“The deal is an 8 pref with 70/30 equity split.”
Got it? No? Welcome to the world of equity splits, where deal makers throw around words like “preferred” and “waterfall.”
If you’re new to syndications, these terms can be confusing and intimidating. If you don’t understand the terminology when looking at a deal, chances are you don’t truly know what kinds of returns to expect.
Note: this post is a primer on the most common terms and deal structures. If you really want to get into the weeds, I recommend CrowdStreet’s post on the same topic as well as Law Insider’s library of clauses (which has examples of what these look like in an actual operating agreement).
Below you’ll see some examples of distribution clauses. A distribution clause is referred to as the “distribution waterfall” or just “waterfall.” When evaluating an investment, it’s very important that you understand the waterfall clauses because they determine who gets paid first (and second and third…), how much they get paid, and when.
The Easy Way
The simplest structure is a straight equity split. In this scenario, investors are given a defined percentage of all cash flow and equity on sale, and it’s usually described as something like “60/40” or “70/30,” with the first number being the share that’s allocated to the investor.
In an operating agreement that waterfall would look something like this:
So long as Cash Flow permits from Operations, the Manager will make the following distributions to the Members and the Manager.
- First, to the Members, pro rata in accordance with their Percentage Interests, in an amount which will equal 70% of the total distributions made to the Members and the Manager, collectively under this Article; and
- Then, to the Manager, in an amount equal to all remaining Distributable Cash (30% of the Distributable Cash) with respect to such distribution.
There also will be a section for capital transactions, such as a sale or refinance. It’s essentially the same except the very important caveat that all proceeds must go to investors until they’ve gotten back their original investment. You should make sure a clause similar to the one below is in any opportunity you evaluate.
First, the Members will receive all of the cash as a return of capital until they have received a return of one hundred percent (100%) of their initial Capital Contributions, if such cash exists;
The Preferred Return Way
A preferred return (aka “pref”) is a great option for investors. In a nutshell, it sets a “hurdle” that an investment must return to passive investors before the operator can be paid. So on an investment of $100,000, a 7% preferred return means you will get a minimum of $7,000 annually. (Note that this not a guaranteed returned. Nothing is guaranteed in life, and in fact it’s illegal to guarantee a return. If an operator is using that word, refer them to this Investor SEC Bulletin.)
Aside from the lower risk for investors, the fact that the operator is willing to offer a preferred return is a sign of confidence. The operator is essentially saying, “we are so confident in this deal that we are willing to forgo payment until the investors get a a good return first.”
Look for Accrual
A preferred return should be accompanied by accrual of returns if the hurdle is not met. That is, if for some reason the investment is not performing and the operator cannot pay out the full 7%, the remainder should accrue on the company balance sheet in anticipation of future payoff. So on that hypothetical investment above, if the operator only can pay 6% in the first year, in the following year you should receive 8%. Below is an example of how this might look in an operating agreement.
First, to the Members holding Class A Units, pro rata in proportion to the amount of any Accrued 7% Preferred Return as of such date in respect of each such Unit as of the date of distribution, until the Accrued 7% Preferred Return of each Class A Unit is reduced to zero;
The above scenarios cover the vast majority of syndications. However, for complex deals, such as a development project staged from raw land purchase to construction to final operations, the payout structures can be quite complicated. As an investor you should take the time to understand exactly how much you get paid, in what order of preference and when. Read the documents closely, ask questions of the operator, and do your due diligence.
If you’re an operator who wants to learn more about advanced strategies, I highly recommend Anthony Chara’s Deal Structuring Workshop.
DJ has been a serial entrepreneur for over 20 years, founding multiple companies in the software and media industries. He began real estate investing in 2016 and loved it so much that in 2017 he decided to focus on it full time.