This practice note examines issues to consider when drafting the promote mechanic provisions of a limited liability company operating agreement (also referred to as the joint venture agreement). Sample provisions illustrating the concepts discussed in this practice note are included in the exhibit.
This practice note assumes that the limited liability company is formed in a state with a statute similar to the Delaware Limited Liability Company Act (6 Del. C. Sec. 18-101 et seq.). The members of the limited liability company may be referred to herein as members or partners. This practice note assumes familiarity with basic principles of real estate joint ventures agreements.
For additional real estate joint venture resources, see Real Estate Joint Venture Resource Kit (90/10 Real Estate Joint Venture).
Promote mechanics are built into the distribution waterfall provisions of a joint venture agreement. To understand promote mechanics, one must also understand the distribution waterfall provisions.
The distribution waterfall provisions dictate which of the parties will receive cash returns on their investment and the relative priority and timing of distribution of such returns. The "waterfall" refers to the order in which available cash is distributed to the parties, and the "promote" is embodied in the waterfall.
The waterfall varies from deal to deal and is typically tailored to the specifics of the transaction. The waterfall may also vary within the same joint venture agreement for different categories of available cash, such as operating cash flows and capital event proceeds.
It is called a waterfall for good reason. The waterfall structure can be visualized as water cascading down a series of ponds. The water represents the available cash to be distributed to the parties. Water fills the first pond in the sequence and, if there is enough water, the excess water flows over the rim and down into the next pond in sequence. Each pond represents a separate agreement between the parties as to how available cash will be split among them at that level.
The rim of each pond in this illustration is what is referred to as the "hurdle." Prior to reaching the rim of the first pond (i.e., achieving any of the hurdles), the joint venture typically distributes available cash pari passu, meaning each party's return ranks equally in priority, and pro rata in amount, meaning relative to each parties' respective percentage ownership in the joint venture.
After a hurdle is achieved, a party may be entitled to a share of profits that is greater than the pro rata share that the party would otherwise be entitled to based on its ownership percentage. This disproportionate share of the proceeds is the promote, or, as known in other forms of alternative investment, "carry," and the right to a promote or carry is often called a promote interest, carried interest, profits interest, or colloquially as sweat equity.
The Sponsor and the Sponsor's Promote
There are typically two types of parties to a real estate joint venture: the sponsor and the capital investor(s). Sponsors play an active role in the venture, sourcing, and securing property investments, financings, and other equity investors. Underwriting and due diligence for investments is often handled by the sponsor. Sponsors also usually act as the managing member, managing the joint venture and potentially the venture assets, including day-to-day construction and development, operation and leasing of the property, and its ultimate disposition. Greater risk comes with the role of sponsor who often assumes responsibility for cost overruns and provides a guaranty of recourse obligations in financings, thereby likely reducing the cost of financing to the venture. In this role, sponsors contribute their valuable relationships, expertise, and experience to the venture.
While joint ventures of other alternative investment types may be owned relatively evenly (e.g., 50/50 or 60/40), it is more common in real estate joint ventures for the sponsor to own a much smaller equity stake than the capital investors, for example, 2%-15% owned by the sponsor and 85%-98% owned by the capital investors. Determining the percentage ownership interest of the sponsor requires balancing two of the capital investors' goals: to have greater control over key major decisions typically given to those with a significant majority equity stake and, at the same time, for the sponsor to have a sufficient investment (or "skin in the game") so that the sponsor and investors' interests are aligned and the sponsor remains committed to maximizing value.
The promote can be thought of as both compensation for the sponsor's critical role in the venture as well as a powerful incentive tool motivating the sponsor to create value or discover hidden value, and ultimately generate profits that exceed budget and business plan expectations. Upon achieving such superior returns, the sponsor would be entitled to the promote, that is, the sponsor would receive an excess share of distributions at a level greater than the sponsor's percentage interest in the joint venture. This kind of graduated profit-sharing mechanism incentivizes the sponsor to outperform so that greater distributions will flow into the downstream ponds in which the sponsor will be entitled to a larger share. The details of the profit-sharing agreements of the different ponds are called the promote mechanics.
Keep in mind that a promote is separate and distinct from fees that a sponsor may earn in a deal. Fees may include acquisition fees, disposition fees, asset management fees, development fees, financing fees, property management fees, leasing fees and commissions, license/franchise fees, technical services fees, pre-opening fees, purchasing fees, and guaranty fees. Although fees are beyond the scope of this practice note, it is worth noting that such fees may cause a misalignment of interest between the sponsor and any investor in that the sponsor may have a relatively small equity stake in the venture but can receive substantial fee income even if the venture's performance is below expectations and the capital investors do not achieve their anticipated returns.
Calculating Available Cash for Distribution
In a real estate joint venture, there are generally two sources for cash distributions:
- Operating cash flow (e.g., rental income from tenants) -and-
- Cash from liquidation, refinancing, casualty or condemnation proceeds, or the sale of capital assets (or capital proceeds)
Each are often referred to as available cash or cash available for distribution in the joint venture agreement. Available cash may be offset by liabilities, including costs of sale, sums required to redeem loans on a disposition, current liabilities such as debt service, taxes, insurance, general operating expenses, and other budgeted expenditures and reserves or other holdbacks for contingent liabilities. As noted earlier, the sponsor will often charge the joint venture a series of fees. These fees may be netted from property cash flow and reduce the overall return and cash available for distribution for the investors.
Parties to the joint venture agreement will heavily negotiate the definition of available cash for distribution. See Related Companies, L.P. v. Tesla Wall Systems, LLC, 159 A.D.3d 588 (2018) as an example of litigation that may ensue when a joint venture agreement fails to define available cash. Plaintiff Related argued in its summary judgment motion that "available cash" meant "any money that [the venture] has or is able to obtain, irrespective of whether [the venture] operates at a profit or loss." Defendant Tesla argued that the term referred only to "after-tax profits available to the company after the payment of all costs and expenses." Since the company had no cash, the court ruled in favor of Tesla on Related's motion and reversed the lower court's grant of summary judgment because the existence of available cash was a condition precedent to passing funds through the waterfall.
The sponsor may argue for an open-ended definition of available cash to include, simply, all net cash proceeds received by the venture from any source and determined by the sponsor or managing member to be available for distribution. This would allow the sponsor to exercise its judgment and reserve amounts for known or anticipated future obligations. The investors, however, may prefer that the definition of available cash set out the specific obligations, liabilities, and fees to be deducted from gross proceeds in determining available cash and will want a nondiscretionary requirement for the sponsor to distribute such available cash.
The net surplus cash then goes through the waterfall set out in the joint venture agreement which will provide for the return of equity, the payment of any agreed hurdle before the promote, and then payment of the balance in the pre-agreed proportions which gives the sponsor its promote. Available cash from revenue typically will be paid either monthly or quarterly or more frequently as the sponsor elects, and available cash from a capital event will be paid within an agreed number of days following the closing of the applicable transaction, such as five days, subject, in each case, to the distribution limitations imposed by any loan agreement.
Originally published by LexisNexis Practical Guidance.
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