John Berger

Global Guide to Revenue Based Finance

Background

The purpose of this guide and the related articles, is to accelerate the ability for the global community of impact investors to use alternative investment structures. This guide is designed to help entrepreneurs and investors navigate the different legal frameworks that influence alternative investment structures available throughout the world.

Globally the traditional investment structures of debt and equity are well understood and low cost to utilize. The rise of impact investing, catalytic capital, and other innovations has motivated investors and enterprises to seek non-traditional investment structures that better align their financial and impact intentions. One of these emerging structures is Revenue Based Finance. 

The growth of Revenue Based Finance (RBF) has been motivated by the desire for investment structures that provide greater flexibility to entrepreneurs with business models that are not as well suited for traditional debt and equity financing.  For example, Revenue Based Finance is often used when companies don’t yet have predictable cash flows to service debt, and where equity investors cannot reasonably expect to be able to exit their investment. 

Through this guide, you will be able to learn about some of the most common ways to structure Revenue Based Financing investments across multiple jurisdictions.

Methodology

Given the complexity of international legal frameworks, this guide initially includes eight countries, selected because of the nature of their impact investor communities and to include global representation.  The initial countries are (each country title links to that country page)

For each country in this guide, there is a separate country guide that includes information on:

  • For each legal structure explored
    • The legal and tax category (is it considered equity or debt?)
    • Governance rights
    • Investor Qualification Requirements
    • Currency Considerations
    • Collateral Consideration (when relevant)
    • Priority Payment Rights (when relevant)
    • Distribution and Redemption Limitations
    • Legal Limitations to Pricing or Total Return (eg Usary laws)
    • Status in Insolvency Proceeding
    • Limitations of Liability
    • Transfer Restrictions
    • Critical Tax Considerations

Revenue Based Finance Options By Country

Summary Observations

Dependence on Existing Corporate Structures

In all of the countries in this guide, the proposed Revenue Based Finance structures are created using modification of existing debt or equity structures.  We found no instance where a country’s laws specified a corporate structure specifically designed for Revenue Based Finance.  

Common Legal Impediments

The primary restrictions on Revenue Based Finance are related to each country’s laws on the issuance of dividends, share repurchases, and usury.

For Equity Based structures, some countries limit the distribution of dividends either by requiring board authorization for the approval of each dividend, or by constraining the total payment of dividends to retained earnings or some other measure of excess capital.  

The limitations on the amount of dividends have significant structuring implications.  Early stage companies or companies with low, seasonal,  or highly variable profits are likely to have periods where their legal ability to pay dividends is restricted, thus reducing investors’ potential returns.  

  • Singapore had no such restrictions. 
  • Germany: “Any payment of Guaranteed Dividends can therefore only be made from free capital, i.e., distributable profits and distributable reserves”.  
  • Brazil: “The Brazilian entity must have accrued profits in its financial statements sufficient to offset any losses from previous fiscal years, so that the positive difference may be distributed.”
  • Mexico: “No distribution of dividends is allowed if there are no net profits or if 5% of the net income has not been separated for forming the statutory reserve.“
  • South Africa: “ In order to declare a dividend, it must reasonably appear that the company will satisfy the solvency and liquidity test as set out in section 4 of the Companies Act.”
  • England and Wales had no such restrictions.
  • The Netherlands: “Permissible only if the company’s equity exceeds legal or statutory reserves.”

In the face of limitations on dividends, the primary structuring option for Equity Based RBF structures is redemption at a premium above par. This guide did not explore limitations on above par redemption in sufficient detail.

For Debt Based structures, the primary structuring consideration is usury laws. Because of the variability of revenues, it is easy for Revenue Based structures to have periods that deliver high returns and others with lower returns.  Structuring RBF could be limited if a country’s usury laws limit the total return to the investor, or prohibit periods of high return.

