Most of our portfolio companies have enjoyed previous successes as: real estate developers, agents, property managers, and managers of projects; film producers; oil & gas producers; and hedge fund managers. Many have capitalized their companies and previous operations with their own money and or limited outside-investor funds. Most have seen a need to re-organize their financial and operational structures as the administrative burdens of managing multiple projects with differing sets of investors are becoming too complicated. Some have now come to the juncture where their track records are very good, and they have earned the right to manage large pools of assets—cash and property with full discretionary authority.
Whether or not they can publish a track record, many management teams are ready to set-up an operation where they can access pools of equity capital quickly to take advantage of opportunities as they arise. Having immediate access to large pools of equity capital relieves the problem of feeling the pressure of missing out on great opportunities, because of the need to arrange the financing for each deal separately, as they arise. This can be accomplished more effectively with a standardized Fund or REIT structure, than any other type of organizational structure.
Most start-up or early stage Funds organize and capitalize a management company first. Some may elect to keep their current management company intact and use current cash flow and or capital to start this process. Others elect to start fresh and form a new management company to specifically and exclusively become the fund-management company. The decision rests on a handful of factors. However, the primary factor being the ability either to seed fund the management company internally from current cash flow of existing operations or the need to fund externally. If seed funding internally, then one could keep the existing company and evolve it. If one needs to fund it with outside investors, then starting fresh with a new management company makes more sense because it’s far easier to engineer a new entity for a securities offering than an older one. Like an operating company, one could offer convertible notes for seed capital, or more appropriately convertible participating preferred shares (or units for an LLC) for development capital, that is callable and/or convertible into a small amount of the management company’s common shares (or units for an LLC) at a later date. Preferred equity may be more appropriate due to the larger amount of capital needed to fund a large Fund or REIT.
Depending on the current size of the operation, the management company then sets up a private Fund to either remain private or eventually convert it into a publicly traded Fund. For most start-up or early stage management companies, it makes sense to initialize a private Fund as an LLC and grow its investor base to 100 or more before registering as a corporation prior to conversion into a publicly traded fund (Exchange Traded Fund or “ETF” or Real Estate Investment Trust “REIT”). ETFs and REITs technically need to be formed as a corporation (it is easy to convert an LLC into a corp.), have at least 100 investors—with no single investor owning more than 9.9% (the 5–50 test)—then file Form 1120 with the IRS to avoid the double taxation of a corporation.
The following structures are designed for all types of Funds. Here, we’ll use the example of a private real estate Fund that plans on issuing its Fund’s shares as a REIT, through a broker-dealer, for eventual listing on a securities (stock) exchange—a Real Estate Investment Trust or REIT. For simplicity’s sake, whether your Fund remains privately held Fund or you choose to go public as an ETF or REIT, we’ll continue to use the term “Fund” to include both types of Funds, private, as well as public.
Once the Fund has been formed, the management company manages the assets of it. For instance, the Fund’s assets would include: Real estate for REITs or Real Estate Funds; film titles or other rights for Film Funds; oil & gas leases, properties, or other rights for Oil & Gas Funds; and securities, bullion, art, derivatives, commodities or other related assets for Venture/Hedge Funds.
The management company may contract with each Fund it creates or in the case of LLCs, it can use the LLC’s Operating Agreement as the contract—for a far more powerful position. Generally, raising $1–$5 million in seed capital for the management company is sufficient to market and sell the shares of a Fund or two. The seed capital amount is normally dependent on the size of the Fund(s) and should represent no less than 2% of the Fund’s proposed total amount to be raised or $1,000,000 whichever is more. Need $200 million for your Fund? Consider raising $4 million in seed capital for the management company, which will “Lend” the Fund a portion of the seed capital. This will enable the Fund to establish itself as a qualified capital-raising entity, through the issuance of securities. Once the Fund is capitalized, the management company is paid back the loan plus any accrued interest.
To understand how to properly structure one or more Funds, imagine one relatively small management company capitalized with $1 million to enable it to:
- Hire the proper management-team members to carry out the task of initially raising capital for the Fund then tend to the funds’ day-to-day operations.
- Afford the professionals—i.e., attorneys, accountants, broker dealers, financial advisors, R&D consultants, etc.
Imagine one Fund being created and capitalized simultaneously along with the capitalization of the Management Company. The management company’s fee structure for handling the Fund can be a combination of any number of various factors, but the industry norm is as follows:
Depending on difficulty of management and within industry norms, the Management Company typically receives a management fee of 1-3% on the total assets of the Fund. The Management Company shares in a percentage (normally 20%) of the net income and net capital gains from portfolio properties, as well. If the Management Company is a licensed real estate-brokerage firm, it may share in all or part of the real estate-brokerage commissions from the purchase and sales of portfolio properties. In addition, if the Management Company is a licensed property management firm then it may also share in all or part of the property management fees. However, the real estate commission and property management fee structure often creates a conflict of interest, so we strongly suggest against it, especially if your Fund will eventually go public.
