Listen as Adam Hooper and Mark Roderick discuss operating agreements and waterfalls.
Mark Roderick is a very boring corporate and securities lawyer. Since the JOBS Act of 2012, he has spent all of his time in the Crowdfunding space and today is one of the leading Crowdfunding and Fintech lawyers in the United States. He writes a widely-read blog, www.CrowdfundAttny.com, with a wealth of legal and practical information for portals and issuers. He also speaks at Crowdfunding events across the country, and represents industry participants across the country and around the world. He can be reached at (856) 661-2265 or firstname.lastname@example.org.
Adam Hooper – Hey Tyler.
Tyler Stewart – Hey Adam, how are you today?
Adam Hooper – I’m great, welcome RealCrowd listeners to another episode of the podcast. Tyler, who do we have?
Tyler Stewart – Adam, today we have Mark Roderick, crowdfunding attorney at Flaster Greenberg PC.
Adam Hooper – That’s a familiar name.
Tyler Stewart – It is, we’ve had him on before, haven’t we?
Adam Hooper – We have. Just couldn’t get enough of him.
Tyler Stewart – No, last time you got him weepy, this time I believe you got him to get a little nerdy.
Adam Hooper – I did, we got nerdy, I put him on the spot, he put me on the spot. He’s the first, he flipped the script.
Tyler Stewart – How was is being on the other side of the conversation?
Adam Hooper – It’s a little different. It’s a little different, but good episode, I think a lot of good information. You know, Mark is one of the most informed guys out there. In our space. Been practicing law for decades. Knows this stuff in and out, right, so I think he’s got a really unique insight and input into how these deals are structured. We talked about operating agreements, we talked about waterfalls, we talked about even a little history of why an LLC even exists.
Tyler Stewart – Not only does he have great knowledge on the crowdfunding space, he’s very passionate about it and he wants to see it go in a positive direction. Which comes across in this podcast. And he has some exciting things he’s working on to help improve the space.
Adam Hooper – He does and it’s, we talked about it before and we touched on this one. There’s just no getting around the complexities of some of these terms and structures. And that’s one of the things that he’s definitely passionate about, and we certainly share here at RealCrowd, is trying to bring some more clarity, transparency, and simplicity to some of these documents. So you’ll hear in the episode some things we might be working on together and hopefully making it a little bit easier for investors and our listeners out there to really understand the differences between these deals and how they come together.
Tyler Stewart – Absolutely, and as a listener, read the transcript. Mark’s going to point out some things to look at in the operating agreement and what are some red flags, what are some quick hits to look at.
Adam Hooper – Definitely. And as always, listeners out there, if you have any comments, questions, or feedback, please send us an email to email@example.com. And with that Tyler, let’s get to it.
Tyler Stewart – Let’s do this.
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Adam Hooper – Mark, thanks for joining us again today. Glad to have you back on for another episode.
Mark Roderick – I’m delighted to be back with you, Adam.
Adam Hooper – Good, well so we were just talking, we left off our last one with a quick tease that there might be some more information coming about operating agreements, and all the fun nuances of how these things come together. Hopefully today we can cover some of the basics around how these deals are structured. For the listeners out there, you know, when you’re looking at different deals, whether it might be in an LLC or a limited partnership, some of the key terms or key clauses to look for in those agreements. So we should probably start Mark with how are these deals typically structured.
Mark Roderick – Well most of the deals you see structured today are through limited liability companies and I’d be happy to talk about those generically. You still do see some deals through limited partnerships, but that’s about it, I’d say 90% of the deals you see are limited liability companies or LLCs, and the other 10% limited partnerships or LPs.
Adam Hooper – And what’s the distinction between those two?
Mark Roderick – Well, I’m glad you asked that, Adam. And before we got on the air I warned you that this was going to get a little nerdy, and so this is the first part of it. So to start at the end point, the limited liability company has been created to sort of be the perfect form of business organization. So that’s where we end up, but I will, given the opportunity go back hundreds of years ago and there were no business entities, and I mean 600 years ago. And then the history of business entities, culminating in LLCs, I warned you, has been that governments slowly but surely accommodate laws to satisfy the needs of business people. So way back when, when the merchants of Venice were having overseas expedition and the merchants were being held liable for everything that the organization did, and so that’s when we started to have corporations to limit liability, it was a response to a commercial need. And then we fast forward and fast forward and fast forward until the 20th century, and we start having things like limited partnerships as well as general partnerships and all different kinds of corporations including I’m sure you and your listeners have heard about sub-chapter S corporations. These were all responses to commercial needs expressed by business people. And then we fast forward even further and we get to the early 1980s, and in Wyoming of all places. Wyoming invents a new form of organization called the limited liability company. And all of us sophisticated lawyers on the east coast and west coast said, “Now that couldn’t possibly work because it was invented in Wyoming.” But lo and behold, the Wyoming folks got a favorable tax ruling from the Internal Revenue Service confirming that indeed these wonderful entities that protected all of the owners, all of the owners, from liability just like corporations would nevertheless be taxed like partnerships, meaning as pass-through entities with no entity-level tax. And immediately in the early 1990s every state adopted its own limited liability company statute. So my point in that whole nerdy story is that the reason we use limited liability companies today so universally, or nearly universally, is not a coincidence. It’s because the limited liability company is a culmination of a process whereby the laws accommodate business people and the LLC was created to be the perfect business vehicle. And that’s why it is, and so that’s why it is used so universally.
Adam Hooper – I know you mentioned the taxation. There’s and no entity-level taxation, so again a lot of our listeners are from the technology or the venture world where 99 plus percent of those companies are set up as Delaware C corporations so there is taxation at the actual company level versus LLCs where there’s no taxation at the entity level. Can you go a little bit deeper on that?