  • Singapore had no such restrictions. 
  • United States “In some states, predatory financing practices could lead to claims under state unfair and deceptive acts and practices, usury, predatory lending, fraud, good faith and fair dealing laws.“
  • Germany: “It has been determined by German case law that a loan agreement by which a lender causes himself or a third party to be promised or granted pecuniary advantages which are clearly disproportionate to the performance (i) by wilfully exploiting the weaker position of the borrower or (ii) by gross negligently denying that the borrower only engages in the pressuring conditions due to its weak position, will be null and void”
  • Brazil: “Our understanding is that the legal rate limit is not applicable to financial and capital markets transactions. However, interest limitations may apply to debentures and other securities subject to private placements that do not involve financial institutions and that are not registered in organized markets and, therefore, follow the same rationale as loan transactions (as opposed to debentures subject to public offerings, which are considered investments in the capital markets).”
  • Mexico “There is no objective standard or percentage of what is considered usury being subject to court interpretation considering the court precedents […] it is not that this limitation would prohibit revenue based financing, as long as the interest is proportionate to gross revenues, irrespective of the fact that there could be periods with high payments.”
  • South Africa: “If a transaction falls within the scope of the NCA, the interest will be subject to a cap.”
  • England and Wales had no such restrictions.
  • The Netherlands had no such restrictions.

Acknowledgment and Disclaimer

Toniic would like to thank TrustLaw, Thomson Reuters Foundation, for facilitating the connection with pro bono law firms that conducted the research underpinning this resource. This resource is offered for information purposes only. It is not legal advice. Readers are urged to seek advice from qualified legal counsel in relation to their specific circumstances. We intend the resource’s contents to be correct and up to date at the time of publication, however, we do not guarantee their accuracy or completeness, particularly as circumstances may change after publication. Toniic, the assisting pro bono law firms, and the Thomson Reuters Foundation, accept no liability or responsibility for actions taken or not taken or any losses arising from reliance on this resource or any inaccuracies herein.

Revenue Based Finance

Revenue Based Finance are a category of contingent payment investment structures where the payment to the investor is contingent on the amount and timing of the issuers financial performance, typically measured by cash basis revenues. While, for reasons outlined below, it is most common to use revenue as the contingent payment source, some structures use other income statement or cash flow accounting entries. (See Demand Dividends as example) As a term of art, these structures are frequently considered to be part of Revenue Based Finance despite the use of a different accounting lines.

Reasons for Revenue Based Finance

Revenue Based Finance is often used as an technique for realizing an alternative exit when other financial Strucures are not likely to provide an exit to investors. Revenue Based Finance is also used to achieve Appropriate Capital to algin company performance with investor returns

Revenue Based Finance Structuring Options

The structures are typically designed to stop paying investors when the investor has received the negotiated target return. Typically, that negotiated return is expressed as a multiple of the initial investment.  For example, investors seeking a 3X return target that has invested $100,000 would receive their share of revenues until the investor has been paid $100,000 X 3 = $300,000. It’s important to note that the investors return on capital will depend on the timing of the payments – and thus will depend on the rate of revenue growth.   The same 3x return target will have a much better return on capital if the company has fast revenue growth compared to the same company if it experiences slower revenue growth.

Revenue Based Exits can either be set up as debt or equity structures depending on the local laws.  When using equity they are typically Redemption Based Exits in that the issuer is obligated to repurchase the equity from the investor at a specified premium.  In Revenue Based exit Structured as debt, the payments to the investor are treated as a mix of interest and principal payments.

Revenue Based Finance Structures

Demand Dividends

Demand Dividends are a structure created by Santa Clara University. Demand Dividends are contingent payment instruments that dedicated a percentage of free cash flow as the source of returns to investors.  Like Revenue Based Exits, they are typically designed to stop paying investors when the investor has received the negotiated target return.

Royalty Financing

Royalty Financing in Impact Investing repurposes the royalty payments from traditional finance to meet the needs of Impact Investors

In traditional finance, Royalties are a mechanism for paying for intellectual property.  Most legal jurisdictions have clear definition of royalties and their accounting treatment and definition may vary between legal jurisdictions.

Many impact investing structures would be significantly easier to classify as royalties as the accounting and tax rules for royalties are well defined and simple.   Royalties are only treated as income as the sales on which those royalties depend occur.  For example a book publisher will owe royalties to an author only when that author’s book sells.

Unfortunately many tax juridiscinos limit the use of royalty accounting to their traditional use as payments for intellectual property.   For example, in many jurisdictions a Revenue Financing structure cant simply be called a Royalty Structure with the hope that the accounting will be as simple as royalty accounting.  This is because doing so would facilitate tax avoidance structures in traditionally busessiness.

Redemption Based Exits

Redemption Based Exists re typically equity structures where the investment structure requires the company to redeem (repurchase) the equity shares from the investors.  The terms of repurchase agreements vary between structures but generally include a method for the investors to, over the life of the security, receive a specified multiple of their original investment as the premium paid for the redemptions.

