Emergence of New Capital Providers – Exploring Alternatives to Traditional Expectations and Structures

EXECUTIVE SUMMARY

The Capital Access Lab (CAL) is a national pilot initiative that aims to find, promote, and scale innovative investment managers who are providing new kinds of capital to underserved entrepreneurs and communities in the United States.

In July 2020, the Capital Access Lab announced its investments in 5 funds investing in underserved entrepreneurs through innovative investment structures: 1863 Ventures, Anzu Partners, Capacity Capital, Collab Capital, and Indie.vc. During the selection process of these 5 funds, the Capital Access Lab identified over 100 funds focused on underserved entrepreneurs. This report analyzes the approach of a subset of 20 funds that responded to our survey.

Through our analysis, we learned that funds investing in underserved entrepreneurs through alternative investment structures are often nimble investment vehicles that operate in the very early stages of the portfolio companies’ development, really enabling these companies to raise the first essential capital to fuel their growth. They do not invest exclusively in high growth sectors like traditional VCs; our study shows that they are often sector agnostic and have a wide range of return expectations and initial criteria for the investment that are much more flexible than what we typically see in traditional venture capital.

Whereas these funds face challenges related to covering the structural and operational costs of running an investment fund with relatively low Asset Under Management, they represent a nascent and very targeted approach to serving underserved entrepreneurs. Through this report, we hope to highlight their work, support their growth, and inspire potential funders and donors to invest in them. 

BACKGROUND

The Toniic Institute, through the Impact Terms Platform, developed this report about the work of the Ewing Marion Kauffman Foundation and the Capital Access Lab on investment funds adopting alternative investment instruments.  The Capital Access Lab is designed to provide risk capital to new investment models that do not resemble traditional venture capital or lending, spurring the formation of new financing mechanisms that increase capital investment to underserved entrepreneurs who have been historically left behind due to their race, ethnicity, gender, socioeconomic class, and/or geographic location.

The objective of this report is to review the lessons learned from the Capital Access Lab’s work and to share innovative ways investors can invest in entrepreneurs who are underserved by venture capital and traditional lending structures. Our goal is to describe emerging approaches to investments, liquidity, and risk/return profiles that can be more inclusive for entrepreneurs. 

The Capital Access Lab (CAL), formed in 2019, is a national pilot initiative that aims to find, promote, and scale innovative investment managers who are providing new kinds of capital to underserved entrepreneurs and communities in the United States.  The Capital Access Lab was created to help address this capital gap by creating a new vehicle to invest in alternative capital funds survive those entrepreneurs  That same year, the Lab’s lead investor and sponsor, the Kauffman Foundation, released a report, titled “Access to Capital for Entrepreneurs: Removing Barriers”, which observed that a surprisingly high percentage of entrepreneurs – more than 83% – do not access bank loans or venture capital. 

To source prospective funds, the Capital Access Lab created an online application process through which funds or proposed funds could apply for consideration for funding.  The CAL did not widely publicize the announcement of this opportunity and instead relied primarily on word of mouth and limited media. When the fund application was announced, responses far exceeded their expectation.  CAL had expected 20 to 40 funds to apply in the first year but ended up receiving close to 150 applications.  Of those, over 100 fit the requirements for application.  “One of the most positive signals to us – [was that] the submissions were mostly first-time fund managers and aspiring investors wanting to bring capital to their community” said John Tyler, Kauffman Foundation General Counsel. The CAL team was also encouraged and surprised by the diversity of the applicants.  Roughly 55% of applicants were women and 50% persons of color.  The large and diverse application pool reveals a significant demand for and interest in alternative capital structures.

The CAL had expected that many of the applicants would be larger funds that saw alternative capital structures as an additional opportunity. (Traditionally it is difficult for funds smaller than $10 million in assets to generate enough fees to cover their overhead.) Unexpectedly, the applicant pool included many smaller funds that would have traditionally been considered too small to rely only on traditional management fees, but instead many funds were a part of related organizations that could support the overhead.  These related organizations included nonprofit business accelerators, Community Development Financial Institutions (CDFIs), and other organizations that wanted to bring investment capital to their communities. For example, 1863 Ventures, one of the funds that received investment, already had an active business development program and wanted to start an investment fund as a means of furthering its mission.  

