Probably the worst thing that could happen in your career as a syndicator or a fund manager is having to make a bad capital call, having to call up investors and say, “You know, we just need a little bit more money or you’re going to lose money.” It’s a terrible situation. We’re going to talk about two different ways that we deal with capital calls and how we put it into an operating agreement and let investors know in a PPM. It’s what I look at as a syndication attorney, and you should know what your options are.
Now, having to make a capital call is awful. Fortunately, I’ve never needed to make one in any deal that I’ve done. But it certainly does happen quite frequently that there will be a point where you’re going to need to call your investors and let them know you need more money, or bad things are gonna happen.
I’ve almost had this happen once as money ran dry when a lawsuit started up in a deal that I had going. The lawsuit itself was eating up a lot of lawyer fees. At the same time, it was diminishing the account that we had in reserve. Fortunately, that didn’t happen. We made it out just in the nick of time, and I was able to recover that syndication without doing a capital call.
Making a capital call just feels icky, right? You’ve made all these promises to your investors about what you’re going to do, and to not be able to deliver just feels bad. It just feels wrong. But there are things you have to do. Sometimes you got to get that extra money. It could be something like a lawsuit or deferred maintenance, or maybe it’s something that happened – a freak of nature – and it’s just not covered by insurance. In order to make everything work, still make your tax payments, you’re gonna need to do what needs to be done, or service the loan, of course.
Now, in order to do this, there are really three ways we handle it. The worst way, probably, is to just not include it at all. Depending on the deal, that’s pretty safe to do. You can always go back to your investors and ask for more money; it just may not be spelled out in the operating agreement. So it’s not uncommon to leave it out because it’s kind of an uncomfortable conversation. I get it. I would still encourage investors, syndicators, and fund managers to think about it and include it as part of the operating agreement. But if you’ve got the right kind of structure and enough reserves, I guess it’s probably okay to leave it out.
Now, the most common way to deal with capital calls, where it is included, is to treat it as a loan. So you put a call out to your investors and say, “Okay, investors, listen up. We’ve got to raise an additional $500,000. We need to do it because of XYZ. And as part of that, we’re going to offer this loan that you can invest in. Make that loan of $500,000, we’re going to pay you off as quickly as we can. We’re not going to be making any distributions until the loan is paid off. And then we’re going to do it at an interest rate of 10%,” or whatever percentage you determine would make the most sense. So that’s one way to do it.
The second way to do it is a mandatory capital call. So a mandatory capital call looks like this: “Investors, we need $500,000. Each of you owns 10%, so I’m gonna need to get $50,000 from each of you. Now, if you don’t give that to me, it’s going to work like this: That $50,000 that you don’t contribute is going to come off of the amount of equity that you own already. And it’s going to go on one of the other investors’ ledgers, but it’s also going to go more than that. We’re going to actually decrease your equity more than the $50,000 worth. We’re going to decrease it, say, $75,000 worth and give that $75,000 worth of equity to the investors who pick up the slack.”
That’s the more confrontational approach, but it’s the much more effective approach sometimes. A loan environment just doesn’t work, and you aren’t going to be able to do it, and somebody’s gonna have to be able to step up. And if nobody steps up, then where are you at? But with a hammer – or I guess you could call it a carrot and stick model – a mandatory capital call works pretty well.
My name is Tilden Moschetti. Those are the ways that we set up capital calls most commonly for a real estate syndication, or occasionally for business as well. If we can help you set up yours, please don’t hesitate to give us a call. We specialize in Regulation D rules 506b and 506c.