The Nuts and Bolts of PropCo-OpCo

Published in

Alpaca VC

9 min readJan 10, 2023

Authors: Adam Sofen, Daniel Fetner & Ryan Freedman

This post is part of an ongoing series by Alpaca exploring the next generation of real estate and the opportunity we see ahead. New to the series? Start here to read the previous posts.

You’ve already learned why PropCo-OpCo structures are increasingly attractive to both PropTech founders and investors. Now it’s time to start filling in the how: the nuts and bolts of the structure and a few of the most important questions to ask upfront.

For this installment of our ongoing investigation into the future of real estate, we’re excited to welcome the insights and expertise of guest author Adam Sofen. As the head of the U.S. real estate practice at Allen & Overy, Adam has advised clients on PropCo-OpCo structures throughout his career — they’re a flexible and efficient tool that traditional real estate companies have used for years, and they’re well suited to help PropTech ventures, too.

First, a quick recap: In a PropCo-OpCo structure, a business that earns income from real estate segregates its assets into two different entities, each of which is capitalized differently. For a PropTech venture, this means the venture’s real estate assets can be financed more efficiently than with venture capital funds, and it gives access to investment from traditional real estate players who might not have the risk appetite or the institutional mandate to invest directly in PropTech.

Starting Point: What are the building blocks and how do they fit together?

There are lots of variations on the PropCo-OpCo idea, but here’s one typical way it might work for a PropTech venture:

The OpCo owns the venture’s tech, IP, data, and employees. It attracts venture capital like a regular technology startup.
The PropCo owns the venture’s real estate assets, like land, buildings, and leases. Instead of receiving venture capital, it may get financing via traditional real estate financing, (i.e. a mortgage collateralized by the real asset).
In most instances, the PropCo allocator will serve as the GP of PropCo, especially if they have the expertise and are contributing significant capital. (That said, the choice of the GP will ultimately depend on control rights and other various factors).
There may be one or more contracts between the PropCo and the OpCo — for example, a management agreement, financing agreement, license agreement, or a master services agreement.
Under these contracts, the PropCo may pay the OpCo, and/or the OpCo may pay the PropCo, for services rendered.
PropCo pays OpCo (e.g., for the use of the OpCo’s technology or its brand, say, or for the OpCo employees’ management of the PropCo’s assets, or access to the OpCo’s reservation network or software platform).
OpCo pays PropCo (e.g., the PropCo may act as a lender to the OpCo to finance the underlying construction of… say… modular homes, thus collecting interest from the OpCo. Or, in other cases, such as co-working, the OpCo may be a rent-paying tenant to the PropCo).

Real World Example: Glamping

Here’s one way it could work:

The PropCo buys the land/campground and is the borrower under a construction loan facility from a bank that funds part of the acquisition and development cost of new campsites.
The OpCo’s employees manage the campsites on the PropCo’s behalf. Clients book the campsites using the OpCo’s reservation system, accessed via the OpCo’s website, and pay the PropCo nightly rent.
The PropCo in turn pays the OpCo a percentage of its gross monthly rents as a management fee and a license fee for the use of the OpCo’s reservation system.
The PropCo’s profits (net of the management and license fees), are either retained by the PropCo to fund the growth of the campsite network or are distributed to the PropCo’s partners.

That description should sound familiar to commercial real estate investors because it’s essentially how many of the best-known real estate firms are organized today. The PropTech twist is that the relationship between the OpCo and the PropCo is even more symbiotic; the OpCo — the technology company — unlocks additional value while the PropCo allows the OpCo proof of concept and scale.

In fact, the logic of the PropCo-OpCo structure can be extended to the point where the PropCo and the OpCo are entirely separate companies without common management at all. That’s how much of the U.S. hotel industry works today: one company (the equivalent to our PropCo) owns the hotel, while other unaffiliated companies (equivalents to our OpCo) manage it and own the brand under which it is marketed, (which is why brands like Hyatt and Marriott increasingly own little actual real estate).

Getting Down to Business — How do Founders and Investors execute on PropCo-OpCo?

Given how widely used PropCo-OpCo structures are and how different the industries use them, the specifics of the PropCo-OpCo contract (and the terms under which the PropCo is governed) can vary widely — they will depend among other things on:

The venture’s business model.
The type and capital intensiveness of its real estate.
The founders’ goals and their relationship with their funding partners.

Because there is no one-size-fits-all template, when we sit down with founders to set up a PropCo-OpCo structure there are a few key questions we ask them to consider. Let’s unpack these questions in more detail:

Question #1: How will the PropCo be capitalized?

More than anything, the specifics of the structure and the details of the PropCo-OpCo contract will turn on this question. However, in a typical transaction:

The PropCo is capitalized by third-party debt secured by the property and equity from real estate investors.
The OpCo is capitalized by venture capital and bank financing.

Each component will have different costs of capital, covenants, security, and risks. In order to optimize the capital structure it is important to have a partner that is fluent in both real estate and venture capital capitalization models.

