Section A: Introduction
In this section, we give an overview of an OpCo / PropCo structure, and point out some instances where it might make sense.
What is an OpCo / PropCo structure?
Put simply, a dual financing 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 holds the IP. The OpCo is typically financed by venture capitalists.
And then, what is the PropCo?
Think of the PropCo as the entity that acquires land, signs leases, and in general, holds the more capex and duration intensive parts of the business. The PropCo should typically not be financed by VCs, especially after the company has secured product-market fit (think Series A and beyond). Alternative sources of capital such as PropCo funds, real estate developers, credit funds and the like are increasingly looking at PropCo financing opportunities.
Why go for an OpCo / PropCo structure?
- In short, it leads to less dilution and better alignment of risk with the associated cost of capital — see Section C for more details and a numeric example.
- Venture capital, by some measure, is the most expensive source of capital; once a business has been derisked beyond a certain point, there’s merit in stripping out the more asset-heavy parts of the business, and financing them with alternative, cheaper sources of capital.
- This typically applies for businesses that are assuming contractual liabilities (think leases) or buying fixed assets (think land parcels or furniture) and can demonstrate relatively stable cash flows at scale (think cash flows from co-living assets that operate at stabilized occupancy).
What are some business models where the OpCo / PropCo play makes sense?
- Dark stores, where operators are signing leases and unable to secure management share agreements. Such leases can / should be typically financed by pools of capital that don’t come from VCs.
- Co-working companies, where once again operators are signing leases or buying assets, instead of signing management share agreements.
- Co-living companies. The same rationale as above, though one could also finance the upfront capex (for example, furniture) through alternative pools of capital.
- Short-term rental operators where the landlord/property manager is assuming the asset or lease on their balance sheet.
- Health, wellness, and fitness startups, where the operators are opening physical spaces which augment the mobile/tech offering.
- Full-stack, tech-enabled real estate developers and general contractors.
- Experiential retail companies with physical locations.
- Self-storage and logistics companies that are optimizing space and operations by owning or leasing the underlying asset.
When do PropCo structures not make sense?
- When the physical asset ownership or long-term liability is a one-off scenario for the business to prove out that the tech works, which is the primary focus of the team.
- When leadership is clear-eyed about scaling through management share agreements only.
- In the early days of a company, when signing leases or owning assets through venture capital is a quick way to scale and build track record to eventually look at alternative financing sources.
Section B: Getting a bit granular
In this section, we look at capitalization and governance for OpCo and PropCo entities controlled by the same management. For aid of understanding, we will be looking at one example where the OpCo serves as a GP in the PropCo entity (more below). There are more variations to this relationship but the conceptual framework broadly remains the same.
How do we start thinking about executing an OpCo / PropCo structure?
To simplify things, we would break it down into 3 buckets:
- Capitalization and governance of the OpCo.
- Relationship between the OpCo and the PropCo.
- Capitalization and governance of the PropCo.
So what about capitalization and governance of the OpCo?
- As far as the capitalization and governance of the OpCo are concerned, nothing significantly changes post the introduction of a PropCo: the VCs remain the same; the governance remains the same; the management and VC’s stake in the OpCo remains the same.
- The OpCo continues to function as a technology company, focused on writing software, building product, and analyzing data. It subsequently licenses its technology to the PropCo for a fee.
What is the relationship between the OpCo and the PropCo?
- PropCos, quite often (not always), are structured as GP/LP entities. For the purpose of this piece, we will assume that to be the case.
- In such cases, the OpCo is either the sole GP or the co-GP of the PropCo.
- The LPs for PropCos are a growing and evolving breed — see Section D for more details here.
Ok, so how does the PropCo get capitalized via this GP/LP structure?
Typically GP stakes vary between 5.0% — 10.0% of the total equity deployed in a PropCo.
- As an example: for a $50 mn, ground-up residential development that is looking to raise $25 mn in equity and $25 mn in debt, the GP would be required to contribute anywhere between $1.25 mn — $2.50, representing 5.0% — 10.0% of total equity raise.
- Since the OpCo is the GP of the PropCo, the $1.25 mn — $2.50 would flow from VCs + retained earnings (if any) in the OpCo to the GP of the PropCo.
