typically due to skipping that particular step. You have to structure your waterfall correctly.
Imagine a scenario where you’re giving investors 75% of the profits. The property sells, and you provide investors with their 75% share while taking 25% for management. The investors still lose in that scenario, because they weren’t made whole with their investment before paying them out and going through the shares. Upon making a sale or refinancing, you’re generally giving the investors their money back and then going right back to the top of the waterfall. Run through that same distribution waterfall again to ensure the preface is paid and then finally handle the splits.
The management and the sponsors receive everything that’s left over. There’s a big benefit there, made possible by a simplified performance hurdle that makes it easier to do the share splits. Operationally, you do the shares until you get to the capital transactions, the refinance, or the sale. Give the investors their money back and their percentage of the profits then do your evaluation. Did the investors at least receive that reasonable return on investment or internal rate of return? If not, the sponsor side will reduce their percentage to the extent necessary to ensure that this reasonable return was hit.
IRR & ROI
IRR and ROI have come up a few times and understanding what they mean is helpful to this whole concept. IRR stands for internal rates of return, whereas ROI is the return on investment.
ROI is a calculation of their return based on their original investment. It takes into account whether there’s been a refinance that paid back any of their money. It doesn’t change the equation from initial money to total funds out, though. ROI works if you don’t have a lot of refinancing or different sales that are taking place and returning capital to investors.
When those things do take place, or you’re looking to return the capital quickly to the investors through a refinance, buying assets, or you’re going to sell some of them to return the investor funds, IRR may make more sense to evaluate your performance hurdle. You can also do these with preferred returns, but it’s more common on the performance hurdles. IRR considers a statement of cash flow over a period, along with the differences in the capital basis or the amount of money they still have in the deal.
Conclusion
With this article, you’ve had an overview of how the distribution of fees and profits can be broken down. The best structure for a deal depends on several different factors, so finding something that works in one scenario might not serve you in the next one. Some deals will yield the most benefit from a high preferred return, for instance, while others perform best with no preferred return at all. You can’t paint everything with one brush and expect the best results every time. Regardless of the terms you end up setting, the important thing to remember is that you need to stick to them.
Now that you have the information you need and explanations of much of the terminology you might encounter, you can expand on that. Things will start to look different with bigger deals, so there’s always more to learn!