Enterprises that Need More Funding
It’s not common, but sometimes a sponsoring real estate company that has earlier purchased a property with investor money realizes, after operating the property for some time, that more money will be needed -- perhaps the planned renovations went over budget, or an environmental issue arose that needs to be cleaned up. How do the sponsors deal with these circumstances, and what are the investors responsible for?
There’s always the possibility that an enterprise will need more funding. Revenues may not be at the level expected, expenses may have gone significantly over budget – there are a number of reasons why additional money may be needed. Most sponsors that Realty Mogul works with are very experienced and know to plan conservatively, which includes establishing a significant capital reserve to prepare for unexpected costs. Yet even with top-notch managers leading a project, things can sometimes go wrong, and a “capital call” – a request to the members / partners of the sponsor’s entity for additional funds – may be made.
How these capital calls are dealt with is determined at the outset of the transaction, when the investment funds are being raised. This is when the terms of the operating agreement (or partnership agreement) of the sponsor’s entity – the limited liability company or partnership actually holding title to the property -- are negotiated.
At Realty Mogul, we make clear when we first begin discussions with a sponsor that we will not be making any additional capital contributions to the project after our initial investment. The nature of crowdfunding makes it exceedingly difficult to approach the various member investors to contribute more to a company that is already running a shortfall. As a result, we make it clear at the outset of sponsor negotiations that we will not be in a position to contribute to any capital calls that may arise. We also review carefully the sponsor’s proposed operating agreement to make sure that it accords with our requirements in this regard.
Sometimes, operating agreements specify that a sponsor will be responsible for any capital shortfalls and that it will need to line up separate debt financing to fund such shortfalls in a way that will directly not affect the members’ equity interests. Other agreements might provide that if a sponsor requests more funding from the existing members, such additional funding will be optional, but that those members who elect to not contribute additional funds will either (1) suffer some dilution of their interests (since members who do contribute will now have an proportionally more capital invested) or (2) be deemed to have taken a loan, from the company or the contributing members, at an interest rate anywhere between 5 – 20%, for the amount requested but not contributed. Terms vary as to whether the non-contributing member can receive any cash distributions while any such loan remains outstanding.
This typical arrangement is in contrast to the proposed terms of some other operating agreements that we’ve seen, which can sometimes be quite harsh for members who elect to not contribute additional funds. Sometimes a non-contributing member will be deemed to be in default under the operating or partnership agreement, with a whole raft of consequences. For example, we’ve seen some proposed agreements demanding that a non-contributing member (1) have his capital account in the company reduced by 50%; (2) not receive any further regular distributions; (3) not receive any payouts whatsoever until the company or partnership is dissolved or liquidated; and/or (4) if the manager wants, be forced to sell his diminished interest back to the limited liability company or partnership.
Even with highly experienced project sponsors, things can sometimes go wrong and a project may require additional money. Although some investors may choose to contribute additional capital, at Realty Mogul, our policy is to not enter into arrangements where our investors will be required to make any further capital contributions. It is important that investors understand, however, that in those situations where a sponsor does make a capital call, some degree of dilution may occur to the interest of the investing Realty Mogul entity (and thus to the interests of our investors) or, alternatively, the Realty Mogul entity may be deemed to have “borrowed” a loan from the company or the contributing members, which may halt further distributions until the project again generates enough distributable cash to pay back any amounts that were “borrowed” from the company or contributing members to cover the Realty Mogul entity’s portion of the sponsor’s capital call. In either case, returns to investors may be adversely affected.