09/06/2017 by Attorney Richard J. Crouch
Your colleagues may have approached you about investing in a real estate development project or similar venture. If it is your first investment of this nature, you may wonder how to best memorialize the deal and which questions you should ask on the front end to best protect yourself. You may have general expectations for the deal but still need assistance in reducing those concepts to written form, in order to best implement mechanisms designed to keep control of your investment. When you are just starting out, this part of the process may not seem important, but being organized and hammering out issues early on can save you a lot of complications and money down the road. Several broad, but non-exhaustive, areas which you should consider are as follows: (i) organizational structure, (ii) internal operating procedures, (iii) financing/project related costs, and (iv) accounting methods.
A. Organizational Structure: A new company, or “special purpose entity,” is usually set up as the investment vehicle for a development project to better shield investors against liability from third parties. The type of entity selected will determine your exposure to liability, taxations on your distributions, and the formalities that will need to be maintained with respect to company action. You should ascertain who the other investors are using as their attorney and/or accountant, and who the investors expect to pay for such services. You should address how long you want the company to exist, especially if you prefer a quick return on your investment and the ability to exit smoothly.
B. Internal Operating Procedures: This could quite possibly be the most critical consideration because it will determine what control you will have over your investment. You will need to know who will act on behalf of the company (the “Manager”) and what actions the Manager may take without the approval of the other investors versus which company actions will require an affirmative vote of the investors. For investor votes, you should determine what percentage is required (simple majority, two-thirds, or something higher) in relation to the percentage that you will own. You must also have a right to audit company financial records.
You should address what would happen if there is a dispute among the investors and how it would be handled (i.e., arbitration versus court proceedings). You should also ascertain which attorneys represent whom among the investors and whether any potential conflicts exist. Generally, it is difficult to cash out of a development project prior to a major event such as a sale or refinancing of the property. If a particular investor wants the flexibility to cash out of the project, exit mechanisms should be negotiated. Furthermore, if one of the other investors dies or receives an offer to have their ownership interest purchased, the remaining investors may desire to have a right to purchase the exiting member’s ownership interest in the project.
C. Financing/Project-Related Costs: It is rare that investors pay entirely for a project out-of-pocket, and numerous additional expenses are often overlooked by investors. There will typically be a lender involved, and you should ask which lender is being used to finance the project and what the associated costs will be. Your fellow investors may expect (and the lender may require) you to sign a guaranty in connection with the financing, especially if you are holding a significant ownership percentage. If you must sign a guaranty, make sure other similarly situated investors are also liable in the same capacity. Also, if your fellow investors make any misrepresentations to the lender, you need a provision in place whereby they indemnify you if such misrepresentation triggers a default, and the lender looks to you to honor your guaranty. Further, you must assess how creditworthy the other investors are by reviewing their financial statements if possible. You should also ascertain (i) who among the investors is covering settlement costs, and, (ii) if there will be a number of government approvals required to complete the deal, who will cover those costs. Finally, you should determine whether the managers are permitted to issue one or more capital calls in which the investors are required to invest additional money into the project. If so, a cap on such additional investment should be considered.
D. Accounting Methods: The accounting methods to be used by the investment entity will affect your analysis as to your desired return, and you should always have an accountant review all of the financial statements and pro forma projections to best assess profitability. Pay particular attention to the reasonableness of the assumptions regarding costs of development, anticipated income from the project, and the timeline for development. You should ascertain if there is a hierarchy in terms of investors receiving their returns or if distributions are simply in proportion to the size of your ownership interest. You should agree on exactly how profits will be calculated and how expenses are to be allocated.
If you are uncertain as to what to include in your agreement with other investors, consulting your attorney and accountant prior to entering into a deal should be viewed as preventative maintenance that may address important issues before potential conflicts arise. The more specific your business plan and preparation, the easier it will be for your lawyer to help you structure the transaction.