How We Use Transaction Structure to Protect Our Investors
Last week, we mentioned structure as one of the 7 things to consider when investing in an equity transaction. Today, we will explain how we use structure and the collective power of RealtyMogul.com’s investors as leverage to establish one of the most important things that we consider when evaluating an equity deal – investor protection.
When investing in an equity transaction, RealtyMogul.com investors typically pool their money into a Realty Mogul Special Purpose Entity (an “SPE”). That SPE subsequently invests, as one investor, in the property-holding joint venture entity, which is typically structured as a limited liability company (an “LLC”).
In addition to the liability and tax benefits provided by an LLC to its members, the LLC also provides predictability through its operating agreement. An LLC’s operating agreement serves as a contract among the members of the LLC (that includes our investors) and the managing member (in most cases, the sponsors operating the property), detailing how the LLC will operate.
Here are a few key provisions we focus on when negotiating operating agreements on behalf of our investors:
As with any enterprise, there is always the possibility that additional funding will be needed. To protect our investors from additional capital requirements, our deals typically include a provision that makes capital calls optional. We also strive to limit the negative consequences for not participating in capital calls by limiting the dilution of our investors’ interests and by restricting the terms of any member loans.
In addition to allowing contributions from current members during a capital call, an LLC manager may decide to bring in new investors to raise the needed capital. To protect our investors, we strive to require that these new members be brought in on the same terms as the initial investors.
We advocate to provide pro-rata voting rights for our investors, prohibiting a manager super majority.
A passive investor is usually comfortable with the LLC manager handling the day-to-day management of the company/property. However, we make sure our operating agreements require that if the manager partakes in certain prohibited activities, the majority or super-majority of members may vote to remove the LLC manager.
We prohibit managers from disclaiming the applicability of their fiduciary duties generally, and at a minimum, require managers to affirmatively state that they have a fiduciary duty for the safekeeping and use of all funds and assets of the LLC.
We also strive to define “Majority” as fifty-one (51%) percent or more of the membership interests in the LLC to prevent managers from requiring “super-majorities” to enforce member voting rights.
Passive investors’ voting rights are generally limited to major events such as the property liquidation or removal of the manager. We strive to expand these rights to include matters that could impact our investor’s interests such as changing the business of the company, procuring additional financing of the project and/or entering into material amendments of the operating agreement.
We push each transaction to require the manager to provide the LLC tax reports promptly after the end of the calendar year so we can ensure our investors receive their tax documents on a timely basis. While this could be challenging to enforce at certain times, it has proven to work with most sponsors.
If the manager elects to hold the property beyond the expected hold period, we aim to protect our investors by giving them the right to either force a sale of property itself or have an option to sell their interests.
We require managers to set forth in the operating agreement the fees that will be payable to them and/or their affiliates. We also seek to limit their ability to enter into agreements with affiliates, such as property management agreements, without a majority vote from the members.
Investor protection is one of our core values here at RealtyMogul.com. It drives our thinking, our behavior, and our decision making. We consider it when sourcing deals, screening sponsors, underwriting transactions, structuring, and managing them through payoff. We understand real estate investing carries risk and no real estate investment guarantees a return so we want to make sure we can protect you, as an investor, in ways that we (legally) can.