05/11/2017 by Attorney Richard J. Crouch
Sooner or later your colleagues will approach you about investing in a development deal or similar venture if they have not already done so. The investment vehicle for such a project will typically be in the form of a limited liability company (“LLC”). Before getting involved in an LLC investment in commercial real estate, you should carefully consider your exit strategies if the real estate venture (or the management thereof) does not meet your expectations. Many statutes are flexible and accommodate all sorts of exit arrangements. However, in the absence of an express agreement setting forth such mechanisms, statutes do impose a number of restrictions on an LLC member’s right to exit. The exit terms, along with most other important terms and conditions governing the LLC, are typically found in a document called the “operating agreement.” It benefits both the investor group and the management group to negotiate and document exit terms in the operating agreement at the earliest stages of the venture.
Some exits are planned by investors as a component of the original investment decision, while others are emergency exits for when things begin to unravel. It is generally better to expressly provide for exit rights in the operating agreement rather than relying on restrictive statutory default provisions. If a particular investor wants to cash out of the project, exit mechanisms should be in place to enable him or her to do so, with minimum difficulty. Furthermore, if one of the 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.
Some of the standard exit mechanisms that investors may want to consider for the operating agreement include the following: (i) drag-along rights (whereby the initiating member can require the sale of an entire venture), (ii) tag-along rights (whereby the non-initiating member can insist on the sale of the entire venture), and (iii) buy-sell arrangements (whereby the right to sell or buy the others’ interests and the conditions pertaining to that right are predetermined).
Buy-sell arrangements, which tend to cause the least amount of disruption to other investors and any lenders financing the project are, generally, the preferred exit mechanism for investors. Careful investors will typically craft the mechanisms by which investors may exercise their right to sell their own ownership interests or buy the ownership interests of others, including the (i) method and content of notice required, (ii) rights of first refusal, (iii) valuations and price calculations of ownership interests, and (iv) timing within which such transfers must occur. Such exit strategies will be critical (i) in the event of death, disability, or bankruptcy filing of one of the investors or (ii) if one investor simply desires to transfer its interest and/or disassociate itself from the project.
When you are just starting out, this part of the process may not seem important, but being organized and hammering out these exit mechanisms early on can save you a lot of complications and money down the road. If you are uncertain as to what to include in your agreement with the other investors, consulting your attorney and accountant before entering a deal should be viewed as preventative maintenance that may address important issues before potential conflicts arise.