Examples include Indie.vc

Hybrid Strucures

Hybrid Revenue Based Finance Strucures typically provide investor returns by a mix of redemptions with another payment stream like interest payments or dividend payments.   Examples of hybrid structures include Performance Aligned Stock

Key Considerations for Deal Structuring

Legal and Accounting Considerations

Complexity

Complexity is an important consideration when seeking the most appropriate capital for a company.  If the needs for capital are appropriately met with traditional structures then using traditional structures will likely reduce transaction costs and investor reticence.

Many of the alternative exit structures are new, are not well understood by many practitioners, and have less clarity about their tax, accounting, and legal merits than traditional exits.  These complexities can add costs and slow the transaction process.

Equity vs Debt

It’s important to understand that just because a security is labeled as “equity” or “debt” does not mean that the local tax authorities will accept that label.  It is common for tax authorities to have procedures to reclassify securities based on their economic structures.  Any reclassification could significantly change the economics of the security and/or increase the difficulty of accounting and other compliance elements.

We recommend any investor or entrepreneur seeking to use an alternate exit structure seek professional advice on the tax implications with a specific focus on reclassification risk.

Usury Laws

When an alternative exit uses a debt structure or a structure that could be reclassified as debt issuers must be careful that the nature of the contingent payments don’t violate local usury laws.  Usury laws are laws that set a maximum interest rate on debt payments.

What is interest vs principal?

When an issuer pays an investor some return on a debt structure it needs to be clear to both parties what portion of the payment is interest and what portion is principal.  This distinction is important because generally the return of principal is not taxed but the interest is subject to taxation.

Traditional investment structures calculate the principal and interest portions of a payment using near-universally accepted amortization tables.  With many alternative exit debt structures it is not clear how to create an amortization table that is accepted by the local tax authorities.

For example, consider a debt based alternative exit where the source of returns is a fixed percentage of revenues until the investor receives 3 (three) times their initial investment (a revenue based contingent payment).  If the investor invested $100,000 then when the transaction has completed its duration the investor will have received $300,000 in payments of which $100,000 has to be treated as return of principle and $200,000 has to be treated as interest..  If the first payment is $10,000 – what portion of that is principal and what is interest?  It might make sense to call ⅓ principal and ⅔ interest.  It also might make sense to call the entire $100,000 of payments principal and then all the rest interest.

While it is possible that your local tax jurisdiction will not have clear rules, it is more likely that they do have rules for properly apportioning principle and interest because not having those rules would have made it easy for investors to take advantage of their absence and create investment structures that are intended to delay, defer or avoid taxes.

Complicated accounting requirements

Some tax jurisdictions solve the above referenced question of apportioning interest and principle by imposing complicated tax accounting methods that can be burdensome to administer and may even create tax disadvantages to the investor.

For example, in the United States the law (26 CFR § 1.1275-4) reqires contingent payments instruments to be treated as if they were not in fact contingent using the Noncontingent bond method. In addition to the added complication, this often has the negative consequence of requiring, in the early years of an investment, the investor to pay tax on income they will not receive until the later years of the investment.

Distribution rules (eg re dividends and Board approval)

Local lay may have rules that need to be carefully considered when using equity instruments for alternative exits, especially when using a dividend as part of the structure.  Traditionally dividends may need to be authorized by the board and their may be restrictions on payment if the issuer does not have retained earnings.

Downside Protection

Traditional investment structures have clause for when the investment does not perform or when the company is forced to restructure or close.  The order in which creditors and investors get repaid in those cases is one of the negotiable features of term sheets but is generally based on the overall structure of the transaction with debt having higher preference than equity.  To the extent that an alternative exit has an economic structure that is different than its legal structure (eg a debt based exit that offers equity returns) the parties need to consider the appropriate downside protection.

Considerations by Legal Jurisdiction

The key questions that you need to ask to figure out what exit structures work in a given local legal system:

  • Do the tax authorities have rules for reclassifying debt as equity (or vice versa) – that is, is it possible that designing a debt instrument that pays variable payments (eg revenue based) would be reclassified as equity
    • if those rules exist you may need to create an equity structure
    • if those rules don’t exist then,
      • how are contingent payment debt securities taxed and accounted for.
        • how is each payment split between the return of principle vs interest? (need to know for investor and issuer – may not be the same)
        • are there rules that force contingent payment debt instruments to be accounted for in a way that may create phantom tax (in the US, for example, you have to act as if the payments were non contingent and create an amortization schedule and make tax payments based on that schedule – not just on what each payment ends up being)
    • Could designing an equity structure with mandatory redemptions be reclassified as debt
      • if yes this loops back to the questions re debt payments above
      • if no then equity with mandatory redemption contingent on (revenue %) is an easy option

Example Term Sheets


Additional Resources

Video: Alternative Term Sheets

Social Venture Circle hosted this interactive webinar on Alternative Term Sheets featuring Drew Tulchin (Upspring Associates), Lauren Grattan (Mission Driven Finance), and John Berger (Toniic).