Mark Roderick – Sure, so the tech industry is a peculiar industry, or should I say it’s very different than the real estate industry. I mean, I very often set up even tech companies as LLCs and I actually wrote a little pamphlet that’s on my blog about choosing between C corporations and LLCs for tech companies. But the basic idea, the reason tech companies are corporations is they never expect to make money, so they never expect to pay tax at the corporate level. And they completely expect to have one of two things happen to them. They’re either going to go public as corporations, do an IPO, or they’re going to get bought. And frequently they’re going to get bought for cash and stock. And when you’re a corporation it’s easier to be bought in a tax free transaction for stock than if you’re an LLC. So, yeah, the tech industry is sort of unusual in that that is the planned trajectory of every you know, every start-up in Silicon Valley has that planned trajectory. It doesn’t happen for most of them, which is why I usually suggest forming as an LLC there as well. But in the real estate business what you’re hoping to do is you’re hoping to generate cash flow, which tech companies do not typically, and you’re hoping to have that cash flow tax deferred so you might get checks from the real estate project but you don’t have to pay tax on the cash you get because the depreciation in the real estate project is sheltering that cash flow. And again that’s not happening with tech companies, so they’re two very different animals tax-wise, which is why you typically see them in different kinds of corporate structures.
Adam Hooper – Got it, so then back to the real estate, you’ve got the tax benefits, you’ve got the you would say limited liability corporation so I’m assuming again there’s some, as you said earlier, the trading companies were essentially getting held liable for everything that their companies were doing so these liability protections came into place, and that’s what’s got us to now this current form of the LLC that’s so widely used. When an investor is investing into an LLC what are they actually getting, are they getting ownership of what?
Mark Roderick – Well, they are getting the same thing that they would get if they owned stock in a corporation. So when you become the owner of a limited liability company you own equity. Just as in a corporation equity is called stock, in the world of limited liability companies what you, the word used to describe what you own varies from state to state. So it gets, can be a little confusing. In Delaware, which is where, you know, most of these projects are formed, it is called in a very prosaic and descriptive way, a limited liability company interest. That is what it is called and it just represents equity. And you can think of it as a share of stock.
Adam Hooper – Okay, and then whatever that entity owns, you own your percentage share of whatever that entity goes out and purchases or owns.
Mark Roderick – Yeah, I mean, you own, indirectly you own that asset but particularly in LLCs it’s better not to think of yourself as owning any particular percentage of the underlying asset. And the reason for that, which I know we’re going to go into in more detail later if I don’t talk too much, is that how the profits from that asset, let’s say it’s an apartment building. How the profits of the asset are divided among the owners of the LLC is completely in the discretion of what the agreement among them says. So it’s, it’s very difficult and not very useful to think of yourself as owning any particular specified percentage of the underlying asset. What you own is an equity interest in the company.
Adam Hooper – Then when you say ownership, what types of ownership are in a LLC?
Mark Roderick – Well, I mean, so when I’m using the word ownership I’m using it at the alternative to I’m just lending money to the LLC. So if I just, if I lend $100 to the LLC I’m a creditor of the LLC I’m not an owner. Within the broad category of ownership, that’s kind of what I was alluding to, ownership in an LLC can mean all kinds of things. Just as really it can mean all kinds of things in a corporation. So in a corporation there’s common stock, there’s preferred stock, there’s convertible preferred stock, there’s convertible notes. We have all those things in LLCs too and because LLCs are a creature of contract more than they’re a creature of statute we can create within our LLC any kind of ownership structure we want. So we can do things like have Class A shares and Class B shares and Class Y and Z shares, each with a different, slightly different, or significantly different interest in the profits of the organization. And they are all ownership interest, it’s all equity ownership even though the rights among all those different types of ownership can be very different.
Adam Hooper – And then the, you mentioned these are a creature of contract versus statute. The contract that governs all this is that operating agreement, and those are of every different flavor you can imagine, right. Those come in many, many different shapes and sizes like we talked about on our last episode. There’s really no standardization right now in the world of operating agreements, is there?
Mark Roderick – There is not and that is very unfortunate, and that’s, I am going to be actually next week releasing some standardized documents including operating agreements for Title III. And I want to very soon thereafter do the same thing for Title II because as you say, the operating agreement is really the only, that’s a little bit of an overstatement, usually the only important contract among the owners of the company. And so it’s super important and super important for investors and sponsors and everyone else to be able to understand. And yet many of them are not understandable and they’re all different from one another, and to ask an ordinary person, here, here’s a 40 page document, you read it and understand what you own. You know, it’s a daunting task at best.
Adam Hooper – And so let’s go through some of the provisions that you would see in a typical operating agreement. And again, you know, we’ve seen them vary from, I mean, they can be just a couple of pages, right. It could be as simple as you need if it’s just an LLC you’re forming amongst a few friends, it might be a fairly simple agreement versus some of the ones that we’ve seen on RealCrowd for some of these bigger deals were like you said, 40 to 60 pages plus. I’m assuming most of those are going to have some standard terms in there, some structure within those operating agreements.
Mark Roderick – Yes. And so let’s talk about what some of those things might be. One group of things is going to talk about who’s running the show, management. And you can do in an LLC absolutely anything you want to do so I often have people say to me, “Well I want to own 51% so I can control the deal,” and I always say, “You don’t have to own 51%.” Again the ownership percentages and the voting control are two completely different things. In fact in a LLC you can have someone control the show who doesn’t have any ownership interest at all, which we sometimes do. But so you can do anything you want, any kind of voting structures that you want. Typically in the deals that you’re going to see on a crowdfunding site like RealCrowd, the management structure is pretty straightforward, and that is the deal sponsor controls everything. The investors are typically completely passive. This is, you know, not an enterprise in which investors expect to have any vote. And the typical operating agreement, although it may take 12 pages to say so, really just boils down to saying the sponsor controls everything.
