Equity Sharing 101 (Part 2)

By Andy Sirkin (Part 2 of 2)

Previous: Click here to read part 1 of this article…

[Author’s note: This material has been excerpted from The Equity Sharing Manual, first published by John Wiley and Sons in November 1994 (order the book). While it remains useful and relevant, it is not as current and complete as the more recent article Questions and Answers on Equity Sharing, and we suggest reviewing that article before reading this one.]

Concluding The Equity Share

What happens at the end of the equity share?

Most equity sharing arrangements are intended to last for a specific time period or “term”. At the end of the term, the occupier has the right become sole owner of the property by buying out the investor. If the occupier chooses not to buy out the investor, the investor may buy out the occupier. The equity sharing contract provides a formula for calculating each owner’s buyout price. If neither party wants to buy out the other, the property is sold and the sale proceeds are distributed among the owners.

How do the owners calculate the buyout price?

The value of each owner’s share in the property is called “Cotenant Equity” and is the sum of the owner’s Capital Contributions and profit share. Cotenant Equity is the price for an owner’s share in the event of a buyout or the amount of an owner’s proceeds in the event of a sale.

Guide–Calculating Cotenant Equity

Assume Elm Street appreciates from $200,000 to $250,000. In addition to Initial Capital Contributions of $14,500 by the Smiths and $10,500 by Laura,, the owners made Additional Capital Contributions of $3,000 by the Smiths and $2,000 by Laura. They also agreed that the Smiths would get credit for $594 in Monthly Capital Contributions.

Step 1: Calculate Total Equity

Appraised Value $250,000
Cost Of Sale (6.5%) <16,250>
Mortgage Balance <175,000>
Total Equity $58,750

Step 2: Calculate Capital Contributions

Initial Capital Contributions $25,000
Additional Capital Contributions 5,000
Monthly Capital Contribution 594
Total Capital Contributions $30,594

Step 3: Calculate Total Profit

Total Equity $58,750
Total Capital Contributions <30,594>
Total Profit $28,156

Step 4: Calculate Davidson Cotenant Equity

Davidson Initial Capital Contribution $10,500
Davidson Additional Capital Contribution 2,000
Davidson Profit Share (45% X 28,156) 12,670
Total Davidson Equity $25,170

Step 5: Calculate Smith Cotenant Equity

Smith Initial Capital Contribution $14,500
Smith Additional Capital Contribution 3,000
Smith Monthly Capital Contribution 594
Smith Profit Share (55% X 28,156) 15,486
Total Davidson Equity $33,580

This relatively simple calculation yields each owner’s buyout price. It also approximates the amount each would receive if Elm Street were sold. Actual proceeds would be different if the sale price were not exactly $250,000 or the costs of sale were not exactly 6.5%. Calculating Cotenant Equity is more difficult if the property value stays the same or goes down.

Why subtract “costs of sale” in a buyout?

The calculation of Cotenant Equity should always include the subtraction of the approximate seller closing costs even though these costs will not actually be paid in a buyout. This procedure prevents the purchasing owner from paying more in a buyout than the selling owner would receive in a market sale.

What happens to the mortgage in a buyout?

As part of a buyout, the purchasing owner must either refinance or convince the original lender to remove the other owner’s name from the existing loan.

Example–Buyout Mortgage Options

Assume Elm Street is worth $250,000 and the Smiths need $25,170 to buy out Laura.

  • Option 1: Refinance
    The Smiths would need to qualify for a large enough loan to pay off the balance of old loan ($175,000), pay Laura ($25,170), and pay any loan fees associated with the new loan.
  • Option 2: Keep Existing Mortgage
    The Smiths would need to convince the lender that they were qualified for the loan and that it could safely release Laura as a borrower. They would also need to either have the $25,170 in cash or be able to borrow that amount from a relative, friend or “home equity” lender.

What is the buyout procedure?

The owners begin by establishing the value of the property, and calculating the investor’s Cotenant Equity as described in above. The occupier then has a specific time period to determine if he can afford to buy out the investor. Since loan qualification is often a major factor is the occupier’s decision to purchase, the time period should be sufficient for the occupier to shop for a loan, submit loan applications, and get a commitment from a lender.

If the occupier decides to complete a buyout, he gives written notice to the investor along with a good faith deposit. An occupier who cannot afford a buyout and is reluctant to move might try to delay sale by giving a buyout notice. To prevent this tactic, buyout notices should be binding and an owner should face penalties if he fails to complete a buyout after giving a notice. This will deter owners from using the buyout procedure to delay sale of the property. Because the notice is binding, the occupier must be certain he can afford the buyout before giving the notice.

