The OpCo / PropCo introduction. The guide to less dilution | by Kunal Lunawat | Agya Ventures | February 2022
Part A: Introduction
In this section, we provide an overview of an OpCo/PropCo structure and highlight some instances where it might make sense.
What is an OpCo / PropCo structure?
Simply put, a dual funding structure.
Let’s break it down. What is an OpCo?
Think of the OpCo as the entity that builds the tech+ product, owns the data, and owns the intellectual property. The OpCo is usually funded by venture capitalists.
And then, what is the PropCo?
Think of the PropCo as the entity that acquires land, signs leases, and generally owns the most capex- and time-intensive parts of the business. The PropCo should generally not be funded by VCs, especially after the company has secured the market fit of the product (think Series A and beyond). Alternative sources of capital such as PropCo funds, real estate developers, loan funds and others are increasingly seeking PropCo funding opportunities.
Why opt for an OpCo / PropCo structure?
- In short, this leads to less dilution and a better alignment of risk with the associated cost of capital – see section C for more details and a numerical example.
- Venture capital, to some extent, is the most expensive source of capital; once a business has been de-risked beyond a certain point, there is merit in eliminating the most asset-heavy parts of the business and funding them with alternative and cheaper sources of capital.
- This generally applies to businesses that take on contractual responsibilities (think leases) or purchase fixed assets (think land or furniture) and can demonstrate relatively stable cash flows at scale (think cash flow from cohabitation assets that operate at stabilized occupancy).
What are the business models where the OpCo / PropCo game makes sense?
- Dark shops, where operators sign leases and are unable to obtain management sharing agreements. Such leases can/should generally be financed by non-VC pools of capital.
- Coworking businesses, where once again operators sign leases or buy assets, instead of signing management sharing agreements.
- Co-living companies. The same logic as above, although one can also finance initial investments (e.g. furniture) through other pools of capital.
- Short-term rental operators where the property owner/manager assumes the asset or lease on their balance sheet.
- Health, wellness and fitness startups, where operators open up physical spaces that increase mobile/tech offering.
- Full technology property developers and general contractors.
- Experiential retail businesses with physical locations.
- Self-storage and logistics companies that optimize space and operations by owning or leasing the underlying asset.
When do PropCo structures not make sense?
- When physical asset ownership or long-term liability is a one-time scenario for the business to prove the technology works, which is the team’s primary focus.
- When management is clear about scaling through management-sharing agreements only.
- In the early days of a business, when signing leases or owning assets through venture capital is a quick way to scale and build track record to eventually seek out alternative funding sources.
Section B: Getting some granularity
In this section, we examine the capitalization and governance of OpCo and PropCo entities controlled by the same management. For ease of understanding, we will look at an example where the OpCo serves as the GP in the PropCo entity (see below). There are more variations in this relationship, but the conceptual framework remains broadly the same.
How do you start thinking about running an OpCo / PropCo structure?
To simplify things, we would break it down into 3 compartments:
- Capitalization and governance of the OpCo.
- Relationship between the OpCo and the PropCo.
- Capitalization and governance of the PropCo.
So what about the capitalization and governance of the OpCo?
- Regarding the capitalization and governance of the OpCo, nothing changes significantly after the introduction of a PropCo: the VCs remain the same; the governance remains the same; the management and VC stake in the OpCo remains the same.
- The OpCo continues to operate as a technology company, focused on writing software, building products, and analyzing data. He then licenses his technology to the PropCo for a fee.
What is the relationship between OpCo and PropCo?
- PropCos quite often (not always) are structured as GP/LP entities. For the purposes of this article, we will assume that is the case.
- In such cases, the OpCo is either the sole GP or the co-GP of the PropCo.
- LPs for PropCos are a growing and evolving breed – see Section D for details here.
Ok, so how is the PropCo capitalized through this GP/LP structure?
Typically, GP equity interests range between 5.0% and 10.0% of the total equity deployed in a PropCo.
- For example: for a $50 million residential development, which seeks to raise $25 million in equity and $25 million in debt, the GP would be required to contribute between $1.25 million and $2.50 , i.e. 5.0% to 10.0% of the total capital increase.