One of the major advantages of the PropCo-OpCo structure for a PropTech venture is that the equity in the PropCo can be marketed to limited partners from the traditional real estate world, such as investment funds and family offices. These capital providers may not have the appetite or internal authorization to invest in pure-play technology startups, thus they may find PropCo equity fits their requirements while also offering them the potential for higher returns than a legacy real asset class.

It’s worth noting that at all levels of the capital stack, as GCM Grosvenor’s Mo Saraiya points out in this terrific webinar, a PropCo-OpCo structure will generate more interest from both lenders and investors if the PropCo’s real estate has intrinsic value that can be easily repurposed by a different business if the PropTech venture isn’t successful.

Question #2: Who makes decisions for the PropCo?

In most instances, the general partner of the PropCo will retain ultimate decision-making authority over the PropCo’s business — that is the role of the real estate investors.

But the other parties in the PropCo capital stack will insist on a say as well.

The OpCo can have input on the types of real estate, the improvements, and the management of the underlying assets.
A mortgage lender usually negotiates for the right to approve important property-related decisions, like property purchases and property sales, budgets, major capital expenditures, and large leases. The mortgage borrower is normally subject to detailed affirmative and negative covenants regarding property-related matters, and the cash flow from the property is distributed according to a pre-set waterfall (often through bank accounts controlled by the lender).
Major LPs usually get certain rights such as veto rights over a variety of “major decisions” (generally more extensive than the consent rights afforded to limited partners in a fund structure), and the right to remove the general partner and unwind the joint venture for cause, (usually limited to serious matters like fraud, willful misconduct, material breach of the joint venture agreement or criminal acts, but sometimes also including a “key person” event resulting from the founder’s departure from the business).

There’s no getting around the fact that taking a PropCo lender’s or a PropCo LP’s money likely means giving that lender or LP a voice in major matters.

Mitigating Risks: There are a few ways a founder can mitigate the risk of being hamstrung by disagreements

Resolve as much as possible upfront, but try to build in flexibility. Both the PropCo lender and the PropCo LPs should sign off on an initial business plan that allows the PropCo to execute a growth plan without second-guessing. But since a PropTech venture will put an even higher premium on agility and the ability to change course than a traditional real estate owner would, the PropCo should try to negotiate for flexibility — for example, the right to scale up with new properties or offload poorly performing ones — even at the expense of maximizing PropCo capital proceeds. The most important rights should be discussed at the term sheet phase, to put a stake in the ground.
Pick partners who share your vision. Because even the most founder-favorable documents will still give the PropCo lender and PropCo LPs a seat at the decision-making table, it’s crucial to pick them carefully. The founder may want to prioritize choosing partners they know well and who have a demonstrated track record of cooperative and creative relationships in the PropTech world.
Give PropCo investors a share of the upside. The Alpaca team likes to ensure that the PropCo’s LPs acquire warrants in the OpCo when it makes sense for both parties. This makes the LPs happy (by giving them a slice of the PropTech venture’s upside potential), but — more importantly, from the founder’s perspective — it promotes alignment of interest with the LPs and encourages them to view their investment as a long-term partnership.

Question #3 What is the economic deal between the PropCo and the OpCo?

As discussed above, there are a few possible avenues for the OpCo to be compensated from the PropCo’s revenue streams:

Fees: Under the PropCo-OpCo contract, the OpCo may get a fee stream from the PropCo, frequently calculated as a percentage of the PropCo’s gross revenues.
Net cash flow and net proceeds: To the extent the OpCo retains a common equity stake in the PropCo, it will also be entitled to its share of regular (non-carried interest) distributions to the LPs of net cash flow and net proceeds from property sales or refinancings.

For the PropCo, the revenue streams and returns come primarily from the following:

Rent: The PropCo may receive rent from third-party tenants or from the OpCo itself.
Interest: The PropCo may serve as the lender to the OpCo for project financing, in which case it will collect interest on the loan.
Warrants to buy interests in the OpCo.
Asset appreciation as the technology enhancements from the OpCo may result in the real estate becoming more efficient and valuable.

When it comes to assessing the dynamic between cash flows, fees, shared revenue streams, and asset appreciation, readers will quickly recognize the “flywheel” effect that begins to take place between the OpCo and the PropCo.

Looking Ahead: A New Lens to View the PropTech World

While this overview is by no means inclusive of all the intricacies associated with structuring PropCo-OpCo transactions, nor is it meant to highlight “market” terms, we hope founders and investors can draw upon the content to think about structuring their respective businesses and investments in a new and, potentially advantageous construct. We see a tremendous opportunity for both founders and real asset allocators to continue fueling the transformation of an industry by working together and thinking creatively as to the best approaches for structure, synergies, and value creation. Let us know how we can help!

Please Reach Out!

If you’re an entrepreneur considering a PropCo-OpCo structure or an institution exploring the PropCo space, please reach out to adam.sofen@allenovery.com, daniel@alpaca.vc and ryan@alpaca.vc. We’d love to speak with you.

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