The buyout closes 60 days later when the investor deeds his ownership share to the occupier and receives his Cotenant Equity in cash. All transaction costs, including bank fees, escrow fees and recording fees, are paid by the occupier because costs of sale were already subtracted from the investor’s proceeds during the calculation of Cotenant Equity.

If the occupier waives his right to buy out the investor, the investor can buy out the occupier using the same procedure.

The most important element of a buyout procedure is strict time deadlines. Buyout deadlines insure that either a buyout or a sale takes place on or close to the originally scheduled end of the equity sharing term. Keeping the term on schedule is very important if one of the owners is depending on receiving his money on a certain date. In our agreement, the occupier’s buyout right expires four months before the end of the equity sharing term. The investor has 30 days after this expiration to make up his mind. This means that all buyout rights have ended three months before the end of the term, allowing ample time to market the property if both buyout rights are waived.

What if neither owner wants a buyout?

If both owners waive their buyout rights, the property is offered for sale. Most owners have no difficulty completing the selling process without referring to the equity sharing agreement. But some owners don’t agree on pricing strategy, choice of real estate agents, or acceptance of an offer. Disputes frequently stem from differences in owners’ motivations to sell. To avoid these disputes, the equity sharing contract should provide a detailed process for pricing and selling the property designed to keep the sale process moving forward on schedule. The owners are free to ignore it unless there is a dispute.

Example–Potential Sale Dispute

Suppose that when preparing their equity sharing contract, the Elm Street owners insist that details of selling the property be left out. They reason that everyone will have the same goal, to get as high a sale price as possible, and they feel uncomfortable tied down to a mandatory sale procedure.

At the end of the equity share term, the Smiths cannot afford to buy Laura’s share but love the house and the improvements they have made and hate the thought of moving. Laura is pregnant and has found her dream house in a Chicago suburb. She is in contract to buy it and needs her money from Elm Street as soon as possible.

Everyone thinks that Elm Street is worth $250,000-$270,000. The Smiths figure they can wait until a buyer comes along who really appreciates the house, and they don’t want to leave one dime on the table. Their price: $269,000, firm. Laura needs a quick sale to get out of her tiny apartment before the baby is born. Her price: $249,000. They compromise at $259,000.

A month passes with no offers. Laura’s due date is three months away. She begs the Smiths for a price reduction. They are sympathetic, but say they simply cannot afford to take less. Neither party feels they can compromise further.

List–Sale Rules

  • Rule 1: Begin At Appraised Value
    If you cannot agree on initial asking price, follow the appraisal procedure, and price the property at appraised value.
  • Rule 2: Real Estate Agent Selection
    Designation of a particular agent is appropriate if both owners used the same agent for acquisition and were pleased with his services. Otherwise, require an agent who has no previous relationship with either owner. That way, if you are unable to agree to use a particular owner’s agent, neither owner or agent will feel as if the other is being favored. Some alternatives to this approach include: a provision for co-listing by two agents, one picked by each owner, or a short listing periods where the owners’ agents alternate; but most agents feel that these strategies interfere with the marketing effort.
  • Rule 3: Mandatory Price Reduction
    Require a reduction of 5% each time an asking price has been unchanged for 30 days. Many owners balk at rapid price reductions. They know how much their property is worth and the buyers who are staying away are mistaken as to value or just cheap. Sometimes their price is backed up by one or even two appraisals, proving the buyer are wrong. But if a property has had no sales activity for 30 days, it is overpriced. It is unfair for one owner to delay the end of the equity sharing term by being stubborn or unrealistic. A mandatory price reduction program is the most critical element of a sale-related section in an equity sharing agreement. If Elm Street had appraised at $250,000, the owners could still have agreed to list it higher; but when that strategy failed, they could have relied on their agreement to resolve their price-reduction dispute.
  • Rule 4: Mandatory Acceptance of List Price Offers
    Mandatory price reductions may not be enough to resolve disputes between a motivated and an unmotivated owner. Require that the owners accept any offer at or above list price. Otherwise, an owner who was forced by the contract to allow a price reduction can prevent a sale by refusing to accept an offer.

How do the owners determine appraised value?

Establishing property value is the starting point of both buyout and sale. In buyout, the value becomes the basis for determination of buyout price; in sale, it becomes the initial asking price. The equity sharing contract must have specific and mandatory appraisal provisions.

