Builders and Contractors Exchange
Weekly Bulletin: 31 Oct 2005
Distilling The Development Deal. Avoiding Pitfalls Of Handshake Agreements
By: Richard J. Crouch
So your colleagues have approached you about investing in a development deal or similar venture? If it is your first investment of this magnitude, you may wonder how to best memorialize the deal and which questions you should ask on the front-end to best protect yourself. You may have general expectations for the deal but still need assistance in reducing those concepts to written form, in order to best implement mechanisms designed to keep control of your investment. When you are just starting out, this part of the process may not seem important, but being organized and hammering out issues early on can save you a lot of complications and money down the road. Several broad, but nonexhaustive, areas, which you should consider are as follows: (i) organizational structure, (ii) financing/project related costs, (iii) internal operating procedures, and (iv) accounting methods.
A. Organizational issues: Companies are usually set up as investment vehicles for deals to better shield investors against liability from third parties. The type of entity selected will determine your exposure to liability, taxations on your distribution, and the formalities that will need to be maintained with respect to company action. You should ascertain who the other investors are using as their attorney and/or accountant, and who the investors expect to pay for such services. You should address how long you want the company to exist, especially if you prefer a quick return on your investment and the ability to exit smoothly.
B. Financing/Project-Related Costs: It is rare that investors pay entirely for a project out-of-pocket, and numerous additional expenses are often overlooked by investors. There will typically be a lender involved, and you should ask which lender is being used to finance the project, because some lenders have far more reasonable requirements. Your fellow investors may expect (and the lender may require) you to sign a guaranty in connection with the financing, especially if you are one of the larger investors. If you must sign a guaranty, make sure your other investors are on the hook in the same capacity. Also, if your fellow investors make any misrepresentations to the lender, you need a provision in place whereby they indemnify you, if such misrepresentation triggers a default, and the lender looks to you to honor your guaranty. Further, you must assess how creditworthy the other investors are by reviewing their financials. You should ascertain (i) who among the investors is covering settlement costs, and, (ii) if there will be a number of government approvals required to complete the deal, who will cover those costs.
C. Internal Operating Issues: This could quite possibly be the most critical consideration, because it will determine what control you will have over your investment. You will need to know who will act on behalf of the company (the "Manager") and what actions the Manager may take without the approval of the other investors versus which company actions will require an affirmative vote of 2/3 of the investors. You should confirm how much voting power you will have, because you do not want to be involved in a squeeze-out situation, if other investors gang up on you. You must also have a right to audit company financial records.
You should address what would happen if there is a dispute among the investors and how it would be handled (i.e., arbitration versus court). You should also ascertain which attorneys represent whom among the investors and whether any potential conflicts exist. If a particular investor wants to cash out of the project, exit mechanisms should be in place to enable him to do so with minimal difficulty. Furthermore, if one of the other investors dies or receives an offer to have their ownership interest purchased, the remaining investors may desire to have a right to purchase the exiting member's ownership interest in the project.
D. Accounting issues: This will affect your analysis as to your desired return, and you should always have an accountant review all of the financials/projections to best assess profitability. You should try to cap cash contributions, so you do not have to keep forking over money to company. You should ascertain if there is a hierarchy in terms of investors receiving their returns or if distributions are simply in proportion to the size of your contribution. You should agree on exactly how profits will be calculated, so that you are not stuck shouldering certain costs unnecessarily.
If you are uncertain as to what to include in your agreement with other investors, consulting your attorney prior to entering into a deal should be viewed as preventative maintenance that may address important issues before potential conflicts arise. The more specific your business plan and preparation, the easier it will be for your lawyer to help you structure the transaction.
Questions?
If you have any questions about this article or any other related matters, please contact:
This article is meant to bring awareness to this topic and is not intended to be used as legal advice.