REPAYMENT AMOUNTS Case study: variable loan, based on free cash flow for cacao co.

A foundation invested in an emerging market cacao supplier, using debt with repayment paid back as a share of free cash flow, until a repayment cap is met.

The investment was structured to help maintain founder control, as the founder viewed the company as a long-term enterprise with no logical buyer or other traditional “exit.” In addition, the parties wanted to: (1) maximize the company’s use of the investment to accelerate growth before repayment and (2) protect investor downside (through debt seniority) while share participation in upside (through conversion option and participation rights).

Target IRR: 15% +

Deal type: Subordinated Variable Payment Debt

Company: The company is a Central American supplier of cacao that assists local cacao farmers with financing and training, in addition to sourcing, processing (fermenting and drying), and exporting cacao to high-price markets. At the time of investment, the enterprise had over 2 years of operational history and had achieved revenue. The founders projected profitability after 3 years from the time of investment.

Investor: The investment was led by an impact-oriented foundation, whose mission is to use market-based solutions to eradicate extreme poverty. The investment targeted financial returns slightly below market rate.

Key innovation

Flexible repayment terms and cash flow-based royalty: The unique approach is reflected in the repayment terms, which provide:

  1. a 2-year repayment holiday,
  2. payments computed by reference to free cash flow (similar to operating profit), and
  3. total payment of 2x issue price, anticipated in about 7 years, based on a mutually agreed upon business plan outlining the Company’s projected spending, revenue, and capital use.

Special considerations

Tax considerations: Characterization as debt: The original term sheet lacked a “hard” maturity date, which created an issue of whether the instrument may be characterized as equity rather than debt for tax purposes. As a result, a 10-year maturity was added with a Company agreement to use best efforts to complete repayment by year 7.

“Original issue discount” (OID): The instrument generates OID, primarily due to the variable payment structure but also as a result of the 2-year payment holiday. The OID on this debt instrument will likely require reporting using the “noncontingent bond method” under the OID rules.

Other considerations: Skill- and time-intensive investment: This investment required a higher-than-average skill/experience level of the investment team, largely due to (1) negotiation/determination of the business plan and (2)  the tax and OID issues (see above). The investment team relied on substantial (pro bono) legal assistance to finalize the investment, although many of the complicated legal and tax issues addressed exist in other impact investment structures and are not unique to this investment.

Significant prior relationship: The Company and investors had (1) a high level of confidence in each other, (2) a significant alignment of financial and impact goals, and (3) a strong, positive relationship, all of which helped to overcome the legal and tax issues and reach agreement on the requisite business plan. On deals without an extensive relationship and history between the parties, it may be necessary to compute payments using a “top line” metric, such as gross sales (rather than free cash flow).

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