During their due diligence process, the Capital Access Lab identified over 100 funds focused on underserved entrepreneurs, eventually selecting five: 1863 Ventures, Anzu Partners, Capacity Capital, Collab Capital, and Indie.vc. 

The Capital Access Lab includes as one of its initiatives, the Capital Access Lab Fund which is a donor advised fund housed at Impact Assets. That fund was capitalized by the Kaufman Foundation. The Capital Access Lab Fund, and a separate funding source from Rockefeller foundation, have invested in the five funds that were selected by The Capital Access Lab. 

To ensure the preservation of a recognized charitable purpose under Section 501(c)(3), the Kauffman Foundation developed a charitability term sheet which it has made publicly available as an example of how a foundation structured a particular investment to further its charitable mission and ensure accountability thereto.

Although CAL could not invest in all the funds, they recognized there was a lot to learn and share about their innovative investment structures. This report analyses the approach of a subset of 20 funds who responded to our survey.  

RESEARCH – RESULTS AND ANALYSIS

Toniic and the Impact Terms Platform conducted research for this study using a combination of interviews with the principals and a formal survey.  The survey participants consist of funds that had applied to the Capital Access Lab during their initial funding period. Twenty funds participated in the survey. The data below highlights some key takeaways from our review.

FUND CHARACTERISTICS

TARGET FUND SIZE

Fifty percent of survey respondents reported a target fund size of less than $10 million.  

This target size is consistent with the population of over 100 applicants who applied for funding from CAL – as 50% of those applicants also reported a target size under $10 million. If these funds were to use the traditional VC fee structure that means that they would expect to receive under $200,000 per year in management fees to cover management costs. These low fees are generally considered below the viable amount required by a fund management team without external middle and back office support.

INVESTMENT STAGE

Ninety five percent of participants report that they will invest in seed or pre-seed stage companies. Of those participants, 55% said they would also invest in Series A investments, leaving 45% who only target seed or pre seed stage investing. Only one fund participant would not invest in seed or pre seed stage companies targeting only post seed investments. 

TARGET INVESTMENT SIZE

Consistent with the small average target fund size and largely seed stage investing, 65% of the participants expect to invest less than $300,000 per investment. Only 10% of respondents would invest more than $500,000.

TARGET SECTORS

45% of the respondents have indicated that they are sector agnostic, and 25% of the respondents (among the open-ended responses) included Food and Agriculture as one of their funds’ focus areas.

While traditional VC funds often target high growth sectors such as IT, Health Care, Financials, Telecommunication, the survey respondents did not indicate a strong tendency towards these sectors.  

FINANCIAL INSTRUMENTS USED

The following section analyses the financial instruments used by these funds to invest in underserved entrepreneurs. The classification process of these alternative investment structures is a challenging process  because there is not an agreed-upon vocabulary for many of the emerging investment structures, nor agreement about whether they should be broadly classified as equity or debt.  For example, respondents may have differing opinions about if the Demand Dividend Structure should be debt or equity, so we asked about that structure as both debt and equity then combined them when appropriate to our analysis.

COMMON FEATURES OF ALTERNATIVE INVESTMENT STRUCTURES BASED ON CONTINGENT PAYMENTS

To structure these investments, investors typically start with a target IRR, make a range of estimates of the company’s future performance, and then structure the other terms and features of the investments, including the repayment terms such as the percent of revenues and return multiple cap to achieve that target IRR.

The survey asked a series of questions about the details of the alternative investing structures used by that participant.  The questions were designed to get further details around what we anticipated would be the most common structures used: a variation of contingent payment structures.  Seventy-five percent of the respondents reported using some form of alternative investment structure based on contingent payments (revenue-based debt, redeemable equity, or Demand Dividends).  