Our position is based on a fundamental philosophy of the initial capitalization of a management company, first or simultaneously with the Fund. This strategy will enable the management company to afford the process of going after larger sums of capital for one or more Funds. In turn, the entrepreneur is moved to a higher level and enabled to raise substantial amounts of capital so they have access to these funds with full discretionary authority.
Also, to satisfy a broker-dealer’s concerns about the risk of any investment, especially private investments, it’s normally wise to offer to list the Fund’s securities subject for sale on a publicly traded stock exchange. Otherwise, the likelihood of getting any broker-dealer to participate in the offering is very low. The same goes for the individual accredited investor. Without a “Liquidity Event,” such as an exchange listing or an outright-sale option, the probability of getting any investor interest is highly unlikely.
To relieve the burden of cost from the entrepreneur to the new-investor pool, you can budget for an exchange listing, which is found within the offering’s “Use of Proceeds” statement and the pro forma Sources and Uses Statement. Simply put, investors and broker-dealers are more than willing to shoulder the expense of creating the liquidity event—in this case, the exchange listing.
Suffice it to say, there are unlimited ways to seek capital. However, there are only a few methods to capitalize a private Fund with substantial amounts of capital while maintaining the vast majority of common equity ownership and voting control of the Fund’s management company, as well as management control over one or multiple Funds. Clearly, we cannot design or illustrate an optimum capitalization plan for your Fund(s) in a book’s dissertation, however, whether you have been through the capital-raising process or not, we are sure you will appreciate and learn from our process.
To increase the likelihood of obtaining enough assets and/or cash to make the effort a success, an issuer of securities would be wise to consider listing the Fund shares on a publicly traded stock exchange within a year to enable investors to realize liquidity and to attract broker-dealer interest. Without this liquidity event, investors have no incentive for swapping their titles for shares; and there is a low probability of getting broker-dealers to participate in selling the offering for a commission. Ultimately, if you can raise money and/or assets for the fund with your personal-investor contacts privately, an exchange listing is not necessary…otherwise it is.
As federal and state tax regulations limit ways to structure a Fund and its Management Company, the most common scenario employed includes the following:
- Set up and capitalize a Management Company as a LLC (with seed or development capital) to further capitalize the Funds and manage a series of separate Funds.
- Set up and capitalize a series of Funds as LLCs or Limited Partnerships that will own the assets or properties, by issuing common or preferred equity.
- Once you have sufficient assets or properties, you have the option to roll up all the Funds into a privately held or publicly traded fund, if this encompasses your exit strategy.
Specific to REITs
The true value of a “Tenants In Common” (TIC) deal structure is the availability of the 1031 Tax Deferred Exchange, for REITs. This exchange holds up if: one property is registered as Tenants In Common; and that property is held by one entity, regardless of ownership by one investor or an investor pool. Although the interests and distributions are prorated to each investor’s capital-contribution amounts, for tax purposes, the TIC property is treated as if it’s held by one entity, including the 1031 Tax Deferred Exchange. In addition, TICs are professionally managed—generally by a Property or Real Estate Management Company.
On the other hand, a pool of properties, such as a REIT or Real Estate Fund, will not qualify for the 1031 Tax Deferred Exchange; but as long as one uses the REIT Template to purchase a single property and registers each share or interest holder as “Tenants In Common,” using the Financial Architect’s REIT Producer™ will work for producing TIC Investment Deals. The Management Company Templates will work like a charm too, as most entrepreneurs will invariably need to form and/or capitalize a Management Company to handle the volume of administrative work that will be involved in managing “One Property Portfolios” or TICs.
If you have a serious interest in building one—or a portfolio of TICs—to manage, we suggest you purchase and slightly modify the REIT Producer™ to assemble the required securities-offering documents needed to pool investor capital.
Common or Preferred Equity?
Either type of equity can be used to capitalize the Fund. The advantages and disadvantages are as follows:
Issuing Common Equity to capitalize the Fund:
- Common equity is the industry norm and therefore may be easier for investors to understand and accept as a deal structure.
- Common equity shifts the vast majority of risk to the Fund’s common or preferred equity holders and away from the Management Company.
- Common equity shifts the vast majority of return to the Fund’s common or preferred equity holders and away from the Management Company.
- Common equity is harder to sell through general solicitation and advertising; because unless one has three years of an audited track-record of asset performance, one cannot advertise any type of expected return.
Issuing Preferred Equity to capitalize the Fund:
- Preferred equity is not the industry norm and therefore may be more difficult for investors to understand and accept as a deal structure. However, once understood it is very popular with retirees seeking income from their investments.
- Preferred equity shifts the vast majority of risk to the Mgmt. Co. and away from the Fund’s common or preferred equity holders.
- Preferred equity shifts the vast majority of return to the Mgmt. Co. and away from the Fund’s common or preferred equity holders.
- Preferred equity is easier to sell through general solicitation and advertising; because one can advertise the stated dividend (Corp.) or distribution (LLC) as the expected return, without the need for three years of an audited, track record of asset performance. The stated dividend will enable you to effectively compete with financial institutions for investors.