This session explores term sheets and alternative term sheets to see how we can ensure we are bringing in the triple bottom line and our own personal beliefs to our investing and entrepreneurial efforts.

This session was organized by SVC’s member-led working group, The Future of Community Finance. In partnership with the American Sustainable Business Council, Intentional Media, JumpScale, and Opportunity Collaboration. Supported by The Accountkeepers, Bromberger Law, and SustainVC.

Covid 19 is a lesson in why alternative investment structures are needed

This article and all the articles tagged Tactics or Ideas are opinion articles and therefore only reflect the view of the author. 

Covid-19 is teaching us many lessons that take the form of “that thing we used to do, or that idea we used to feel safe thinking, turned out to not be that good an idea after all.”  Covid 19 is teaching us the value of resilience and flexibility.   

Companies that need cash and wish to borrow to survive the crisis have no idea when their cash flows will once again become predictable.  Companies that thought they had predictable cash flows and have borrowed against those predictions are now stuck with fixed payments they can’t meet.  

The core problem with traditional debt for social enterprises is agreeing to fixed payments against variable revenue streams, negotiated early in a company’s life when revenue is most unpredictable.  Many enterprises in the countries where Covid-19 lockdown measures have been implemented are going to fail. It’s not true that “no one saw this coming.” Covid-19 specifically, yes; but unpredicted swings in revenue early in the life of a company?  Both foreseeable and foreseen.  

There is an alternative, but it’s been practiced only at the fringes.  This global crisis presents the opportunity to reconsider how we structure early stage investments.  For the many companies in trouble, Revenue-Based Finance (RBF) approaches are among the most promising ways to restructure debt to assure repayment in the long run.  Little has changed about the long-term prospects of most of these companies; yet many have total uncertainty about near-term revenues. A return to revenue growth is likely, but the timing is completely unknowable.  This type of situation is a perfect recipe for the use of RBF.

For new financings, the benefits of RBF have never been clearer.  If a crisis can quickly slow the economy once, it will happen again — why not design our financing structures for flexibility and resilience?  Revenue-Based Financings are investment structures that link the returns to the investor with a company’s revenue. This type of structure is in the interest of both the social enterprise and their investors.  There are many ways to structure RBF and you can learn more about structuring options at impactterms.org  

Because the payments due to investors from RBF structures vary with company performance, they are designed to handle exactly the kind of stress and uncertainty we are seeing in this crisis (and others like it in the future). A company that borrowed using an RBF structure, instead of traditional debt would not be forced to make payments that they can’t afford but if they miss put them in default. Its action also saves the investors in the company. Yes, the investors’ returns will likely decline as payments get pushed to the future, but that’s a much better problem than losing their whole investment.

One investor using RBF both for restructuring and new investing is Capacity Capital, a new fund investing financial and social capital into small revenue-generating growth businesses, especially the overlooked and underestimated.  For example Capacity Capital recently made an investment in RentSons, a company that helps people link up with “helping hands”. Rent Sons had a mix of existing debt obligations that, as is common in debt structures, did not offer the company the flexibility they needed to manage downturns in the business cycle.  They now have the flexibility they need thanks to Capacity Capital restructuring those old debts and providing new financing in a combined RBF financing.  

Through a new RBF investment they are providing RentSons additional growth capital and restructuring their old debn

For investors and companies that have used traditional debt and are facing likely default, this is a great time to consider restructuring the debt using an RBF structure.  When the timing of cash flows is uncertain but the company’s prospects are still strong, the traditional option is equity. However, the investor has to believe they will one day be able to sell that equity.  By restructuring into an RBF structure, the company can have the flexibility they need to recover, and the investor can have a realistic path to recovery and profit.  

It will take some time before we have enough perspective to look back and draw final conclusions from this experience, but one clear lesson we can learn today is the value of flexibility and we can put that lesson to work today by using Revenue-Based Financing and the other alternative investment structures featured on ImpactTerms.org