These structures are flexible and can be designed to include a variety of features. The core feature of these structures is that they are contingent on something like the amount and timing of the portfolio companies’ revenues.  Therefore, the return to the investor will vary based on the features of the investment and the financial performance of the company. 

Basis of calculation

Of the 75% participants that stated they will or do use a form of contingent payment structure – 40% said they would invest using gross cash receipts as a basis of calculation, and 47% reported they would invest using net cash receipts.  Thirteen percent reported they would use either gross or net cash receipts. Demand Dividend structures did not seem to affect this ratio, even though Demand Dividends typically use net cash receipts as a basis of calculation.

Return Expectations

Respondents reported a wide range of target IRR for their investments ranging from 2% to 35% and averaging 15%. We did not specify if we were asking for the target IRR for the fund or individual investment, but we believe that most participants were answering at the fund level.

Minimum annual revenue required for investment

Respondents reported a wide range of minimum required revenues for the investees ranging from under $50,000 per year to over $5 million per year.  The median required revenues was $300,000-$400,000 per year.

Minimum annual revenue growth rate

Respondents reported a median required forecast annual revenue growth of 20-30% with only 16% requiring revenue growth of more than 40%.  This differs significantly from the kind of minimum revenue growth requirements you would see from traditional VC.

Half of those who are making revenue based (or similar) finance structures are investing in seed or pre-seed, and will invest into forecast revenue growth below 30%.  These characteristics are not common in traditional venture capital so this demonstrates the growth of new sources of capital, that are willing to invest with non-traditional approaches.

Minimum gross margin of target companies

Considering the role that revenues play in the calculation of repayment, we also asked about the minimum required gross margin in order to repay the investment. Respondents reported a minimum median target gross margin of 30-40%. At Impact Terms, our  expectation was that lower reported minimum revenue growth rate targets would result in higher the margin requirements.  We had this expectation because for an investor to receive a target return of X% on an investment in a lower growth company, that company typically must be able to support a higher percentage of cash flow paid to the investor which requires higher gross margins.

The opposite was the case, as it turned out. The funds that were willing to take the lowest forecast revenue growth in seed stage companies were also willing to take the lowest gross margins. Like the wide range in target IRR, this demonstrates that there is a much wider range of return expectations and minimum requirements than we see in traditional venture capital.  One possible explanation is that the funds accepting lower gross margins for lower revenue growth companies are doing so as part of a strategy to provide the appropriate capital to the entrepreneurs.  That is, the entrepreneurs they are targeting may simply not have higher revenue growth and margins so the funds used alternative investment structures with return features that the companies could afford.

Percentage of revenue used to repay the investment

Thirty-three percent of respondents indicated that their average percentage of revenues used to repay the investment is 5%, and overall 66.6% indicated an average percentage of revenues lower than 10%. This is typically repaid by the portfolio companies monthly or quarterly out of minimum targeted gross margins of 30-40%.

Forms response chart. Question title: How much is the typical percentage of revenues used?. Number of responses: 12 responses.
Average return multiple cap

Thirteen participants use an average return cap – meaning the average cash-on-cash multiple of the invested capital to be returned to the investor over the life of the investment.  The industry average return cap is generally between 2x and 3x the initial invested amount. As an example – a cap of 3x on a $100,000 investment would mean the investment is complete when a total of $300,000 has been repaid.  This is a common structuring feature of alternative investments that are based on revenue, cash flows or similar contingent payments.  The total IRR of that investment would depend on the time it takes for repayment as well as the cap, so a 3x cap investment that takes 10 years to pay out would have a lower IRR than a 3x cap investment that takes 5 years to pay out.

