This is part 1 of a 2-article series. Please check back to read our article on taxation of distributions and allocation of profits and losses.
You are a restaurateur with a great idea for a restaurant and feel it is a cannot-miss investment opportunity. There are several different options to raise the capital you need to open and grow a restaurant, but for this discussion we will focus on capital investments from friends, family, and business partners. You can easily incentivize these investors by ensuring they will be rewarded for their contributions to your success, and should things go south (it happens), ensuring they will be able to recoup an equitable portion of their investment. It is important that all investments are tracked to ensure the proper order of distributions and partner capital payouts. In the discussion below, we’ll cover raising and distributing capital for your restaurant startup.
What is capital?
Partner capital is undistributed capital (what an investor contributes) and earnings. Think of it as a personal bank account that holds each investor’s unreturned equity of the entity. A common method for maintaining and tracking investor capital is to create different classes of shares for investors. Operating Agreements for restaurants with multiple investor classes should include paragraphs that detail who gets paid and when as it pertains to profits and losses, annual distributions, and distributions upon liquidation. How much the members of each investor class receives in distributions (both annual and liquidating) depends on where they rank on the ordering tiers laid out in the Operating Agreement.
Also, consider guaranteed payments and yield on unreturned capital. Typically, the restaurateur is not the one fronting most of the capital but puts in endless hours of hard work to get the restaurant open and on the path to success. Guaranteed payments are payments made to partners for services rendered without regard to income, and are used as an ongoing reward for their ‘sweat equity’. Partnerships are not able to offer wages to members but these guaranteed payments would accomplish the same goal. Conversely, investors need to be rewarded for their willingness to invest cash with no foreseeable return. Including an unpaid yield provision in the Operating Agreement may alleviate this delayed return. These unpaid yields (also referred to as a preferred return) are based on a percent of contributed capital and would be paid prior to any other distributions.
What does an Operating Agreement look like?
Here is an example of an Operating Agreement for multiple classes of shares:
(a) All distributions shall be made to the Members in the manner set forth below in this Section 7.01.
(b) Periodic Distributions of Cash Available for Distribution. Subject at all times to the Company’s current and future capital needs and its liquidity, including the availability of current cash flow, which shall be determined by the Board in its sole discretion, and subject to Section 7.01(d), the Board may from time to tome cause the Company to make such distributions of Cash Available for Distribution as the Board may determine. Any such distributions shall be made as follows:
(i) Until such time as until the amount of the Unreturned Capital Contribution for each Class A Member is $0.00:
(A) First, to the Class A Members, pro rata in proportion to their Unpaid Yields, until the amount of the Unpaid Yield on each outstanding Class A Unit is $0.00;
1. 90% of the remainder to the Class A Members, pro rata and in proportion to the number of Class B Units held by them.
2. 10% of the remainder to the Class B Members, pro rata in proportion to the number of Class B Units held by them.
(ii) From the time the amount of the Unreturned Capital Contribution for each Class A Member is $0.00 , and thereafter until such time as Distributions to Class B Members total $1,000,000 in the aggregate (without regard to amounts paid to the Managers pursuant to Section 302(h):
1. 25% of the remainder to the Class A Members, pro rata and in proportion to the number of Unites held by them; and
2. 75% of the remainder to the Class B Members, pro rata in proportion to the number of Class B Units held by them.
(iii) From the time that Distributions to the Class B Members total $1,000,000 in the aggregate, and thereafter, to the Class A Members and Class B Members, pro rata in proportion to the number of Units held by them.
How do I read an Operating Agreement?
In this example, distributions are first paid as a preferred return (think accrued interest) to investors who are owed one. Then, there is a 90/10 split for the Class A and Class B members until everyone in Class A has returned to their initial investment, at which time the split becomes 25/75 until Class B members receive a total of $1,000,000.
Some key concepts are Pro Rata, Unpaid Yield, and Unreturned Capital Contribution. Pro Rata refers to an allocation based on percent of ownership. For instance, if you own 20% of the Class A shares, you should expect 18% (20% X 90%) of the second- tier distributions. As explained above, unpaid yield is an accumulated preferred return that an investor will receive before any other distributions are allocated. Unreturned Capital Contribution is the cumulative amount each investor has given to the entity, adjusted for prior distributions. If you contributed $250K and subsequently received $50K of distributions, your Unreturned Capital Contribution would now be $200K.
As each subsequent distribution tier is reached, it is important to track individual members of each class of investor to ensure each member receives the return they are entitled to in the proper order. This method of distributing cascading returns to each investor is called a distribution waterfall.
We advise tracking potential distributions based on a hypothetical liquidation. This models what each class and class member would be owed if the entity were to liquidate. Liquidation distributions are similar to normal operating distributions after any outside investors (banks, government loans, and even personally secured loans) are repaid.
Example: Distributing Capital
Here is an example of such a distribution waterfall with hypothetical liquidation of capital, using the Operating Agreement paragraph from above. In this example, we will look at an entity that has accumulated partner capital of $750K.
Details: $250k capital contributions; 8% yield on unreturned capital; capital balance of $750k:
|Unreturned Capital Contributions (Class A)||From||To||Amount||Unpaid Yield*|
|Hypothetical Liquidation of Capital||Class A||Class B||Total|
|Unpaid Yield – 7.01(B)(i)(A)||$42,000||$0.00||$42,000||$708,000|
|Pref Distribution – 7.01(B)(i)(B) – (90/10)||$250,000||$27,778||$277,778||$430,222|
|Pref Distribution – 7.01(B)(i)(B) – (25/75)||$107,556||$322,667||$430,222||$0.00|
In this example, the entity has been in business for three years but has yet to distribute capital. If they were to distribute any cash, it would first have to cover any unpaid yields. Any remaining distributions are paid according to the operating agreement, up to the balance of partner capital (in this case $750K).
If a restaurant is successful enough, the opportunity arises to give all investors a return on their capital and further share in the growth of the restaurant. At this point, the restaurateur could seek to buy out the investors (typically at a premium) or perhaps seek additional funding for expansion. Due to the success of the restaurant, it may be easier to secure additional capital calls. Adding more levels of investor capital means adding more levels to the waterfall.
Concepts such as tracking distribution waterfalls for multiple levels of capital classes are certainly not the ideal use of a restaurateur’s valuable time. It is imperative you partner with a CPA firm that specializes in handling restaurant accounting that covers every aspect of your growing business. At RY CPAs we are ready to assist you with your restaurant accounting needs. Feel free to reach out and set up a discovery call.