Adam Hooper – And then in that sponsor control and investor passive role, what are some of the characteristics, like what would you see are the duties and responsibilities of the general partner, the managing member, and I guess we maybe we should even clarify that term. Managing member versus general partner. One and the same, different words, how do those differ?
Mark Roderick – For practical purposes, one and the same. Technically however, so we’ll be a little nerdy again, there’s no such thing as a general partner of an LLC, technically. The general partner is a hold-over from the world of limited partnerships, which used to be how real estate was done before LLCs were invented in Wyoming. So there’s no such thing technically as a general partner in an LLC, but as you know many people still use the term to…
Adam Hooper – Right, the term carries over.
Mark Roderick – The term carries over thereby confusing everyone. We often use the term generically just to mean the person in control of the LLC, but that certainly could be confusing for people. The actual people in control of an LLC can also have different names depending both on the structure of the LLC and the state in which it was organized.
Adam Hooper – That’s crystal clear.
Mark Roderick – So some LLCs are just managed by the owners, who are typically called members. And those are called member-managed LLCs. And then other LLCs are managed by a group which is analogous to the board of directors of a corporation. In Delaware and many other states those are called the managers of an LLC. In at least one state, Minnesota, it’s called a board on governors. So again just increasing the chance of confusion. But I’m going to use the widely used and Delaware-specific term, manager. So in a Delaware LLC, you can either have it be managed directly by the members, a sort of direct democracy, or managed by managers. And in all the deals that you’re going to see on most sites, the LLC is going to be managed by managers, and the managers are typically going to be one manager not plural, which will typically be an entity that is owned by the deal sponsor. So that is, again you’ll see 12 pages to lay all this out, but that’s what it’s going to boil down to. It’s a called a manager, it’s not called a GP. And it is typically an entity that is owned by the guy or gal who is actually running the project.
Adam Hooper – And are there any specific terms or tip offs or headings or sections that an investor can easily go to to try to ascertain that fact? Right, like where is that in the operating agreement, and how important is that?
Mark Roderick – There’s always a main heading called Management. So that’s where you’re going to see it. You should also, that should also be very clearly disclosed in the disclosure document, which we discussed last time, the so-called PPM. Among the key elements of the deal should be who’s running the show. But then beyond who it is, then the question is what are the responsibilities of that person. And what are the potential liabilities of that person. And whether investors have the right to throw him or her out if he or she is not doing a good job. And all that is possible in an LLC, you can do anything you want and you know, in the Wall Street world when you’re dealing with private equity, it would be very typical to see the institutional investor have a bunch of rights, to have veto rights over major decisions, you know, borrowing money or admitting new members or so forth. In the crowdfunding world it’s very unusual for investors to have any such rights. In the Wall Street world, the institutional investor could often kick out the manager under certain circumstances. In the crowdfunding world, very, very unusual for the investing public to be able to kick out managers. So investors can look at the operating agreement and see what rights over management they have. Can they expel the manager if the deal’s not going well. But it’s very unlikely that they’re going to see any such rights. Do you ever see on your platform investors having those sort of quasi-management rights?
Adam Hooper – No, I think you’re right. You know, the control provisions of an institutional deal are very, very different than what you would see in a typical syndicated deal, whether it’s on a crowdfunding platform like RealCrowd or otherwise. And what we see is much more consistent with the typical, again, kind of historical syndication, where the manager has the entire control provisions and the investors that are coming in are very passive. And that’s also, again, that’s different than just kind of trying to tie back into the technology world and the venture space. A lot of the investors that come into a venture-backed company or an angel-backed company have a lot more value to add for the success of that company than money that comes into real estate deals, right. There’s not really a lot of value that a passive investor can add in a real estate deal versus what we typically see in the technology side of the world. So that’s sometimes a bit of a confusion for investors that are out there that are in the tech space, they are active angel investors. Maybe they’re expecting or anticipating a little higher level of activity or a higher level of control in the real estate investments, but that’s just not typically seen when you have deals like this that are syndicated. Whether it’s online or through a traditional channel that’s been done historically for decades.
Mark Roderick – Exactly, and I mean, that’s certainly my experience and on a related point, I mentioned earlier that investors can see what the responsibilities of the manager are. And from a lawyer’s perspective, that question includes what can an investor sue a manager for if the investor let’s say loses money or is unhappy. In an institutional setting, where the institutional investor is represented by counsel, there can be a lot of give and take and negotiation over this point. What are the legal responsibility of the company’s management. In the crowdfunding world where there is no negotiation, where the investors are coming in as passive investors, what you typically see is the manager in the operating agreement disclaiming all legal responsibility to the maximum extent permitted by law. And laws, because laws are written in response mainly to the desires of the more powerful commercial interests, laws in states like Delaware allow the manager to disclaim almost all liability. So except for things like embezzlement or something like that, the fact that the manager of a real estate LLC just does a really poor job, makes poor decisions, he or she is probably not going to be legally liable for those poor decisions under the typical operating agreement.
Adam Hooper – And that’s the limited liability corporation side of things, right.
Mark Roderick – Well it’s beyond that, I mean, limited liability, the term limited liability in a limited liability company just means that the owners are not personally liable for the debts of the organization as they would be in a general partnership. So if you borrow money from a bank, the LLC borrows money from a bank, the members are not liable to the bank to pay the money back. But this goes beyond that. This goes to the personal responsibility of the folks who are running the organization. Their personal legal responsibility to the owners of the organization. So let me put it this way, typically, universally, the manager of a real estate limited liability company has a significantly lower legal liability to the investors than say the CEO of a public company has to the public shareholders. Yeah, so it’s important people should understand, investors should understand that they’re not going to be able to look to the manager, meaning sue the manager, if things go wrong. The same as they might be able to in a public company. ‘Cause most operating agreements in this space disclaim all that legal liability.