Below are two (2) illustrations to compare offering Common or Preferred Equity to capitalize the Fund. Both infographics illustrate capitalizing a management company by selling convertible participating callable preferred equity to obtain the necessary seed capital of $1-$3 million to launch a private real estate Fund or REIT.
Issuing Common Equity for the Fund
The Fund issues Common Class -A- voting equity for cash and/or assets. No matter what the decided percentage of leveraging debt to be used, the Fund(s) only issue Common Class -A- voting equity.
Issuing Preferred Equity for the Fund
The Fund issues Class -B- non-voting convertible participating callable preferred equity for cash and/or assets. No matter what the decided percentage of leveraging debt to be used, the Fund(s) only issue common, class -A- voting equity.
IMPORTANT: With Financial Architect®, you have two fundamental choices of issuing securities for capitalizing the Fund—common or preferred equity. If issuing preferred equity for the Fund, you also have two choices for seed or development capital for the Management Company—issuing convertible notes for seed capital and convertible-participating preferred equity for development capital. Whereas, if issuing common equity for the Fund, you only have one choice of issuing convertible-participating preferred equity for seed or development capital for the Management Company. The reasoning is that with the shifting of the vast majority of risk and return to the Mgmt. Co. (as the majority owner of the Fund’s common equity) the convertible notes for seed capital mitigates risk for investors in the early stages of this deal structure.
In general, most wealthy folk’s investment portfolios are allocated toward two primary classes of investment. The first portion of their investment portfolios is known as “safe” money investments, such as; Certificates of Deposits, US Treasury, Municipal and Corporate Bonds & Notes, low-leveraged Real Estate, and Oil & Gas Interests and Preferred Equity. The second portion of the investment portfolio is known as “risk capital,” which is generally invested in common stocks, high-leveraged real estate, speculative oil & gas interests, and other “alternative assets” such as precious metals, private placements, commodities, etc. On average, safe money normally makes up 70%–90% of most portfolios. Risk capital makes up the balance.
Imagine simultaneously conducting two securities offerings not only to attract the risk capital portion of their investment portfolio, but more importantly to attract their larger “safe” money portion of their investment portfolio. The management company’s securities-offering is used to attract “risk capital,” and the Funds’ equity offering is to attract “safe money.” To further mitigate the risk in “risk capital, the management company’s preferred equity securities-offering is designed to be as safe as possible thereby making it the safest part of the “risk capital” portion of an investment portfolio.
Unleveraged common class -A- voting equity in the Fund also mitigates financial risk of investing in the Fund.
Now for the piece ‘de resistance.
The Fund’s Securities as Currency
You can trade your Fund’s securities to purchase assets. That’s right; you can use equity shares or units of the Fund as currency to attract and purchase the actual assets that will go into the Fund. You don’t need cash if you will be listing those securities on a publicly traded stock exchange, because those shares will become liquid and can easily and quickly be converted to cash. There are sale restriction rules, such as Rule 144, which require investors to hold pre-IPO-issued shares for a period of time—currently six months—after the IPO. This waiting period is normally not an issue for the sellers of asset because it’s a sale where a sale may not have occurred otherwise. Consider offering the first set of investors the ability to transfer their assets into the fund at their original cost basis. This will enable them to defer their capital gains until they sell the shares of the Fund. Liquidity and tax deferral secured with the assets they trade for the equity. Brilliant strategy, but rarely used because most don’t cater to the seller’s needs only their own.
The Dollar Amount(s).
The dollar amounts raised depend on a handful of factors, but suffice it to say that you’ll make your decision based on two primary factors: 1.) the cost involved with the various, registration processes or the dollar-limitation amounts provided by the various exemptions from registration and 2.) the IRRs produced for the Mgmt. Co. and the Fund by CapPro for Funds™ as you move through the process of pricing the securities.
More often than not, it is wise to plan to over capitalize your Operating or Management Company and the Fund(s). There’s an old accounting adage… “Everything costs twice as much and takes three times longer than originally planned” that has some truth to it.
From a regulatory perspective it’s important to stay within the parameters of the exemption from registration restriction. So if you believe you only need $500,000 in seed capital to launch your company and plan to conduct a Title III – regulation crowdfunding capital raise supplemented with a Regulation D 504 (self-limited to a $1,000,000 offering) or SCOR offering, consider moving the capitalization to the limited amount of $1,000,000 under those exemptions. If you find that things are going exceedingly well with revenues once you’ve hit $500,000 in capital raised, you can certainly close the offering early, as you’re not obligated to raise the full $1,000,000 amount. Conversely, if you were allowed the full amount of $1,000,000 but only disclosed raising $500,000, you’re kind of stuck. You technically can raise the amount to $1,000,000 but it’ll require unanimous shareholder (of the $500,000 worth of securities) approval, possibly regulatory approval at the state level depending on the exemption claimed and opens the door to potential future shareholder litigation. In other words, it’s an administrative nightmare to increase an offering amount – after the fact – than decrease it at your leisure and convenience.