- The LPs contribute the remaining 90% — 95% of the equity raise, which in our example would amount to $22.50 mn — $23.75 mn.
How do we think about governance of the PropCo?
Control and governance in the PropCo are subject to negotiation between LPs and GPs but there is precedence here. This relationship can be viewed from the prism of any other real estate development where the GP is the developer/property manager and the LPs are traditional brick-and-mortar investors.
Section C: Projected Economics of an OpCo / PropCo structure
In this section, we look at projected income streams generated for the OpCo by virtue of its participation as a GP in the PropCo; further, we look at how this dual financing structure positively impacts dilution for the OpCo.
Circling back, what income streams does the OpCo generate from the PropCo?
Three income streams to be precise:
- Technology licensing fees: As referenced in Section B above, the OpCo licenses its technology to the PropCo and typically gets a licensing fee, spread across a few years. The amount varies from deal to deal but is usually a % of gross or net rentals.
- Share of management fees: Separately for being the GP in the PropCo, the OpCo gets a share of the management fees, which is anywhere between 1.0% — 2.0%.
- Share of carried interest: Further, as the GP in the PropCo, the OpCo also gets a share of the carried interest, which is anywhere between 15.0% — 20.0% subject to discussions around preferred returns and hurdle rates.
Can we break the revenue streams down from our preceding example?
Going back to our example of a $50 mn ground-up development (50% debt), let us further assume net rentals of $1.0 mn/year, a 5.0% tech licensing fees, a 2.0% management fees, a 20% carry, and an exit price of $100 mn, where the OpCo is the sole GP in the PropCo. In this case, the three income streams would look the following:
- Technology licensing fees: The OpCo earns 5.0% of $1.0 mn / year = $50,000.
- Share of management fees: The sole GP (OpCo) in the PropCo earns 2.0% in managing $25 mn in equity / year = $500,000.
- Share of carried interest: The sole GP (OpCo) in the PropCo earns 20% in carried interest of ($100 mn — $50 mn) = $10 mn upon exit.
Going back to the original raison d’etre of the OpCo / PropCo structure, can we show how this structure lowers dilution for the OpCo?
As alluded to above, buying real estate and entering long-term leases are expensive undertakings and management should consider cheaper sources of capital than venture dollars.
In our example above,
- The OpCo by virtue of being a GP in the PropCo invests $2.5 mn in the real estate development (10% of total equity). This represents 100% of the amount of venture dollars used to fund the PropCo.
- In the absence of a PropCo structure, for the same project, the OpCo would have to invest $25.0 mn to get the same project up and running.
- In effect, the PropCo structure allows the company to raise $22.5 mn ($25.0 mn — 2.5 mn) from a different and cheaper pool of capital.
Section D: Finding PropCo Capital
In this section, we summarize where startups can look for LP pools of PropCo capital, and why this is an area of growing interest for the real estate industry.
How do prospective LPs think about PropCo vehicles and where does one look for them?
- To begin with, OpCo/PropCo structures are a relatively new phenomenon. The biggest value proposition for an LP in the PropCo is that the underlying real estate assets generate higher yields — given their technology/product differentiation — versus what’s available in the market
- A familiar narrative: Multi-family assets run by co-living operators could potentially generate 5.5% — 6.0% annual yields compared to 3.5% — 4.0% cap rates for Grade A multi-family assets. This 150–200 bps spread in yields is an interesting driver for PropCo investors.
- An additional value proposition is the strategic benefits of partnering with a new-age technology firm — for many stakeholders in the real estate industry, the PropCo represents an opportunity to partner with a startup and get exposure to a new asset-heavy business model, without taking excessive software or technology risk.
- With this in mind, the following spheres of capital may evince interest in PropCo plays: large real estate developers, select real estate private equity funds with a core/core-plus focus, dedicated PropCo funds, select family offices, sovereign wealth funds, and former proptech entrepreneurs with meaningful exits.
In summary, as the real estate technology industry matures, entrepreneurs should increasingly look at PropCo structures, especially for the more asset-heavy parts of their business. This does introduce complexity in operations but the meaningful reduction in dilution and associated alignment with the cost of capital makes it well worth the consideration.