Why are there different types of shares in a deal?

So, you’re beginning to hear there are different types of shares in a commercial deal and are either through:

• reading a PPM you have just received*,
• reviewing a new investor interest survey that includes a tentative pro forma of an upcoming deal*,
• or you are hearing of this through some other casual conversation or research.

Good, I’m glad you are asking.  This is a very important thing to understand before investing in a new deal.

There are three main aspects we need to cover:

1. Definitions
2. Divisions
3. Distributions

Definitions

First, you need to know that the naming of these shares is rather arbitrary (ex. A, B, C, or “passive,” “preferred,” or whatever) but will be clearly defined in the PPM.  Tentative pro formas either give a brief description of the share types they call out or tend to assume you can figure out what they mean by the context – as such documents are not official solicitations nor contractual promises.

But for explanation purposes, let’s go with the most common types of shares and apply the nicknames of “A-shares,” “B-shares,” and “C-shares” for this article.

Passive shares (typically the “A-shares”) are those shares sold (or owned) by the passive investors in a deal.  Passive shareholders do not have any active control on how the property is run nor have any means to make decisions on how management of the property is conducted.  In exchange, the passive shareholders get to sit back and collect distributions.  Of course, they need to understand the deal and its sponsors before investing and need to monitor their investment as there may be provisions in the deal’s operating agreement to exercise certain options in case the sponsor is failing in their own responsibilities – but that’s a topic for another time.  Passive shareholders also will get K-1 statements from the sponsor’s CPA to file with their own tax returns.  The K-1 will show you what the IRS wants to know.

Sponsor shares (typically “B-shares”) are those shares sold (or owned) by the sponsors who are putting together the deal and managing the deal.  Sponsors typically don’t put much (if any) funds into the deal but have a lot of risk up front and during the ownership of the asset.  Depending on the size of a deal, a sponsor may have had to put $30,000 to $100,00 or more into legal paperwork before a passive is even invited to invest.  Some of the individuals in the sponsor group may be held responsible for the bank financing (what we call a “recourse” loan).  In any case, there is a lot of risk the sponsors take in putting a deal together.  If there isn’t enough funding from the pool of passive investors, they could be out a lot of dough.  Therefore, sponsors have a huge incentive for treating their passives well and ensuring they meet the expectations given in the pro forma and that the passives don’t lose their investment.

Special shares (typically “C-shares”) are those shares with special provisions and are not always part of a deal’s constitution.  For example, if the prior owner of an asset is selling (maybe because they want some cash out, or they need to reduce their tax profile to the government), they may also become a future investor in the same property but with a new position as a partner instead of a sole owner.  An example of this would be, a doctor who sells a building they own, turns around and becomes a part owner in the new deal, but also becomes the sole lessee with the option to sublease the whole building to other professionals.  The doctor then is willing to take a lower proportionate return on the C-shares but will make it up by sub-leasing at higher rates than he/she is paying as the sole lessee in the new deal.  The upside of all this is that all the shareholders get a solid lessee by someone who is highly motivated to keep the rents up.  The A and B shareholders are then getting a much more predictable (and less risky) return.

Divisions

Building now upon those simple definitions, it’s also important to know how the division of such shares are used to determine distributions, profits, and losses and are divided among the whole body of shareholders.

For example, in a simple multi-family deal, shares might be divided up like this:

Or in another multi-family deal, shares might be divided up like this:

Another example, In a simple medical office deal, shares might be divided up like this:

Elsewhere in the PPM, other details will be stated as to the privileges and responsibilities of each type of shareholder.

Another variation one might see in share divisions is a “tiered payout” whereby the prorate of distributions and profits are determined by performance thresholds being achieved by the sponsors.  In these type divisions passive investors are awarded earlier in the life of the deal which serves as an incentive for the sponsors to ensure they increase profits, so they get paid also.  An example would be, if profits are below x dollars, then the passives get all the returns.  But once profits get to y dollars, then the passives get 60/40 of the profits from x to y, and if profits get really great up to z dollars, then the passives get 40/60 of the profits from y to z.  These aren’t that common, but can be experienced on new developments especially where there isn’t much profit at first, but as the sponsors get revenue coming in and leases filled, then they will want to get a return for all their hard work.  In these situations each shareholder needs to respect their risk/reward/incentive position.  Being a passive has its benefits – especially to those who don’t have the experience or time to actually be a property manager or sponsor or someone holding the recourse note.  Being a sponsor has its benefits – especially for taking on the greater risk – not to mention all the upfront research and the paperwork.Another variation one might see in share divisions is a “tiered payout” whereby the prorate of distributions and profits are determined by performance thresholds being achieved by the sponsors.  In these type divisions passive investors are awarded earlier in the life of the deal which serves as an incentive for the sponsors to ensure they increase profits, so they get paid also.  An example would be, if profits are below x dollars, then the passives get all the returns.  But once profits get to y dollars, then the passives get 60/40 of the profits from x to y, and if profits get really great up to z dollars, then the passives get 40/60 of the profits from y to z.  These aren’t that common, but can be experienced on new developments especially where there isn’t much profit at first, but as the sponsors get revenue coming in and leases filled, then they will want to get a return for all their hard work.  In these situations each shareholder needs to respect their risk/reward/incentive position.  Being a passive has its benefits – especially to those who don’t have the experience or time to actually be a property manager or sponsor or someone holding the recourse note.  Being a sponsor has its benefits – especially for taking on the greater risk – not to mention all the upfront research and the paperwork.

Distributions

Even though ownership may be clearly denoted as percentages, it’s important to know specific details of how distributions apply.  Again, the PPM will spell this out.  For example, when A-shares are given a “preferred return” then B-share distributions don’t kick in until the A-shares’ preferred return has been met.  Distributions are based on the percentage of ownership and the total capital raise (the total contributions by all shareholders) – but also may be subject to tiered performance and other details denoted in the PPM.  

For an example, let’s say that the split in ownership is 60/40 for A/B shares, A-shares are to get an 8% return, and profits for the period are 8 %.  Then the A-shares get paid 8% on their contribution (annualized) and the B-shares don’t get anything. That’s the simple case. Now if the profits were 10%, then the A-shares would get their 8% plus 60% of the next 2% – thus, A-shares would get 9.2% on their contribution (cash-on-cash return) and the B-shares would get 0.8% of the profits.  Since B-shares didn’t put any cash into the deal (in this example) we can’t describe their return as a percentage of cash-on-cash return but rather as a percent of profits.

In Conclusion

It may seem like there is a lot of moving parts here, and there is, but each has a purpose.  Each type of share is being rewarded for their role in the deal.  For any deal, it takes all the specified share types to make it happen and be successful.

• Passives are being rewarded for putting the funds together to get the deal approved by a bank (since a bank doesn’t finance 100% of any deal).
• Sponsors are getting rewarded for taking the risk of the loan, incurring upfront costs for getting the contracts and creating the PPMs, and taking on the responsibility for managing the asset.
• Special shareholders are being rewarded for whatever special thing they are doing such as putting up some funds and/or ensuring a solid sublease portfolio.  Each PPM will explain all the details for each deal.
  

Footnotes:
* To receive either of these two options, you must already have an existing relationship with one of the sponsors of the deal before you as per SEC rules.  To receive these pieces of information for investing opportunities from Engineers in Real Estate simply click “Join Now” anywhere on this site and then schedule an appointment so we can begin that relationship.