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

Case study: Performance Aligned Stock: Tax efficient investor returns from revenue pool

Target IRR: Varies but generally between equity and debt returns

Investment type: Performance Aligned Stock

History:  Ron Boehm is an experienced social investor whose investments include a pool of social investments.  He was seeking an investment model that would provide him the ability to get timely returns without the need for the social entrepreneur to exit by sale or other traditional exit, which are less common in social enterprise.   He viewed debt as too inflexible and inappropriate for many of his potential investments, especially the early stage investments.

Mr Boehm began exploring investment models using returns that were contingent based on the timing of revenues.  These models assigned a percentage of revenues to investor returns. While there were a variety of existing versions of these models, under US tax law they created negative tax considerations as the investments would be subject to 26 CFR 1.1275-4 – Contingent Payment Debt Instruments, and thus require the Noncontingent Bond Method (“NBM”) of accounting.  The NBM accounting method when applied to early stage companies made it likely that investors would have to pay income taxes before they received income from the company as the accounting method requires the investor to recognize yet unrealized income similar to Original Issue Discount bonds.

Mr Boehm and investor Andy Lower joined efforts with John Berger, a social entrepreneur with a background in investment structuring, to create a structure that would allow contingent revenue based payments without  triggering 26 CFR 1.1275-4. They engaged the law firm of Womble Bond Dickinson to implement the new structure.

Key Innovation

Mixture of Redeemable Preferred Stock and Preferred Dividends.   

The returns to the investor using the  Performance Aligned Stock structure are derived from a percentage of company revenues that are allocated to a mix of prefered dividends and redemptions.   When a company issues Performance Aligned shares the company is committing to used a fixed percentage of its revenues to return capital to the investor via a pre-set ratio of dividends and share redemptions.

At the end of each quarter the company

  1. Calculates the Dividend and Redemption Pool (D&R Pool) – typically 2-8% of cash basis revenue.
  2. Uses the Dividend Portion of the D&R Pool to pay a dividend to all remaining shareholders
  3. Uses the Redemption Portion of the Return Pool to redeem shares.

The Dividend and Redemption Portions are pre-set ratios.  Combined they return a set maximum dollar return to the investors by the time all the securities are redeemed.  For example, if the investors are to receive a 300% return by the time all the shares are redeemed, they would set the Dividend Portion at ⅔ and the Redemption Portion at ⅓.   (Note: IRR will be less than the Target Cash Return due to time value of money)

Target Total Cash Return is mathematically related to the redemption ratio.  The REDEMPTION Portion = 100% / Target Total Cash Return%. The Dividend Portion = 1 – (REDEMPTION Portion)

Target Total Cash ReturnREDEMPTIONDividend
150%67%33%
200%50%50%
300%33%67%

The terms should be structured so that for the agreed revenue projections the investor will have all of their shares redeemed within 5-8 years, meeting the investor’s target IRR.

The investor is still taking an equity-like risk because in the event the company revenues grow slower than forecast, the investor’s IRR declines due to the slower pace of redemptions.  However, the investors can convert their unredeemed preferred shares to common shares at any time.

ACCOUNTING/TAX TREATMENT

Investors who purchase Performance Aligned shares issued by a corporation should be able to treat each redemption as a combination of a return of basis and a dividend.  If the issuer has retained earnings greater than the redemption, then par value of the stock is treated as return of basis and the premium is treated as a dividend. If the issuer does not have sufficient retained earnings (which could happen in the early years in some startups) then the par value and redemption premium are both treated as a return of basis.  

Even though the security is a preferred stock, the issuer may need to follow FASB 150 “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity”.  This rule requires the issuer to record the security as a liability on their balance sheet.

SAMPLE TERM SHEET

Performance Aligned Stock Term Sheet

Deep Thoughts about Revenue-Based Finance Structures

By Brian Mikulencak, Tax Alchemist

11/16/2017

About a year ago, I perceived a general shift in the impact investing community’s appetite for revenue-based financing structures (“RBFs”), from the “curious interest” that predominated in prior years to an increase in the number of investors that modeled, negotiated, and deployed RBFs for the first time. Nevertheless, many investors continue to approach RBFs with cautious reluctance, but may benefit from a couple of thoughts that I’ve had about the past year.

Revenue-based finance structures are still pretty new.

 Perhaps this is a disclaimer, but most parties in early-stage financing deals still turn to the instruments developed and honed in Silicon Valley: convertible notes, preferred stock, “SAFEs,” etc. As a small percentage of deals, RBFs still lack a significant track record and don’t provide a high level of convergence around particular deal terms. This continues to fuel skepticism and provides inertia against trying new deal structures, such as RBFs.

However, many RBF investors and entrepreneurs are increasingly sharing their experiences (including via impactterms.org), and parties have more sources to make the jump from “strong curiosity” to actual implementation.

Revenue-based financing structures can increase transactions costs (particularly in the short-term). 

RBFs can impose higher transaction costs, particularly legal fees, than their traditional early-stage finance counterparts, largely because parties generally have less experience with negotiating and drafting RBFs and less precedent documents available. However, there’s another important reason:

In traditional early-stage finance, investors almost always acquire a perpetual equity stake, whether by purchasing common stock, preferred stock (that converts into common stock), or convertible notes or SAFEs (that convert into preferred stock, that converts into common stock). In other words, traditional early-stage finance employs several different, well-developed roads that lead to the same place: a perpetual equity stake dependent on someone else to determine the investors’ return. That someone else? The large, strategic buyer that purchases the company or the investment bank that facilitates the company’s IPO.

By contrast, RBF investors must work with the company to determine a repayment schedule that dovetails with the unique features of the company and its business. (This requires that the parties trust each other and understand each other’s business and expectations.) However, once structured, RBFs don’t require another party or transaction to determine the investors’ return. In other words, within the entire finance ecosystem, it’s possible that RBFs result in lower overall transaction costs, once accounting for work avoided, and not merely work deferred.

Financial returns and a little help from the tax laws

While RBFs generally schedule repayment terms, they don’t often fix the investors’ actual internal rate of return (“IRR”), due to the repayment flexibility that results from computing repayments by reference to company revenues. Nevertheless, most RBF investors can target a comfortable range of IRRs based on reasonable expectations of the company’s performance, and safeguard against the possibility of zero-return by providing for revenue-based payments shortly after funding, though often after an initial grace period. (By contrast, most early-stage investment structures don’t provide any protection against the very real possibility of a complete loss of investment.) In one deal, however, we structured to mitigate the risk of lowered IRR in the event company revenues lagged significantly behind expectations, using the tax rules.

The investor targeted complete repayment in about 5 years and trusted the company would be able to make complete repayment. However, the investor had some concern that the company’s revenue estimates were a little too rosy and the IRR would be lowered as a result of repayments stretching into the 7- to 10-year range. Indeed, the investor’s IRR would be much lower on a pre-tax basis, but this provided an opportunity to take advantage of certain tax preferences for long-term corporate stockholders.

The parties agreed to structure the RBF as redeemable stock and to characterize the post-year-5 payments as a redemption of the investor’s stock interest. This may provide the investor a basis to treat those later repayments as purchases of “qualified small business stock,” completely excludable from taxable income. While the investor would have preferred to be repaid prior to year 5, this “consolation” could actually increase the post-tax IRR in the event of deferred payment – at no cost to the company.

Of course, this particular transaction was customized for the parties and the company’s business, but provides an example of creative deal structuring by an investor willing to take that step from “curious interest” to actual implementation.