Adam Hooper – Got it.
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Adam Hooper – And now touched on a question that we get a fair amount from the investors is, you know, if I put in 25, 50,000, how much of this am I responsible for? If things go bad am I going to have to come in for another hundred or 50 or 200,000. Am I guaranteeing this, what is my actual exposure based on my initial investment?
Mark Roderick – Yeah, well that’s a super important, super important question. And the answer is, two answers. One, it all depends on what the operating agreement says. So it’s a very valid question. And the second answer is, I have never seen an operating agreement in a real estate crowdfunding deal where the investors were personally liable for anything more than their initial commitment. Okay, so that’s how it should be.
Adam Hooper – I was going to say, before we get too deep into that, where would an investor look in an operating agreement to try to find that information? Is there a section again, or a provision specifically in there that they can get to that information more easily?
Mark Roderick – There should be. There should be a section in the operating agreement that talks about contributions.
Adam Hooper – Okay.
Mark Roderick – Okay. And then there should be a sub-section in there that says something like, “Except as provided above, no member shall have any obligation to contribute capital to the company.” So there definitely should be such a provision and that it should also say that in the PPM, or the disclosure document. Again, I mean, you raised it, which is great, I didn’t raise it, that’s like the most fundamental issue that an investor should be thinking about. If it’s not clear from the document or from the PPM you know, I would say you don’t invest until you can clear that issue up.
Adam Hooper – That’s a big one.
Mark Roderick – Big one, huge one.
Adam Hooper – Good, good.
Mark Roderick – Most important one.
Adam Hooper – Are there other big ones like that in an operating agreement that investors should be looking out for? Oh, I got him thinking, Tyler, I got him thinking now.
Mark Roderick – No, you do, you do. I’m taking a swig of the bottle of whiskey that’s next to me. You got me flustered here.
Adam Hooper – Hey Mark…
Mark Roderick – No that…
Adam Hooper – I was going to say, just to give you a little more time to think about it. As an investor, what is the terminology you’re looking for in the operating agreement to know that that operating agreement is referencing you the passive investor.
Mark Roderick – Well you should be included in the very beginning of the document, it should sort of define who is who. And you should be defined as a member with a capital M, or an investor with a capital I. And so when you get down to the section that says you don’t have to put any more money in, you want to make sure that whatever capitalized term is used in that section, that you have been included in that defined term, wherever it was defined. Now I do want to make one, one point here, ’cause there may be, some of your listeners may be saying, “No that’s not right, that’s not right.” And what they’re thinking about is this, sometimes you will see in an operating agreement for a real estate deal, a so-called capital call provision.
Adam Hooper – Right.
Mark Roderick – That says if we need more money we can ask you for it. And so the folks listening may be saying, “See, see, they can ask you for it.” But the key is that even when you have capital call provisions, typically, almost universally, the capital call provisions will be accompanied by sub-sections that say what happens if an investor fails to put in more money. And those sub-sections typically talk about the dilution of an investor’s interest. So if he used to own 10% and he fails to put in more money now he only owns 8%. They also typically say but those are the only ramifications, dilution is the only ramification, and the investor does not actually have personal responsibility to put the money in, in the sense that we can’t sue the investor. If he fails to put it in, he suffers some economic consequence, but you can’t sue him to make him put it in. So yes there are capital call provisions, but they almost never amount to an actual legal obligation to contribute money. So I just want to make that one clear.
Adam Hooper – And so that could be, the capital call structure could be another one of those big, not a red flag, but another point to certainly review and make sure you understand and are comfortable with how those capital call provisions, what that dilution is or what those damages are. You know, are they overly punitive if you don’t contribute. You know, how those capital calls are structured, that’s another very important part of the contract to be reviewing.
Mark Roderick – It is, yeah.
Adam Hooper – Anything else? I’m not letting you get off without…
Mark Roderick – Well you know, the obligation to put in more money I think you properly pegged as really number one. Something else that can be significant is the ability of the manager, the guy or gal running the show, to bring in new investors and for those new investors to have more rights than you have. And that is, that is a very common, that is a very common structure, so you generally just have to live with that. But you certainly should understand that if the project needs more money, the manager is allowed to go get it from someone and give that person, you know, a better deal. A lower price, that’s a very common thing. I guess the thing that I would say that’s super important is to make sure that the money is going in the right direction. And that, there are little sort of two sub-components of that. I’m always very interested in the fees that the sponsor is paying to itself. And what the operating agreement says about that, because obviously the more fees the sponsor pays to itself, the less money there is to distribute to me as an investor. So I’m very interested in that. And I’m very interested to make sure that the money is being directed, the distributable profits, are being directed in the way that I think they’re supposed to be. I mean, this is something that certainly should be very clearly disclosed in the, in the PPM, but you would be surprised, well you wouldn’t be surprised, but many people would be surprised that many operating agreements, if you read them carefully they sort of, they fail to make the money go in the right direction. And, I think that’s because most lawyers are not finance folks, and some of the concepts like internal rate of return and preferred return are not completely understood by lawyers drafting operating agreements. It’s partly because operating agreements tend to be cobbled together. You know, if we’re going to do one for this deal let’s use the one we did four deals ago, but it’s not quite right. So there does tend to be some confusion in operating agreements about just something as basic as making sure that everyone’s getting the right dollars, the dollars that the PPM says they’re supposed to get.
Adam Hooper – And so when you say money headed in the right direction, you’re comparing the PPM versus the operating agreement. Or is there something more to that?