Example–Potential Appraisal Dispute

Suppose again that at the end of the Elm Street equity share term, Laura is very anxious to get her money but the Smiths would prefer to continue to live in the home Thinking that it will save time and money, the owners agree to use a single appraiser who, two weeks later, values the property at $250,000. The Smiths strongly disagree with this appraisal, and now insist on having another one. Laura reluctantly agrees. The Smiths select another appraiser who is an old friend. Two weeks later the new appraiser values the property at $280,000. Laura thinks this is too high, and she will not agree to average the appraisals because she questions the impartiality of the second appraiser. On the other hand, she can’t afford to wait another two weeks for a third appraisal. The Smiths say they will not pay for any more appraisals, and will not agree to a price below $275,000 no matter what additional appraisals say.

List–Appraisal Rules

  • Rule 1: Binding Appraiser Selection
    You may jointly select a single appraiser, or each select a separate appraiser and average the two appraisals. Either way, you are bound by your selection and cannot insist on repeated appraisals until you get one you like. This approach insures that there will be no arguments and no delays in the buyout or sale procedures.
  • Rule 2: Strict Time Limits
    One owner is often more anxious than the other to complete the appraisal process. To avoid delays, provide firm dates for selection of all appraisers and completion of appraisals.
  • Rule 3: Appraiser Qualifications
    Set minimum standards for appraiser qualifications of appraisers. Most modern agreements allow appraisals by any licensed appraiser or real estate agent. Many owners prefer to use real estate agents because they are generally less expensive than professional appraisers and no less likely to arrive at an accurate valuation. Require at least two years local experience.
  • Rule 4: Impartiality
    Disqualify appraisers with a prior business or personal relationship with either owner. Each owner should have confidence that the appraisers selected by the other owner will give an honest and impartial opinion of value.
  • Rule 5: Cost
    Share the cost of joint appraisals; otherwise, have each owner pay his own appraiser.

What if an owner needs to leave the equity share early?

Each owner wants and needs the security of knowing that the other cannot force a sale before the end of the equity sharing term. The occupier needs this security because moving is traumatic, expensive and time consuming. He may also make some non-reimbursable improvements which he expects to be able to enjoy using for the full equity sharing term. The investor needs this security for proper financial planning; he does not want to be forced to scramble for an alternate investment at an inopportune time. He also wants to maximize the possibility that he will make money on the equity share and, historically, appreciation is more certain over a longer holding period. To provide security for both owners, most equity sharing contracts do not allow either to force an early sale at will.

Unfortunately, circumstances like job loss, job transfers, and illness sometimes require owners to leave the equity share early. Most agreements provide several alternatives for these owners. One alternative for the occupier is to rent out the property. The other common alternatives are sale of one owner’s share, and early sale of the entire property.

Under what circumstances can an owner sell his share?

An owner’s right to sell must be restricted because of the sale’s possible effect on the other owner. Each owner depends on the other’s financial strength, stability, judgment, fairness and willingness to compromise. The agreement must protect each owner from being forced to continue an equity share with a less dependable new owner. But it must afford this protection without prohibiting all transfers.

Our agreement permits all transfers to other owners, spouses and ex-spouses. This ex-spouse provision is necessary to accommodate marital separations. Transfers to trusts are also allowed provided they don’t shift control of the property. The common thread in all of these transfers is that control remains in the hands of original owners.

If there will be a new owner, whether by sale or gift, the remaining original owner must have an opportunity to reject the new owner. Our agreement allows rejection on any “reasonable” basis after review of financial information and a personal interview. Some agreements only allow rejections on financial grounds. This arrangement minimizes the likelihood of rejection and makes interviews unnecessary. But it is easy to imagine a prospective owner who is financially qualified but otherwise unsuitable for the responsibilities and inter-personal demands of co-ownership. Laura’s evil twin sister Polly, a Chicago commodities trader, is a good example. She is wealthy, but well-known to be a shark. She would not default, but she would make the Smith’s lives absolutely miserable. If Laura decides to raise some cash by selling her equity sharing interest in Elm Street to Polly, the Smiths will need to reject her on non-financial grounds.

What counts as a “reasonable” basis for rejecting a new owner? Any reason to doubt financially qualification, financially stability, honesty, reliability, or cooperation. The judgment must be based on the submitted financial data, credit histories, statements made by personal references, and statements made during the interview. If you cannot point to a specific piece of information or a specific statement as the basis for your doubt, it is probably not reasonable. Where a prospective owner is a member of a legally protected group such as racial or ethnic minority, take particular care to establish evidence that the rejection was not based on prejudice; otherwise, you may be sued. To force owners to develop legitimate bases for rejection, the agreement should require that the bases be stated in writing.

Where an owner sells his share, the other should have both a right of rejection and a right to purchase (also called a “right of first refusal”). The right may be exercised at asking price or any lower price which the seller intends to accept. But if an owner declines to purchase at asking price, he cannot change his mind if a buyer later offers that price or more.