- Since the OpCo is the GP of the PropCo, the $1.25m – $2.50 would flow from the VC + retained earnings (if any) from the OpCo to the GP of the PropCo.
- LPs contribute the remaining 90% – 95% of the fundraising, which in our example would be $22.50m – $23.75m.
How do we think about the governance of the PropCo?
The control and governance of the PropCo is subject to negotiation between LPs and GPs, but there is precedent here. This relationship can be seen through the prism of any other real estate development where the GP is the property developer/manager and the LPs are traditional investors.
Section C: Projected Economics of an OpCo / PropCo Structure
In this section, we examine the projected revenue streams generated for the OpCo by virtue of its participation as a GP in the PropCo; Additionally, we examine how this dual funding structure has a positive impact on dilution for the OpCo.
Looking back, what revenue streams does the OpCo generate from the PropCo?
Three revenue streams to be precise:
- Technology license fees: As noted in Section B above, the OpCo licenses its technology to the PropCo and typically receives licensing fees, spread over a few years. The amount varies from one transaction to another, but generally corresponds to a percentage of the gross or net rents.
- Share of management fees: Separately for being the GP of PropCo, the OpCo receives a share of the management fee, which is between 1.0% and 2.0%.
- Share of interest carried: Additionally, as a GP in the PropCo, the OpCo also gets a share of the interest carried, which is between 15.0% and 20.0% subject to discussions on preferred yields and cut-off rates.
Can we break down the revenue streams from our previous example?
Going back to our example of a $50 million development (50% debt), further assume net rents of $1.0 million/year, technology license fees of 5.0%, management fee of 2.0%, a carry of 20% and an exit price of $100 million, where the OpCo is the sole GP of the PropCo. In this case, the three revenue streams would look like this:
- Technology license fees: The OpCo earns 5.0% of $1.0 million per year = $50,000.
- Share of management fees: PropCo’s sole GP (OpCo) earns 2.0% managing $25M equity/yr = $500,000.
- Share of interest carried: PropCo’s sole GP (OpCo) earns 20% deferred interest of ($100m – $50m) = $10m on exit.
Return to original purpose of the OpCo / PropCo structure, can we show how this structure decreases the dilution for OpCo?
As mentioned above, buying real estate and entering into long-term leases are expensive businesses and management should consider sources of capital that are cheaper than risk dollars.
In our example above,
- The OpCo as a generalist in the PropCo invests $2.5 million in property development (10% of total equity). This represents 100% of the amount of venture capital dollars used to fund the PropCo.
- In the absence of a PropCo structure, for the same project, the OpCo should invest $25.0 million to start the same project.
- Indeed, the PropCo structure allows the company to raise $22.5 million ($25.0m – $2.5m) from a different, cheaper pool of capital.
Section D: Finding PropCo Capital
In this section, we summarize where startups can seek LP pools of PropCo capital, and why this is a growing area of interest for the real estate industry.
How do future LPs think of PropCo vehicles and where to look for them?
- For starters, OpCo/PropCo structures are a relatively new phenomenon. The greatest value proposition for an LP in the PropCo is that the underlying real estate assets generate higher returns – given their technology/product differentiation – than what is available in the market
- A familiar tale: Multifamily assets managed by cohousing operators could potentially generate annual returns of 5.5% to 6.0%, compared to cap rates of 3.5% to 4.0% for multifamily assets of category A. This yield spread of 150 to 200 basis points is an attractive driver for PropCo investors.
- An additional value proposition is the strategic benefits of partnering with a new-age technology company – for many in the real estate industry, the PropCo represents an opportunity to partner with a startup and gain exposure to a new asset-rich business model, without taking excessive software or technology risks.
- With this in mind, the following spheres of capital may show interest in PropCo games: large real estate developers, certain real estate private equity funds with a core/core-plus orientation, dedicated PropCo funds, certain family offices, sovereign wealth funds and former proptech entrepreneurs with significant exits.
In summary, as the real estate technology sector matures, entrepreneurs should increasingly turn to PropCo structures, especially for the heavier parts of their business. This introduces complexity to operations, but the significant reduction in dilution and associated alignment to cost of capital is worth it.