Why Are There Different Types of Shares in a Deal?

As you begin your journey, you may encounter various types of shares in a commercial deal. This awareness might arise from different sources, such as:

Reviewing a recently received Private Placement Memorandum (PPM)*
Examining a new investor interest survey, which may include a preliminary pro forma of an upcoming deal*
Engaging in casual conversations or conducting research on the topic.

Understanding these different types of shares is crucial before making any investment decisions in a new deal. To provide clarity, we will delve into three main aspects:

Definitions
Divisions
Distributions

Definitions

It’s essential to understand that the designation of these shares is somewhat arbitrary (e.g., A, B, C, or “passive,” “preferred,” or similar), but they will be clearly outlined in the Private Placement Memorandum (PPM). Tentative pro formas may briefly describe the share types mentioned or assume that you can infer their meaning from the context. However, it’s crucial to note that such documents are not official solicitations or contractual promises.

For explanatory purposes, let’s use the common types of shares and refer to them as “A-shares,” “B-shares,” and “C-shares” in this article.

Passive shares (typically labeled “A-shares”) are those shares owned or sold by passive investors in a deal. Passive shareholders do not exert active control over how the property is managed or make decisions regarding property management. Instead, they receive distributions and monitor their investment, understanding the deal and its sponsors before investing. Additionally, passive shareholders receive K-1 statements from the sponsor’s CPA for tax filing purposes.

Sponsor shares (typically denoted as “B-shares”) are those shares owned or sold by the sponsors who organize and manage the deal. Sponsors often invest minimal funds, if any, into the deal but bear significant upfront and ongoing risks associated with managing the asset. Depending on the deal’s size, sponsors may incur substantial expenses on legal paperwork before passive investors are invited to participate. Some sponsors may also be personally liable for bank financing (referred to as a “recourse” loan). Therefore, sponsors have a strong incentive to treat passive investors well, meet the expectations outlined in the pro forma, and ensure the protection of investors’ interests.

Special shares (typically referred to as “C-shares”) include shares with unique provisions that may not always be part of a deal’s structure. For instance, if a prior asset owner decides to sell and reinvest in the same property, they may become a partner in the new deal, transitioning from sole ownership. An example of this scenario could involve a doctor selling a building and then becoming a part-owner in the new deal while retaining the sole lessee status with the option to sublease the property. In this case, the doctor may accept a lower return on the C-shares but offset it by subleasing at higher rates, ensuring a solid lessee is motivated to maintain rent levels. This arrangement provides A and B shareholders with a more predictable and less risky return.

Divisions

Expanding on those basic definitions, it’s crucial to understand how the allocation of these shares influences distributions, profits, and losses, and how they are distributed among all shareholders.

For instance, in a straightforward multi-family deal, shares might be distributed as follows:

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:

Additionally, the PPM will outline the privileges and responsibilities associated with each type of shareholder.

Another variation in share divisions is a “tiered payout” model, where distributions and profits are proportionately determined based on performance thresholds achieved by the sponsors. In such arrangements, passive investors receive rewards earlier in the deal’s life, serving as an incentive for sponsors to maximize profits and also receive compensation. For instance, passive investors receive all returns if profits fall below x dollars. However, once profits reach y dollars, passive investors receive 60% of the profits from x to y, and if profits exceed z dollars, they receive 40% of the profits from y to z. While not common, these structures may be observed in new developments, especially where initial profits are low. As revenue increases with leased properties, sponsors seek compensation for their efforts. In these scenarios, each shareholder must consider their risk-reward position. Passive investors benefit, particularly those lacking the experience or time to manage properties directly. Conversely, sponsors benefit from shouldering greater risk and the upfront research and paperwork involved.

Distributions

Even though ownership percentages are clearly indicated, it’s crucial to understand the specific details of how distributions apply. Typically the PPM will outline these details. For example, if A-shares receive a “preferred return,” B-share distributions are only disbursed after the A-shares’ preferred return is fulfilled. Distributions are determined by the ownership percentage and the total capital raised (i.e., the total contributions of all shareholders) but may also be influenced by tiered performance and other factors stipulated in the PPM.

Consider an example where ownership is split 60/40 between A and B shares, with A-shares entitled to an 8% return and profits for the period at 8%. In this case, A-shares receive their 8% return on their contribution, while B-shares receive nothing. Now, if profits increase to 10%, A-shares would receive their 8% return plus 60% of the additional 2%. This means A-shares would earn a 9.2% cash-on-cash return on their contribution, while B-shares would receive 0.8% of the profits. Since B-shares did not contribute any cash in this example, their return is described as a percentage of profits rather than a cash-on-cash return.

In Conclusion

While it may appear complex, each component serves a distinct purpose in the deal. Every type of share is rewarded according to its role. In any transaction, the involvement of all specified share types is essential for success.

Passive investors are rewarded for assembling the funds necessary to secure approval from a bank, as banks typically do not finance the entirety of any deal.
Sponsors receive compensation for assuming the risk associated with the loan, covering upfront expenses related to contracts and PPM creation, and taking on the responsibility of asset management.
Special shareholders are compensated based on their specific contributions, such as providing funds or ensuring a robust sublease portfolio. Detailed explanations for each deal are provided in the respective PPMs.

Footnotes:

*In accordance with SEC regulations, to obtain a Private Placement Memorandum or an initial pro forma, you must already have an established relationship with one of the deal sponsors.