REVIEW AND CONCLUSIONS

It is clear both from the large number of applicants for Capital Access Lab funding and from the follow up research we conducted that there is a significant and underserved ecosystem of small funds that are leveraging alternative investment structures to invest in companies focused on underserved populations.  Many of the funds are sector agnostic and not many are targeting traditional venture sectors like IT, Health Care, Financials, Telecommunications.  It is also evident from the wide range of return expectations and the combination of investment structuring features that the funds are willing to invest beyond what we would expect from traditional VCs and that therefore that the funds in the survey can  serve entrepreneurs who fall outside of traditional VC requirements.  

These funds are nimble investment vehicles that operate in the very early stages, potentially being the first professional investors supporting companies in their infancy, effectively de-risking and capitalizing early-stage entrepreneurs.

They also have a wide range of return expectations, including repayment multiples, and initial criteria for the investment that are much more flexible than what we typically see in traditional venture capital.  It has long been a complaint that sources of capital are too fixated on structures designed only for companies with explosive growth, so it is encouraging that this research shows an emergence of new capital providers exploring alternatives to traditional expectations and structures.

Out of the 100 funds that applied to the Capital Access Lab, and more specifically out of the 20 survey respondents, we have observed that about 50% of the funds have a target raise of less than $10 million and 75% of less than $30 million; that 95% invest in seed stage, and about ~50% in pre-seed and Series A; and that 65% target an initial investment of less than $300,000 per investment.   

Toniic, the global action community for impact investing, has also identified the emergence of relatively small and nimble funds (less than 15M in target AUM) leveraging alternative investment structures to address the needs of underserved populations across different investment themes. These includes funds providing loans to farmers to be repaid through a revenue share agreement in order to allow time to the farmers to switch to organic and regenerative agriculture practices and align their cash flows from higher quality produce with the loan repayment, funds providing capital to minority owned businesses in geographies out of the radar of major venture capitalists to facilitate exits, but also funds providing loans to underserved students that can repay their loans only when they start generating income from actual employment. 

While this did not apply to the five funds selected for investment by the Capital Access Lab, these smaller funds are much smaller than typical venture capital fund and CDFI, so small in fact that many are unlikely to cover their operating costs as a fund, and instead use the fund as an addition to existing community service programs.  These funds primarily target seed stage companies and are using a wide range of alternative investment structures.  

In order to support these experimental but smaller funds, it is clearly important to find ways to lower their operating costs.  As noted in this review, important costs like legal, including the added costs associated with using new investing and organization structures, insurance and fund administration are high for these funds.  It can even be difficult to find fund administration services that will support alternative investment structures.  Companies like AngelList are starting to provide some of these services at lower cost but they are still expensive for small funds and they do not offer services to most alternative investment structures. Investors and foundations who wish to support these funds might consider funding start-ups that help provide these services at lower cost to smaller funds.

Agnes Dasewicz, Lead, Capital Access Lab observed that, alternatively, it would be worth evaluating if investments coming from foundations could, when legally allowed, be accompanied by separate resources and donations to cover some administrative expenses and technical assistance.  This is fairly common practice with large international funds who often have sidecar vehicles for technical assistance, and we agree that sidecar grants would help further the ability of small funds to continue to innovate.  

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.

Pay For Success

Pay For Success is a public-private partnership in which a non-government funder pays the up-front costs for a social service intervention and is repaid by a government actor based on the achievement of previously agreed-upon target outcomes

The term “pay for success” (“PFS” in shorthand) is most commonly used in the United States. The concept originated in the United Kingdom under the name “social impact bond.” When the concept was introduced in the United States, the name “pay for success” was adopted because not all projects are formulated with a traditional bond structure. In emerging markets, the term “development impact bond” has emerged to describe this concept in an international development context. 

CHARACTERISTICS

The principle characteristics of a Pay For Success project are as follows:

  • A focus on outcomes, rather than outputs. Payments are made based on the outcomes experienced by the people served by the social service intervention, rather than the number of people served. This is a structural shift from how most social services are funded. 
  • Up-front funding by a non-government funder: The social service intervention is paid for by a private investor, philanthropy, or other non-government funder, who can expect to be repaid only if target outcomes are achieved. If the project is unsuccessful — and the target outcomes are not achieved — then that non-government funder is not repaid for the investment. Therefore, taxpayers are not responsible for paying for an intervention that did not work as planned. 

