Tag: preemptive rights

Reinvigorate American Capitalism Through Crowdfunding

How Can Sponsors Raise More Money When A Deal Goes South?

On By crowdfundattnyIn PodcastsLeave a comment

When a real estate deal goes bad as many are doing now, should limited partners have the right of first refusal to invest rescue capital on the same terms as anything the sponsor can bring in to save the deal?

My podcast guest today, attorney Mark Roderick, calls it ‘pre-emptive rights’ and, as you will hear, he explains it can make the best of a bad situation.

But what does that look like in reality?

Here’s the script:

***

Email #1: From Sponsor to Limited Partners (Investors):

Subject Line: We’re stopping distributions and need more money from you

Sorry investors, we screwed up because we [select from the following]

  1. Didn’t manage the property aggressively enough to account for a downturn.
  2. Underwrote debt levels to eternally low interest rates on variable rate terms and now can’t afford the doubling of our debt costs.
  3. Our original loan is maturing, the value of the property has gone down, debt costs have skyrocketed, rent growth is not what we assumed in our proforma, and the bank will only lend us 60% of our original loan amount.
  4. Cap rates are now nearing 6% not the 4% we projected.
  5. Thought this time was different.

In sum, we need you to pony up more equity so we can avoid losing the property to the bank.

***

Email #2: From Sponsor to Rescue Capital fund (pref equity, mezz debt, whatever)

Subject Line: Have we got a deal for you!

Our offering docs allow us to bring in additional capital under any terms. Our bank will only lend us 60% of the original loan amount so we need to shore up the difference. Can you help us.

***

Email #3: From Rescue Fund to Sponsor

Subject Line: We’re in!

Sure. We’ll come in with the 40% you need. We want second position behind the bank (ahead of your existing LPs) and if you miss proforma targets or fail to pay us on time, we’’ll remove you as GP and wipe out your LPs’ equity.

***

Email #4: From Sponsor to Investors

Subject Line: Great news! We’ve found some rescue capital.

You get first right of refusal on the terms we just got to protect your investment.

Terms are that your new capital will come in ahead of your old [or dilute it out completely], and if we screw up again, you get to remove us as GP.

Please accept these terms or someone else gets them.

Oh, and by the way, the Rescue Capital wants all or nothing so we need unanimous agreement from all Investors or we go with the Rescue Capital.

***

Is this an ‘offer’ or a ‘threat’?

Or is the dialogue different somehow?

At the end of the day, does having pre-emptive rights (right of first refusal) really mean anything?

chess board raising capital

Improving Legal Documents In Crowdfunding: Give Yourself The Right To Raise More Money

On By crowdfundattnyIn Crowdfunding, Crowdfunding LawsLeave a comment

Interest rates have gone up, real estate valuations have gone down, banks have disappeared, and investors have become more cautious. Many real estate sponsors, faced with looming loan repayments, wonder how they’re going to raise more equity.

They might be surprised when they check the Operating Agreement. Too often, Operating Agreements prohibit the sponsor from raising more equity without the consent of a majority of the LPs or even a single large investor. And getting that consent might not be easy or even possible, for several reasons:

  • Existing investors might not agree that new money is needed.
  • Existing investors might be unrealistic about market conditions, thinking the new equity can have the same terms as the existing equity.
  • Existing investors hate being diluted.
  • Existing investors might prefer to contribute the new money themselves on terms the sponsor believes are exorbitant.
  • A large investor might be angling to buy the property for itself at a fire sale price.

When times are good and the Operating Agreement is signed those possibilities seem far-fetched. Then you get to an April 2023.

Knowing that an April 2023 is always on the horizon, sponsors should negotiate hard at the outset for the right to raise more equity. They won’t always get it because people who write very large checks usually get what they want (that’s why we call it “capitalism”). But in my experience, too many sponsors give away the right too easily or don’t even think about it.

If the sponsor has the right to raise more equity, how do we protect the original investors? What’s to stop the sponsor from raising equity from her own family or friends on terms very favorable to them and very unfavorable to existing investors, even if the equity isn’t needed? 

The answer is “preemptive rights.” If the sponsor wants to raise more equity, she must offer the new equity to existing investors first. Only if they don’t buy it may she offer it to anyone else.

Preemptive rights aren’t perfect. The main flaw is that Investor Jordan, who had money to invest when the deal was launched, has fallen on harder times and doesn’t have money to participate in the new round. Or Mr. Jordan does have the money to participate but is no longer accredited and therefore can’t participate. 

Even with the flaws, preemptive rights generally allow for the equitable resolution of a difficult situation, much better than the alternatives most of the time.

You can see my form here. Let me know if you think it can be improved.

NOTE:  Sponsors might also consider “capital call” provisions, i.e., provisions allowing them to demand more money from investors if needed. In my opinion, however, they typically do more harm than good, driving away investors at the outset while not providing enough cash when it’s needed. And in practical terms, a large investor who would balk at allowing the sponsor to raise more equity certainly won’t agree to an unlimited capital call.

Questions? Let me know.