Mark Roderick – Yeah, so you know, the disclosure document, the PPM might say well investors get a, you know, under the distribution waterfall the investors get a 9% IRR and then there’s a distribution, you know, 70% to the investors, and 30% to the sponsor, but when you look at the operating agreement it doesn’t actually achieve that result. And so that’s obviously problematic. And I should hasten to say it’s not because the sponsor is trying to cheat the investor, it’s just that the financial concepts that the sponsor has in mind have not found their way into the appropriate language in the operating agreement.
Adam Hooper – Now that’s certainly one of the things we want to dig into here in a little bit with waterfalls and structures and your comment before about how a percentage ownership isn’t exactly the right way to look at it. But one of the questions that we also get from investors is because of how these processes are typically run, when is my signature binding? Right, when I sign this operating agreement is it binding when I sign it, is it binding when the manager signs it, is it binding when I send the money and the money just deposited. Basic contract law would suggest that you’re not binding until it’s signed by both parties. Is there any leeway in that? I know sometimes there’s power of attorney, there’s some different ways that can come together, aren’t there?
Mark Roderick – There are, and it could be any one of the above. Now typical, in my experience, and I mean, you probably have more light to shed on that question than I do ’cause you’re sort of actually handling the mechanics of these investments, but typically when, in deals that I write, the investor signs one piece of paper, and that is the subscription agreement, which just to confuse things I call the investment agreement, but let’s call it a subscription agreement because that’s usually what it’s called in the industry. So they sign the subscription agreement, and the subscription agreement says a bunch of stuff, although it’s pretty short and simple. But one of the things it says is by signing this subscription agreement I’m also signing the operating agreement, so they don’t have to sign two pieces of paper, just to make it easier for everyone. But another thing the subscription agreement says is once I sign the subscription agreement I am bound. I can’t back out, I don’t have 48 hours, I don’t have an attorney review period, I am bound. The company can reject my subscription, but I the investor cannot pull out. So in my deals, at the time the investor signs the subscription, he or she has made a legally binding commitment, they’re in.
Adam Hooper – And now where would an investor go to make sure there’s clarity around how that functions mechanically. Again, is that another section in there that they can look for, it varies by document?
Mark Roderick – Well, yeah, I varies by document. I mean, when I’m doing all the documents for a deal then my operating agreement says that this is going to be signed by the investors when they sign their subscription agreement. So hopefully it will all work together. Now let me just throw in apropos of nothing, just this is like, you know, part of the reason, maybe the main reason for listening to these podcasts is so when you go to a cocktail party and these issues come up, you can use this terminology and sound smart.
Adam Hooper – Right.
Mark Roderick – And that’s, that’s the the only reason I learned. ‘Cause I’m not really successful at cocktail parties most of the time, but. So here’s just some cocktail party information. We always use the term operating agreement to describe the agreement among a limited liability company and its members. In Delaware however, where most of these things are formed, there’s no such thing as an operating agreement, okay. So they’re actually called, again using Delaware’s very prosaic approach, they’re called a limited liability company agreement, okay. So just to be clear, and the next time you’re at a cocktail party and someone uses the term operating agreement, you get to say, “Well what state?” And everyone glances over at you, including the…
Adam Hooper – I can just see you at a cocktail party, Mark.
Mark Roderick – The attractive woman in, yeah, you just can’t, I mean you know, you probably can imagine my degree of success when, you know, these are my strong lines.
Tyler Stewart – This is what you lead with.
Adam Hooper – Yeah, so that’s how you win the room.
Mark Roderick – This is what I’d lead with, yeah. Yeah, I walk up to, you know, I say, “Do you know about limited liability company agreements?” So anyway, we’re calling them operating agreements, but don’t be confused if you are looking at a Delaware agreement and it is called a limited liability company agreement.
Adam Hooper – Got it.
Mark Roderick – So that, I’m sure that’s the key takeaway for most of your listeners today.
Adam Hooper – Oh, I mean, I think that’s, that’s as good as it gets, right there. Yeah.
Mark Roderick – Yeah.
Adam Hooper – All right let’s switch gears a little bit. Let’s get on to the waterfalls and structures and how these things are actually paid out. You mentioned the importance of making sure your limited liability corporation agreement aligns with what’s advertised in the PPM or being marketed. That’s going to be governed in the operating agreement, right. What the distribution structure in the operating agreement is law, I mean, not law, but that is how the cash flows will be paid out, not necessarily what’s discussed in a PPM, but what’s in the operating agreement actually governs the structure of how those payouts occur, is that correct?
Mark Roderick – That is correct.
Adam Hooper – Okay.
Mark Roderick – I couldn’t have said it that clearly, but you got it for sure, yeah.
Adam Hooper – Flattery definitely works on this guy, Mark, so you’re doing good. So how are waterfalls typically structured? I mean we’ve seen, we’ve done almost 150 deals and we’ve probably seen 150 different structures, right. Most common threads you’re going to see some kind of a preferred return, you’re going to see what’s called a promote beyond that which in the venture world is a carried interest. In the real world typically called a promote. Maybe you’ll see a couple different hurdles. Let’s kind of walk through what those different parts are and how those are and how those are arrived at and they different mean. So what’s a preferred return?
