Terms for Operating Co Investment
Talking to a fund about a JV where one option they threw out was funding the cost to build an operating company and they’d take a piece of it. The fund would act as the LP as well.
It’s just two of us so it would be a big chunk of $ to front hiring a full staff without their support. Alternatively we could team up with an existing sponsor as back office and give them a chunk of our economics.
Anyone have experience with this structure? What would terms look like?
Based on the WSO threads discussing similar investment structures, here's what you need to know about setting up a joint venture (JV) where a fund acts as a Limited Partner (LP) and also funds the cost to build an operating company:
Economic Sharing: Typically, the fund (acting as LP) would expect a share of the economic benefits proportional to their investment. This could include a percentage of equity in the operating company or a share of the profits.
Control and Decision-Making: The fund might also want some level of control or at least significant input into the decision-making process, especially if they are contributing a substantial amount of the capital.
Staffing and Operational Support: If the fund is concerned about the initial costs of staffing and setting up operations, they might prefer a structure where they can leverage existing resources. Partnering with an existing sponsor as a back office could be a viable option. This sponsor could handle day-to-day operations and administrative tasks, allowing you to focus on core business activities.
Terms of Agreement: The specific terms of the agreement would need to be negotiated and could include:
Legal and Compliance: Ensure that all arrangements comply with relevant laws and regulations. It might be wise to involve legal counsel to draft or review the JV agreement to avoid potential legal issues down the line.
Risk Management: Discuss and plan for potential risks, including financial, operational, and market-related risks. Establishing clear mechanisms for managing these risks is crucial.
In your discussions with the fund, it would be beneficial to clearly outline your expectations and concerns, and be prepared to negotiate terms that align with your business goals while providing adequate incentives for the fund to invest.
Sources: Differences between Co-invest and Secondaries?, What returns have you achieved from co-investing in your fund?, What returns have you achieved from co-investing in your fund?
Depends on how big you want to scale, and how quickly. I would be concerned about fronting a full back office without any deals locked down. Acq/AM fees from active deals should shoulder most of your overhead, otherwise I would be worried about the LP funding an ongoing operating deficit, and possibly diluting your % of the OpCo depending on how you structure your JV agreement.
Also, in today's day and age starting a company (specifically an operating co) really isn't that expensive. All the back end tech stuff (web hosting, emails, data storage, corporate account for costar etc) can be set up in a day. The real cost is hiring a law firm to write all your docs. Partnership agreements, offering/subscription docs etc can run you 100k's depending on how you want to raise money. It sounds like you've already done the hard part (finding the guy with money). I would try and retain as much ownership of the OpCo as possible, and keep your LP as happy as possible with his split net of your promote/fees.
Helpful way to think about it, thanks.
Would be a few hundred million in equity, no legacy deals so no AM fees coming in yet.
Guess what I was trying to understand was the specifics about how their funding would work (e.g. they take 20% of OpCo on assumption that they fund $1.5m per year of costs for 3 years, offset by eventual AM fees). Would they accrue a pref on that investment that would further dilute our promote?
I would certainly avoid giving them any form of promoted interest in the opco. Agreeing on a set % ownership (pari passu), provided they fund $XXX overhead for X amount of years seems like the best path forward. Also, $1.5mm seems steep for year 1 overhead for an operating company with no deals, no? Hiring 1-2 acq guys, a controller and an executive assistant should be more than enough to get you started depending on your strategy. Once you have a deal under your belt you can scale where you need to. I would stay leaner for longer on the payroll side of things, especially if that means you retain a higher % of the opco.
1 - Do not give up fee revenue. Fees are to compensate you for literally doing the work. Promotes compensate you for doing well for your investors. Whatever else you may negotiate in terms of giving up promotes, keep the fees. I know they're going to cover expenses for a few years, but after that it's on you to carry that overhead, so think forward to Yr 4 when all of a sudden you've got to feed a bunch of people and you've pledged 25% your fee revenue to your partner.
2 - Make sure your investor picks between being compensated at the OpCo level or the deal level. Either they get some of the upside from successful deals, or they get preferential treatment for their capital as an investor on a deal by deal basis. Not both. On the assumption you'll be investing in worthwhile projects/assets, you shouldn't be letting them double dip by getting good terms on their LP capital AND a piece of the eventual promotes.
3 - Remember this: you are building a business, and they are making an investment. So structure in a buyback of their equity investment or some such, in very precise terms and presumably with optionality on your part as to when to trigger it. Assuming all goes well and you've got a real business cooking in a few years, you and your investor partner are going to have very different priorities about how to run the company. They're going to want to sell assets, realize gains, and make money on a shorter time frame, because they're probably getting paid back from their investment through the piece of the promote they get. The money their investing in the first place is probably coming from a group of LPs they raised money from - they'll have obligations and hurdles to hit to those people, so while your trying to do what will set your new company up for success 5 or 10 or 25 years down the road, you're going to have a partner who is going to be far more concerned with maximizing profits in the next five years, even if that is detrimental to the business as a whole.
4 - Make sure you spell out in very exacting detail what it is that your partner is paying for, and what they're getting in return. Do you get money to put towards deposits, and if so does that count as opex dollars like any other pre-closing cost, or is that considered LP equity on which the IRR clock starts ticking when the contract goes hard?
4.5 - Make sure you build in a salary for yourself. This is a business, and they're making an investment, you don't need to live off ramen noodles and boiled brown rice to pinch pennies if you've got someone investing in the OpCo. You are building something, and it's going to be more difficult than you can possibly imagine, and you deserve to be compensated for that and to have that be spelled out in your operating documents.
Lots of other thoughts but that's enough high level stuff to be going on!
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