Investors in any project can run the risk of dilution. Perhaps additional shareholders buy in, costs go higher than anticipated or management fees become excessive. There are numerous ways through which an investor can see her portion of the pie decrease. One of the methods of managing this risk is via a mechanism called a preferred return.
A preferred return entitles the investor to a certain percentage of the revenues from a project before other parties, like management, get paid. Structured correctly, it can encourage the management team to operate a profitable business. It can also protect the investor’s capital. Consider the following example:
You invest $20,000 in a real estate venture. It is structured a corporation that is formed for the singular purpose of purchasing a six-unit apartment building, increasing its cash flow and eventually selling it. Your purchase entitles you to 5% of the proceeds from the project.
The deal progresses at a reasonable pace, but the costs of operations are higher than expected. As a result, there is hardly any income left over after management salaries are paid. At this rate, you’ll still earn a profit from the investment, but it will be almost entirely from the purchase of the building. The rental revenue from the real estate is just too low. You will have to wait at least five years before making any real money.
A preferred return could protect you in the foregoing scenario. For instance, what if management was not allowed to receive a salary until you’ve earned an annual return of five percent? Such a structure would probably pressure the management team to pay close attention to costs. If they run high, then they – not you – will suffer the consequences. This is known as a cumulative preferred return. You are entitled to a minimum of five percent per year before management gets paid. So, if you don’t earn it after one year, it becomes owed to you.
A preferred return does not necessarily cap your returns at five percent. Rather, it is designed to give you a minimum. For instance, it might be structured as follows:
Management is barred from compensation until investors receive an annual return of five percent. Management may not earn a bonus until investors receive eight percent. If investors receive a cumulative return of ten percent per year, then management may keep 80% of the remaining profits from the venture.
To be clear, a preferred return is not a guarantee. If the project is a bust, then there may be nothing payable at all. But it is a way to make sure that you are getting a fair share of the proceeds.
There is also not a perfect structure for a preferred return. It wholly depends on a combination of the underlying asset, and the desires of management and investors. Some deals may not be conducive to restricting management from compensation. They may not want to do years of work before making a penny. That might be the case for a land development project, which may earn little to no cash flow for three, five or even ten years.
Ultimately, though, a preferred return is a mechanism that investors can use to add security to their investment. It is not always required, but it should at least be considered. Like any winning investment, it should be designed to make you money, while encouraging management to work hard and compensating them well.
Alexis Assadi is an independent investor who concentrates on financing real estate ventures and businesses across Canada and the United States. He also serves as the Chief Executive Officer and a director of Pacific Income Capital Corporation, the general Partner of Pacific Income Limited Partnership. You can follow Alexis Assadi on Twitter for musings about business, politics, internet memes and pictures of his dog.
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