Mark Roderick – Okay, and before I answer your question I just, I have to give a cautionary note here together with a little bit of history. The first thing that I would do when I look at this operating agreement to see whether the money is going in the direction it should. The first thing I want to do is make sure that the operating agreement directly indicates where the cash is going. And the reason I say that is because back in the old day, 20 years ago, 25 years ago, many operating agreements and partnerships were written so that the important provisions had to do with tax allocations. And this is a history that no one wants to know, but back in the old days lawyers used to fight with the IRS about how the income and losses of a real estate entity should be allocated. And so it became popular to write partnership agreements and operating agreements based on an allocation of income and loss, and then to let the cash flow just follow the tax allocations. And you still sometimes see that, these very, very complicated tax allocation provisions with the cash distributions just being the tail on the dog. That is not the right way to do it. And it’s actually really important. What people care about is cash. So the cash in the operating agreement should be the dog, the tax allocation should be the tail. So that’s the first thing I want to say about that. Preferred return means, you can think of it as interest on your investment. So if I invest you know, $1000 and, in a deal that has a preferred return, let’s say it’s a 9% preferred return. Then my preferred return is going to be $90. Okay, simple calculation, but of course as you know even that simple calculation can have some things going on behind it. For example, in some deals the 9% preferred return is cumulative. Meaning if the deal didn’t generate enough for me to get 90 this year, I get whatever the difference was next year on top of my 90 for next year. Right, cumulative, it sort of seems to make sense. But in many deals it’s not cumulative. I would say about half and half in my experience. But again you have more experience than I do. But it is important, right, I mean it really matters whether you’re getting a cumulative 90, a 90 per year, or whether you don’t get it this year you just lose it. And the other thing is whether it’s compounded. So let’s say I’m supposed to get 90 this year, I only get 50. Well does that 40, one does it carry forward, that’s the cumulative issue. If it does carry forward do I get a 9% interest rate on the 40 that I wasn’t paid also? So even something as simple as preferred return. I mean, how in the deals you guys have seen, are your preferred returns typically cumulative and or compounding?
Adam Hooper – Again I think I would echo what you said, they come in all different flavors, right. I think we’ve seen them both ways. We’ve seen, you know, some paid current, some accrue, we’ve seen it compound. I think, again we’ve seen it every which way. And that’s one of the, again getting back to the challenges that we talked about last episode and earlier in this one too, the different shapes that these can come in can be confusing. It can be hard to keep all that straight and that’s why again we’re excited to see what you come up with on the standardized front, and try to bring some more clarity and you know, kind of apples to apples to these things so that across deals you can have a better gut feel or a better, you know, and easier way to ascertain what those cash flows look like and how they’re going to be treated.
Mark Roderick – Well let me ask you this question, I mean I think you and I agree that this should be standardized. If we came up with a standardized preferred return provision do you, you know, obviously you’re a platform, you don’t have a, you’re not the sponsor, you’re not dictating what the preferred returns are. But you, ’cause you have a very strong, very strong market presence, a great brand because of your, you know, you do everything right. Do you think you have the market power to tell sponsors coming on to your site, you know, we’re not going to tell you you have to have a 9% preferred return, or an 8% or a seven or a 12, but we are going to tell you that the preferred return is going to be…
Adam Hooper – Mechanically, right, it has to work a certain way.
Mark Roderick – Do you have that market power?
Adam Hooper – You know I think we’re getting there. If I told you that, you know, we come up with this ideal structure and next week we’re going to implement it site-wide, I don’t think that would happen. One of the challenges, you know, the mind of a real estater, if it ain’t broke don’t break it, right. There’s definitely a comfort in the legacy ways. So anytime you ask people to change it becomes a little bit uncomfortable. That said, as an advocate for investors that use RealCrowd and for the listeners out there, I would love that. I would love to have something that’s more standard, that’s more simple, that’s not, you don’t need an MBA and a finance team to figure out how the heck this cash flow actually gets treated. It doesn’t need to be as complicated as it is, and I think it gets back to what you talked about on our last episode, was these agreements just get layered upon layered upon layered of the 15 deals prior, and there’s artifacts that carry their way through that can cause complications. Not necessarily saying that they’re overtly trying to cause these complications or purposefully causing these complications, but it just happens. These documents get cluttered and clogged and you can have some less than clear provisions in there. So, you know, I would love nothing more than having a standardized set of terms and structure and documents, I think that would be certainly a really, really good step in the right direction for the industry as a whole. And again as an advocate for the investors I think that would be wonderful and something that we’re going to continue to push forward and try to bring some clarity and standardization to these documents and structures.
Tyler Stewart – Yeah, and right now you’ll see the power of the marketplace. So investors are able to go through, compare deal by deal, structure by structure, and often you’ll see the overcomplicated structures won’t perform as well. If you see multiple hurdles, you know, it’s just an avenue investors may not pursue.
Mark Roderick – Well that’s a very interesting observation. And you would have that, I mean, you have that data. So that’s interesting. So I’m not going to become moderator. So tell me what you mean by multiple hurdles. Tell me what you mean by waterfall.
Adam Hooper – Yeah, so in a structure typically you see the preferred return like we just talked about, that’s in essence the interest on your money. Once that then gets hit, how does the cash that’s available beyond that percentage, whatever that preferred return percentage is, how does that get treated? Again, we’ve seen it all different ways. We’ve seen all different numbers, we’ve seen many different ways of doing it. The simplest, and what Tyler was referencing you know, is simple promote, which would be Mark what you said earlier, commonly, you know, a 70 30 split over a preferred return, right. So in your case we got a 9% preferred return, all cash flow that’s available beyond that 9%, 70% of that goes to the investors, 30% of that goes to the manager, pretty clean, pretty simple. That’s the most simple way that we’ve seen a promote, what we call a promote in the real estate world handled.
Mark Roderick – And so just to tie down on that terminology, that 30% that went to the sponsor, even though the sponsor may not have put in any money for that 30%, that 30% is called the promote. Correct. Yeah.