HISTORY

The concept was originated by Sir Ronald Cohen in the UK.

The first social impact bond was implemented at Peterborough Prison near York, UK. In that project, a private investor paid for people who were preparing to be released from prison but deemed to be at a higher risk for re-offending to participate in a new recidivism diversion program. The UK government agreed to repay the investor if recidivism among the participants was reduced by a targeted percentage. The project launched in 2010 and concluded in 2015, with findings that showed a reduction in reoffending. Results: https://www.rand.org/randeurope/research/projects/social-impact-bonds.html

In 2010, the US federal government under President Barack Obama began adapting the concept for use by state and local grantees of federal funding from the US Departments of Labor, Education, and Justice. This work was centralized under the White House Domestic Policy Council’s Office of Social Innovation and Civic Participation. The first projects in the US launched in 2012.

ACTORS IN PAY FOR SUCCESS

Each pay for success project or initiative has the following actors participating:

  • Government actor: A government agency is responsible for paying for outcomes upon achievement, based on terms agreed upon by all parties in the project negotiation. Repayment is generally expected to be consistent with the money the government is saving due to the intervention. For example, a reduction in the number of formerly incarcerated people reoffending leads, in theory, to fewer prisoners that the government must support. 
  • Service provider: The social service intervention is provided by a non-profit or for-profit organization. The service provider contracts with the non-government actor making the up-front investment, so they are paid for delivering the intervention regardless of impact. Typically, the service provider is selected by the investor, with review or approval from the government, through a competitive process and must demonstrate expertise or a track record of success in delivering the service to the target population. 
  • Non-government funder: A non-government funder pays the upfront costs of the service provider to deliver the social service intervention to the target population. This non-government actor is often a private investor, but could also be a philanthropy, community foundation, high net worth individual, or other funder. If the social service intervention reaches agreed-upon outcomes, the actor is repaid. If not, the actor is expected to take the loss. 
  • Evaluator: An independent evaluator is contracted to perform an independent evaluation of the social service intervention provided to the target population, to determine whether agreed-upon outcomes were met. The rigor of the evaluation, including the use of a control group, is determined by the parties involved. 
  • Intermediary organization: Most PFS projects have an intermediary organization that serves a mediation and management role. This organization brings the parties together to create the project and agree on the target outcomes to be achieved. The work of the intermediary organization is often funded by philanthropic donations. 

PAY FOR SUCCESS PROJECTS AND SOCIAL IMPACT BONDS

CRITIQUES / CONTROVERSIES / CONCERNS

Overview of valid critiques of the model —

  • Concern that PFS would siphon money from existing social programs and/or private them has not come to fruition. Model is intended to validate/test whether a new service/intervention is more effective then status quo — governments may or may not end up using that information
  • Evaluations: An independent evaluation is a core part of a pay for success project. The expectations for the rigor of that evaluation have been debated, particularly in the wake of Urban Institute and other early field leaders have argued that PFS project evaluations should be randomized control trials (RCTs) unless there is a compelling reason to use a less rigorous method. 
  • Scalability: Since the launch of the first pay for success projects, a major critique of the model has been the cost of putting projects together. Philanthropic grants are generally still required to fund the 18-to-24-month process.  
  • Concern that governments will not scale successful projects – too early to tell
  • Capacity building for nonprofits

Case Studies

In 2015, India pioneered the world’s first development impact bond (DIB) where the outcome payer was a private foundation. Read more in the following case study from AVPN:

Additional Resources

Video: https://pfs.urban.org/library/content/pay-success-importance-evidence

Contributors

Contingent Payment Structures

Contingent Payment Structures are the most common form of Alternative Exits. Unlike a traditional note or loan, the time and/or payment amounts made by these structures are contingent on some other factor like company revenues.

