The following is adapted from a discussion board on AccountingWeb.
I have a client company which comprises two directors. One owns 2/3 shares and the other the remaining 1/3 shares. The company has bought a property which potentially could be developed into residential units. The minority shareholder will be introducing 1/3 of the purchase cost and nothing further. The majority shareholder will be funding any development via loans introduced and wants to ensure his eventual reward is commensurate with the financial input. I am toying with solutions to achieve this and the one which appears to be the most equitable would seem to be either the issue of further shares based on swapping loans for shares or the crediting of significant interest on the loans introduced. The only other alternative would seem to be remuneration relative to input (with the not insignificant tax & NI matters). It is intended that this will be enshrined in a shareholders agreement. Does anyone have alternative suggestions?
Response from LCN Legal:
This is a good question! There are a lot of different ways of structuring a property development JV, especially where the contributions of the parties to management and to financing is not equal. Unfortunately there are no rules or standard percentages for this, because it all depends on the strength of the parties’ negotiating positions and the perceptions as to the amount of risk involved.
I’m a lawyer not a tax expert, and here are my thoughts from a commercial / legal perspective.
First of all, does the company have any other assets or activities? If it does, then the value of those assets or activities would need to be taken into account.
I would suggest separating out the different types of contribution which each party is making to the venture, and agreeing a fair return for that contribution – then looking at the package as a whole and simplifying it as appropriate.
- Sourcing the property and identifying the development opportunity. Where both parties involved in this? Or would it be fair to reward one of them for this role? This reward may, for example, be reflected in an increased entitlement to share in the net profits of the development.
- Managing the development – remuneration for this type of activity is often expressed as a mark-up on the costs incurred on the development.
- Finance provided as “senior lender” – say up to 60% of the current market value of the property. This would usually be a relatively low rate of interest, especially if it is secured and clearly ranks in priority to the other finance.
- Equity finance provided – in other words, finance over and above the senior loan. In this context, equity need not necessary mean shares – it could be a loan carrying a rate of interest plus a percentage of the net profit on the development.
(You could also distinguish “mezzanine’ finance, namely a slice of finance which is less risky than the equity but more risky than the senior debt – but that’s probably not necessary in your case.)
Once you have brought those elements together and aired the shareholders’ views, you can look at the overall package of remuneration and profit-sharing, and possibly adjust the shareholding ratios to fit the circumstances.
One other thing – in addition to dealing with entitlements to profits and payments, you’ll also need to think about control. This is particularly important if the minority shareholder really is a ‘passive’ party in the venture.
- How will decision-making on the development work? Should the board of directors be deadlocked, so that decisions need to be approved by both directors?
- At what stages will the relevant funds be provided to the company? If this was an arms’ length situation, then funds would usually be released on the basis of an agreed schedule, with confirmation / certification that the relevant costs have been incurred.
- Presumably the plan is to sell the residential units once they have been completed – so what’s the process for doing this? Do both parties need to agree any particular sale, or is there some other default position?
I hope this is helpful!