Adam Hooper – And that would be what we consider a more simple agreement, a simple promote, right. One tier, there’s not a bunch of tiered waterfalls. And so when he’s talking about waterfall, more so you would see that in the institutional world, less so in the more syndicated world that we tend to play in. But when you’re talking about a waterfall, that can get unbelievably complicated and require many multi-tab spreadsheets, cash flow models, to try to figure out. And so a multi-tiered waterfall would be different treatment of the cash flows based on different hurdles, different return numbers. So in our situation we were talking about, if it’s a 9% preferred return, maybe it’s a 70 30 split until there’s a 15% return. And then once a 15% return is hit, and again there’s varying definitions on who gets that 15%, how that 15% is calculated, but once it hits a certain target hurdle, there’s another structure for cash flows beyond that. So maybe it goes to a 60 40 split, with 60 going to the investors, 40 going to the sponsor. And then you can have two, three, four different tiers of these waterfalls and it can get very, very complicated with how these structures are put together. And that was what Tyler was saying, a lot of times what we’ll see is investors just don’t have the experience or the ability or desire even necessary to try to figure out how these waterfalls are calculated. And that complication will be enough for someone to pass. If I can’t easily understand how my cash flow is getting treated and what I’m getting at the end of the day, if I can’t feel confident in that I probably won’t invest in that deal. And so, you know, I’m curious Mark on your end, again, you see a lot of these deals, you see a lot of different structures, multi-tiered waterfalls there’s really no easy way to try to understand them, right. I mean, they can get just incredibly convoluted based on how those cash flows are treated.
Mark Roderick – Yes, and I mean, it is really cool as a former math guy and a you know, corporate lawyer, it’s really cool drafting them, I have to tell you. And I mention that in part because I think that’s part of the reason they exist. Because the finance people, you know, finance people are sort of nerdy too.
Adam Hooper – You can flex your inner nerd when you’re drafting a waterfall calculation.
Mark Roderick – Right and from a finance person’s perspective, if you can make it a little more complicated that’s cool. And I say that only partly tongue in cheek, because after you’ve done one of these complicated things with two or three different waterfalls you kind of look at it and say, “Why the heck did we do that?”
Adam Hooper – Right.
Mark Roderick – Hard to make sense of it. You do see it, it comes from the institutional world where you have big players negotiating with other big players and so, you know, the negotiation you start with one waterfall, and you can’t agree darn it, you know, after the 9% should it be 50 50 or should it be 90 10 and so the compromise is, okay let’s do another waterfall. And if you can’t agree on that one then you do another compromise, well let’s do a third waterfall. So that’s how you get there, it’s a series of compromises between institutional finance and very sophisticated sponsors. And I totally agree with you that it has no place in the retail crowdfunding world, and I’m delighted to hear you say that the market is actually, is actually pushing back. The retail investors are saying, “Hey, I can’t understand it, I’m not putting my money into it.” That’s a sign of really great wisdom on part of retail investors.
Adam Hooper – Well and I think the other thing too is, you know it’s funny is these are all, when you’re going into a deal, these are all projections, right. You’re never going to hit that exactly, these are all projections based on assumptions. And oftentimes we’ll have conversations with sponsors and explaining this, you know we’re not, obviously not advising them or you know, requiring them to structure their deals a certain way, but hey investors that see multi-tiered waterfalls, they don’t like ’em. Sometimes a sponsor will say, “Okay great, we’ll look at this,” and they come back and they can figure out a single tiered promote. And you get to the same return, right, you get to the same net return for both sides. You’re just now 85 different calculations removed but you’re at the same number. So the need for these just uber-complicated structures it’s just not necessary, right, it adds complications and again I think what you said about the inner finance nerd being able flex those muscles, it’s fun, it is fun to build a thousand cell spreadsheet to be able to calculate these things sometimes. But not necessary. It’s certainly not necessary for the simplicity of how these things can be put together.
Mark Roderick – Yeah, and of course anytime, you know, spreadsheets are a great example. I mean spreadsheets are wonderful and complication is wonderful, it’s fun. It’s just that the more complicated that a machine becomes, the more likely that it doesn’t work. And you do see, I mean, it’s more often you see in a very complicated waterfall provision in an operating agreement you find stuff that doesn’t work. One of my pet peeves is how internal rates of return are dealt with in distribution waterfalls in operating agreements because it is so often done improperly. In any one of several ways, but the one I very frequently see is there will be a distribution waterfall, and it’ll say, once investors have achieved a 14% internal rate of return IRR, then it goes 50 50 let’s say. And the definition of internal rate of return says well, it’s based on the distributions that, you know, all distributions that the investors have made to date on all contributions the investors have made to date, and that’s all it says. And as you know the internal rate of return calculation as, no matter how you calculate it, but the most common way is to use the XIRR function in Microsoft Excel. You have to have a residual value to calculate internal rate of return. It’s money in plus money out plus what’s left. So at the point where the investor has made contributions and received distributions, but also still owns an interest in the company ’cause the project hasn’t been sold, you somehow have to put a value on that interest, and if you don’t the XIR calculation, internal rate of return, it simply can’t be calculated. I don’t know if you’re old enough to remember George Carlin the comedian doing sports, on one of his programs, and he would say, “Okay, now for some partial scores,” and he would say, “New York one,” and that was it, you know. So that’s calculating internal rate of return without that residual value, and you see that all that time, and these are in big deals, and at some point, you know, you’re going to, the accountant’s going to say, “Where the hell does the money go?” So anyway, the point being that the more complicated the calculation, the more likely that something’s going to go wrong.
Adam Hooper – Yeah, and this is, you know, keeping it simple, we always recommend that and let sponsors know the more simple you can keep it, the more easy you can make it to calculate for investors to understand how those cash flows are treated, who gets what when, the better the experience is going to be for everybody. And that’s another thing, and I just looked at our clock and we’re already an hour into this Mark, so we got to probably get you back for a third one. You’re just going to be our perennial podcast guest, there’s just so much we want to talk about with you. But one of the…
Mark Roderick – Well, well, here, but I got to play moderator again, and ask you what do you think about the ubiquitous target IRRs used to advertise these deals online?