Royalties are a special case of contingent payments as the payment of royalty is contingent on events that trigger a royalty payment, typically the use of intellectually properly. While Royalties are contingent payments the converse is not true and not all contingent payments are royalties. This distinction is important in countries like the United States that have different tax treatment for royalties than other forms of contingent payment.

Alternative Exits


Alternative Exits are financial structures that allow investors to realize their investments return using methods other than traditional debt and equity investment.

An “exit” is the method the investor uses to get the return on investment including their original capital and their profit. For example, a common stock listed on an exchange, the exit can be as simple as selling to another investor.

The most common traditional exits for early stage equity-like transactions are 1) sale to another investor via a future round of financing, and 2) sale of the whole company to another investor or company.

Alternative exits are often contingent payment structures as they often are designed so that the timing of the payment to investors are contingent on aspects of the issuer’s business.   For example, Revenue Based Financing structures payout periodic investor returns as a percentage of period revenues and thus the payment amount is contingent on revenues.

It is important to note that terms for alternative exits like “royalty”, “revenue share” and “contingent payment” are often interchanged they can have very different tax treatments and thus should be discussed as related but different concepts.


Reasons for Alternative Exits

Alternative exists are often referred to by their specific method or structure which include Royalty Exits.  They can also be called self-liquidating investments though this may cause some confusion as other traditional investment structures are self-liquidating, for example, debt.While many of the existing Alternative Exit structures have been used for non-impact investments, the movement towards social enterprise and impact investing has raised the profile of Alternative Exits because of several factors that are common in impact investing.  Impact investors are increasingly seeking to provide Appropriate Capital to investors.  Appropriate Capital is capital that meets the needs of the investors and fits the specific business model of the entrepreneur so that the capital structure does not hinder the prospect of success.  Many traditional financing methods are not Appropriate Capital.  For example, debt forces a company to pay at a specific schedule but would not be appropriate for a company that can not predict if their business performance will match the debt schedule.  Many equity structures are not appropriate for companies that are unlikely to attract a traditional exit, or would prefer not to pursue one.

In some jurisdictions alternative exits can be structured as Royalty Financing but as Royalties serve a narrow and well specified economic role there are often legal and accounting rules that prevent Royalties from being used for investor returns except when they would otherwise be used to pay for the use of intellectual property.

Investor View

The most common reason for investors to seek an Alternative Exit is that, for the specific investment, they don’t believe that traditional structures will return their capital in their target time horizon.

Entrepreneur View

The most common reasons for an entrepreneur to consider alternative investors are 1) to match their enterprise performance with the return needs of their investors or 2) to preserve the mission or control of their company.

Influencing Factors

Social Entrepreneurs May Not Want to Exit 

It is common for social entrepreneurs to wish to preserve the mission of their organization and protect their involvement in the organization.   They may feel that traditional exits of equity structures will dilute their ability to control mission or maintain their role in the organization.  Therefore they may prefer investment structures that protect their long term equity holdings and their ability to maintain voting control.   

Impact Capital May Be Less Interested In Rewarding Prior Investors 

Compared to traditional (non-impact specific) finance, the motivation of Impact Investors includes social return.  If an investor’s money is just used to pay out prior investors then that investor may not view their capital as having created any additional social returns.  This makes it more difficult to raise follow on rounds that pay out early investors.  Therefore early investors may prefer alternative structures to mitigate this risk.

Early Stage Entities and Visability

The discussion of Alternative Exits in Impact Investing is largely focused on early stage companies. The earlier the stage of a company the less the ability to forecast the near and long term financial performance of the company. It is often unreasonable or infeasible for investors and entrepreneurs to agree on company valuation and forecasts.


Common Alternative Exit Structures

Contingent Payment Structures

Revenue Based Exits

Revenue Based Exits are contingent payment instruments that dedicated a percentage of revenues as the source of returns to investors.  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.

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 Exits

Hybrid exist 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



References



Contributors