July 10, 2019
Here’s how you can use 2 simple clauses to close more Accredited Investors by ensuring they receive the projected returns every time
Ensuring that investors get paid before you do will go a long way in establishing credibility and increasing investor confidence.
To boost investor confidence, experienced syndicators and private companies incorporate several tools at their disposal into the deal structure. The idea behind these provisions is to provide investors with as close to a guaranteed return as possible by prioritizing profit distributions to investors first and in other cases, sacrificing sponsor distributions for the good of the investors.
Preferred returns, Catch-Up provisions, and Look-Back clauses are all tools that seek to accomplish the same goal but each with different timing.
Preferred Returns provide investors with a fixed percentage of profit distributions before any distributions to the sponsors. Depending on the contracted frequency of distributions, Preferred Returns can be made throughout the year on a monthly or quarterly basis. Preferred Returns provide investors with as close to a fixed return as possible.
The typical waterfall provisions in an offering pay investors a Preferred Return then split profits between investors and sponsors according to predetermined percentages. In addition to the Preferred Return, sponsors set specific expectations about projected cash-on-cash returns. If projections go as planned, investors should receive a certain cash-on-cash annual return consisting of the Preferred Return along with a share of profits from operations.
- Investment Amount: $10,000
- Target Cash-on-Cash Return: 12%
- Expected Annual Cash Return: $1,200
- Preferred Return (“PR”): 8% or $800
- Profit Split after PR: 50/50
- Frequency of Distributions: Quarterly
- Quarterly Distribution: 2% PR plus 50% of profits.
- Expected Quarterly Distribution: $300 ($200 PR + $100 Profits)
On a quarterly basis, the investor should receive four equal $300 distributions. As for the sponsors, the waterfall structure provides that after the investors receive their Preferred Return, the sponsors receive 50% of the profits. On a rolling basis, sponsors should receive $100 each quarter – the same as the investors.
The Preferred Return instills a level of confidence in investors by assuring them of an 8% Preferred Return when there is adequate cash flow before any distributions are made to the sponsors.
Let’s go back to our example and throw a wrench into the plans to see what happens. Say in this particular year, everything goes according to plan for the first two quarters but not in the last two quarters.
In quarter three, there is only enough cash flow (i.e., profit) to provide you the investor with only your scheduled Preferred Return of 2% or $200. There is not enough cash flow to provide you with an additional $100 of expected profits from operations. As of quarter three, you should have received a total of $900 in projected returns.
So, going into the final quarter or end of the year, you’ve only received $800, and you’re running $100 behind in your expected cash-on-cash return. At the end of the fourth quarter or end of the year, the syndication is back on track, and there is not only enough to pay the investors their $200, but there is $200 in additional profits, which would normally be split 50/50 between the investor and sponsor giving each $100. The following table illustrates the cash flow situation.So investors are running $100 behind their scheduled expected returns. After quarter 3, there is a $100 deficit owing to investors. Syndications can either ignore the deficits or they can address them to boost investor confidence in one of two ways – either as they occur with a Catch-Up clause that cures the deficits in the succeeding quarter or quarters when cash flow is adequate or at the end upon liquidation or sale of the asset with a Look-Back clause that cures all deficits that have accumulated throughout the term of investment.
The Catch-Up clause would cure the $100 investor deficit of quarter 3 with the $400 in cash flow from quarter 4. After payment of the Preferred Return of $200, instead of distributing the remaining amount 50/50, the Catch-Up clause would mandate payment of the entire $200 of remaining cash flow to the investors, thereby eliminating the deficit.
On the other hand, a Look-Back clause would make up the deficit at the liquidation or sale of the asset. With the Look-Back clause in place, the $200 of remaining cash flow would be paid 50/50 as usual, but when the asset is sold, any net cash flow would first go to the investors to catch up any Preferred Returns and any deficits in distributions to provide investors with their expected cash-on-cash return.
If the net cash flow from the sale of the asset is inadequate to compensate the investors for any deficits, the Look-Back provision will also require that the sponsor give up any profit distributions already received to provide the investors with their expected return.
Preferred Returns, Catch-Up clauses, and Look-Back provisions all contribute to creating a positive perception of you as a sponsor and of your syndication. It lets investors know that you are putting investors first, which is essential towards dispelling any misperceptions of your offering as being a money grab where you put minimal skin in the game and pay yourself first from profits.
These provisions boost investor confidence and will result in more investors subscribing to your offering.
Will you be using these to close more investors?