The two primary reasons to do this are to reward specific investors for investing more than others or investing early.
There are two ways you can do this:
- SUBCLASSES – You can create one or more Class A subclasses (Class A1, Class A2, Class A3, etc.) who have preferential treatment, such as higher preferred returns, than other subclasses. This can be done using a tiered investment structure; for example, Class A1 could be people who invest ≥$100,000 and get an 8% preferred return and Class A2 could be people who invest <$100,000 and receive a 7% preferred return.
- SIDE LETTERS – You can have a side letter with a specific investor — but with the caveat that you shouldn’t have too many side letters in a deal. In the side letter, you agree to give up something from your Class B earnings to pay that investor a higher return.
However, in a commercial real estate transaction, you have to be careful of allowing a single investor to purchase so much of your company that they have to be underwritten on your loan. Your lender will have a threshold percentage of ownership that triggers this requirement. For Fannie Mae loans, it’s 20 percent of the total ownership of the Company; for Freddie Mac loans, it’s 25 percent of the total ownership; CMBS loans may have thresholds as low as 10 percent.
You’ll need to find out from your lender what percentage triggers this requirement. The downside is that 1) the investor may not want to be underwritten, and 2) it may slow down your loan approval process.
If you are thinking about using subclasses in your offering and want more information or if you need help negotiating or drafting a side letter, please click here to schedule an appointment with us.