An emerging market technology company provides services via mobile phones. The entrepreneur is confident in an acquisition opportunity, but investors wanted an alternative liquidity provision because acquisition has been uncommon for African tech companies in the social sector. The deal includes a provision for the company to redeem investor-owned equity at investor discretion after 7 years, mirroring a traditional “liquidity event” payout.
Investors did not want to rely solely on an exit via sale or IPO. At the same time, both founders and investors wanted to maximize cash spent on operations to catalyze growth, as opposed to servicing debt or revenue share payments. In addition, the founders believed that an equity investment would be more attractive to subsequent institutional capital.
Target IRR: > 15%
Investment type: Redeemable preferred equity
Company: The company supplies information content in emerging markets that is accessible from mobile phones and tablets. The company has revenue and initial signs of direct-to-consumer and channel uptake. There is no established market, however, for the product, and no history of M&A in the sector and region where the company operates.
Investor: The investor group is led by a foundation that invests in early stage emerging market companies. The lead investor seeks a reasonable return, with an emphasis on supporting high risk/high impact companies.
Key Innovation
Redemption exit option: Conventionally, redemption provisions are used as downside protection and with the expectation that they are likely to have little practical use. Here, investors believe that redemption is just as likely—if not more likely—than a traditional exit by sale or IPO. The deal is structured to provide an attractive financial return through redemption after 7 years in a transaction that resembles an acquisition from the investor’s perspective.
Key Terms
Valuation: Total raise of $500,000 at $2 million pre-money valuation.
Legal structure: The terms are structured to closely approximate standard U.S. “Seed” preferred equity investment model (except for the redemption provision, which is not standard in U.S. Seed Preferred model).
“Lump sum” redemption: Investors can elect to redeem all or a portion of their shares at any time after 7 years. The right to redeem is individual, rather than based on the affirmative election of a minimum percentage of shares as is often seen in redemption provisions.
Redemption price: The redemption price equals the greater of (1) the equivalent of a 15% per year return and (2) the fair market value of the preferred stock at the time of redemption, as established by an independent valuation.
Redemption payment: The Company may elect to pay the redemption consideration over a two-year period, but subject to 8% interest during that period.
Special Considerations
Tax Consideration: The redemption option raises a question of whether the instrument could be characterized as debt for tax purposes, but such re-characterization is unlikely given the minimum 7-year term and option to redeem only a portion of the shares. Furthermore, other deal-specific factors support equity characterization (e.g., otherwise “thin” capitalization). See “original issue discount” details for more detail on potential tax issues.
“Lump sum” redemption considerations: The big question with this type of “balloon” redemption provision is what happens if the company does not have adequate resources to redeem the stock at the time of the election date. A few notes on this point:
- Investors should analyze the company’s projected cash flow and consider the likelihood that the company will be able to generate sufficient cash to redeem the stock.
- Investors and company may need to work together to modify the redemption payout in order to balance the company’s and investor’s cash needs.
- The company may have negotiating leverage in a scenario in which cash is constrained, depending on the governing laws for the company and investment agreement. For example, even with a mandatory redemption provision in the certificate of incorporation, Delaware law prohibits companies from redeeming stock if the redemption would leave the company insolvent.
- The company and investors may also want to evaluate the ability to finance the redemption through debt or through a later stage equity investment.