Example–Purchase Right On Partial Sale

Assume Laura decides to offer her Elm Street interest for sale at $25,000. She notifies the Smiths, who can afford to buy feel the price is too high. They decide to wait until Laura becomes more realistic and then buy. If Laura gets an offer for $21,000 which she wants to accept, the Smiths will have an opportunity to match it and their strategy will have paid off. But if Laura gets an offer for $26,000, the Smiths will have lost their chance. (Of course, if the buyer is Polly, they can still reject her.)

Once a new owner has been approved, he is permitted to review the financial information of the remaining owner. It is possible that the financial condition of the remaining owner has deteriorated since the equity share began. The new owner has a right to know that trouble may be ahead.

In some states, partial sale can trigger a property tax increase. This could force the occupier to make higher payments. To prevent unfairness, the contract should provide that a new investor pay any increase in property taxes that results from his acquisition.

What if an owner must leave early but can’t sell his share?

It makes sense to allow the occupier to force an early sale of the property provided he compensates the investor for financial losses. If the occupier can’t or won’t live in the property, his obligations are going to be extremely burdensome and it is better for both owners to end the equity share than to risk financial disaster. But this argument does not support allowing an early sale by the investor who has few ongoing obligations to the equity share. Moreover, while the occupier can pay money to negate the investor’s losses, the investor cannot negate the loss of the occupier’s home.

Example–Need For Occupier Early Sale

Suppose that George is transferred to Duluth, Minnesota at the end of year two of the Elm Street equity share. Even if the Smiths could rent Elm Street for $1100, it would not cover all of their monthly payments ($1,354 before tax deductions) plus the cost of hiring someone to fulfill their maintenance and repair responsibilities (probable about $100 per month). Then if Elm Street comes vacant, they will have to pay a rental commission to get a new tenant and cover the lost rent. Through it all, they will need to continue to perform the bookkeeping and bill paying functions. With all these costs, risks and time commitments, the odds of a default rise dramatically. All things considered, Laura is better off if the equity share ends than if it continues.

Under our contract, when an occupier forces an early sale, the investor may choose to receive either his Cotenant Equity or his original investment with interest. If the total sale proceeds are less than the investor’s original investment with interest, the occupier must pay the difference. This requirement insures that the investor will not suffer a financial loss as a result of occupier’s change of mind or bad luck. Before selecting the interest option, the investor should check the income tax impact.

Example–Investor Compensation On Early Sale

Assume that the property value is $210,000, and that Laura has made two Additional Capital Contributions: $1,000 in the month six and $1,000 in month twelve. Using Guide 3.7.2.A., her Cotenant Equity is $8,618. Her other choice is her $12,500 investment with 12% interest.

Davidson Initial Capital Contribution $10,500
12% interest for 2 years 2,520
Davidson Additional Capital Contribution #1 1,000
12% interest for 18 months 180
Davidson Additional Capital Contribution #2 1,000
12% interest for 12 months 120
Total $15,320

After checking with her accountant regarding tax effects, Laura chooses the $15,320. If the total sale proceeds are $21,350, Laura gets $15,320 and the Smiths get the remainder, $6,030. If the total sale proceeds are $10,000, Laura would get the entire amount and the Smiths would owe her another $5,320. Under the Elm Street agreement, the Smiths could pay in cash or monthly payments over three years.

Common modifications of this early sale provision include lowering the interest rate or limiting the investment-plus-interest option to the first two years of the equity share. Another variation eliminates the investment-plus-interest option where the early sale is caused by specific events such as job loss, transfer, and illness. The problem with this approach is that the list can never be exhaustive enough to cover all the situations in which the occupier might need to cause an early sale, and the event that actually occurs will probably be the one left off the list. Yet another variation eliminates the investment-plus-interest option where the early sale is caused by any event “beyond the control of occupier”. But it is never clear whether a certain event qualifies. For example, if the occupier is offered a better job in another town, has an event occurred that is “beyond the control of occupier”? Should the investor suffer a loss? Avoid potential disputes by requiring that the occupier reimburse any loss from his Early Sale.

About the Author

Andy Sirkin has helped structure equity sharing transactions since 1985. In addition to advising homeowners, homebuyers, and private investors on shared equity financing, and preparing documentation for more than 500 equity share arrangements, he has counseled and prepared webpage copy, contracts and agreements for six equity sharing startups, and worked with businesses, local governments, churches, and educational institutions  to structure equity sharing programs. He has also advised government prosecutors in two prosecutions involving fraudulent and illegal equity sharing businesses. He is the author of The Equity Sharing Manual, first published by John Wiley and Sons in November 1994 (order the book).