Adam Hooper – It’s a target, right, I mean, I think the, as I said before these structures and everything that’s put in place, they’re all based on projections and assumptions. Personally and what we recommend investors is, and as other guests on the podcast have said, I would put a lot more faith in historical, actual performance, actual results that these sponsors have seen versus the targets. Anybody can cook numbers to show a target IRR of X, or, you know, X plus 10. And that was something, you know, back in brokerage world. Usually a sponsor’s got three models, right, they’ve got the model that they show to their lender, with some set of financial projections, they got the sponsor they show their potential investors, and they’ve got the model that they know is, the base case of what they actually think is going to happen. And so there’s always some salt, grains of salt that you should take these numbers with because they are based on projections and assumptions. Rarely will they actually hit the numbers that they targeted going in. I think you’ll see different sponsors that will under-promise over-deliver, and then there’s certainly on the flip side too, that’ll shoot for the moon, and it’s hard to hit those numbers. So I would say yeah, to me looking at historical, looking at actual performance, you know, with those assets with, maybe their similar markets, their experience. I personally, without my, taking my CEO of RealCrowd hat off and putting my interested investor hat on, I would look a lot more at what has that sponsor actually delivered in the past versus how this deal is maybe projected. Now if you have the ability to get into the data of seeing what were their target projections for the deals and how did they perform compared to that, right. How close could they underwrite their targets versus their delivery. That’s great data to be able to get to but unfortunately that’s not always available, even for us at RealCrowd. We’ve got that for the deals that have gone full cycle on the platform, but that’s usually not information that a lot of folks have access to. You know, how did the sponsor target the, you know, how did they make their projections for this deal going in and what was the actual performance, how did that track. That’s pretty hard data to get ahold of sometimes. But yeah I would say let’s, you know, I would put more focus on the historicals versus the projections necessarily.
Mark Roderick – Yeah I’d like us as an industry to come up with something to say about target IRRs. I think the market wants us to. I’ve had very high quality institutional real estate sponsors shy away from the crowdfunding market because they don’t like those target IRRs. They think, you know, they’re conservative institutions. Maybe they’re real numbers for deals maybe, they think they’re going to achieve a 14% and they look at, you know, the 18% or 19% or 23% listed and they just say, “Well those aren’t real numbers.” And as you’re saying Adam, you can fool around with those numbers and make them be whatever you want and we just don’t like that world. So I’d like those institutions absolutely to come into this space and I really think we as an industry need to figure out something, some way to present target IRRs that again make it standardized. So are we talking about a three year hold or are we talking about a seven year hold, ’cause that can affect IRR a lot. We just, again, we need people, investors to be able to compare apples to apples.
Adam Hooper – Yeah, I think you’ll get a lot of agreement from us here at RealCrowd and also from the investors out there too that are trying to figure out how do you compare apples to apples when there are so many different variables. You know, they don’t always necessarily have the tools to be able to calculate that on their own, right. If they’re experienced real estate investors it can be a pretty complex calculation to try to figure that out and parse those numbers, yeah.
Mark Roderick – Yes, it can.
Adam Hooper – Well Mark as we wrap up here, I think we touched on maybe two thirds of what we wanted to get to today. But to bring it all back home, are there any resources out there, are there any places that investors can go to get more information about this. And obviously we’ll put a link to your blog again with some of your articles on these, but what are some resources out there that investors can learn more about structures, waterfalls, operating agreement provisions. Do you have anything out there that’s good for investors to go to?
Mark Roderick – Well I actually, I on my blog I occasionally have a post where the sub-heading is Improving the Legal Documents in Crowdfunding. And I’ve posted stuff about IRRs and tax structures. Do you guys have educational materials on your site for investors about waterfalls and so forth? ‘Cause I’m having a hard time thinking of any really comprehensive resources that an investor could look at.
Adam Hooper – Yeah, we’ve done some stuff in the past. We’ve had some discussions here on the podcast, but it is one of those things that is, you know, without a MBA or, you know, finance background or degree, you know, that’s not readily available information. That’s again, that’s one of the reasons why we’ve got you on here and why we’re talking about it. So we’ll definitely link to your blog. We’ll get that in the podcast description here. And then we’ll just have to schedule another time to get you back on and dig even deeper on some of these things.
Mark Roderick – You know, one thing that I did want to say, ’cause we were talking about distributions. Just a real basic thing that you and I are taking for granted that some people might know, or might not know. These are, for tax purposes, these are partnerships even though they are limited liability companies, they’re taxed at partnerships. And one of the things that means is that the cash that you’re taking out is not necessarily taxable to you. So, you know, in the world of corporations you think I got a dividend from General Motors, I have to pay tax on it, but one of the great things about real estate investing, is that because of the depreciation deductions that are being claimed on the underlying real estate asset, those depreciation deductions are flowing through to you as an owner of the company along with your cash. And the result may be that some or even all of the cash you receive from the company is not subject to current tax. We call that tax sheltered cash flow. So that’s a real key benefit to real estate investing generally and I’m sorry I didn’t mention it earlier.
Adam Hooper – Well maybe that’ll be our tease for the next episode. We’ll be able to drill down on that. Well I think that’s all we’ve got time for. We really appreciate it, Mark, great to have you on again. And we look forward to the next one.
Mark Roderick – Terrific, sounds great, thank you again, it’s been fun.
Adam Hooper – Absolutely, and all the listeners out there, as always if you have any feedback, comments, questions, please send us an email to firstname.lastname@example.org, and you’ll hear from us soon.
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