CASE STUDY – Carried Interest by Verified Impact Calculations (CIVIC)

Introduction

In a standard venture capital or private equity fund, the fund manager is entitled to 20% of the fund’s profits. This is known as the “carried interest.”

The innovation of Buckhill Capital and Morrison & Foerster is a set of provisions that can be imported into the relevant documents of most venture capital or private equity fund so that the carried interest is paid out to a fund manager only to the extent that the fund achieves quantified, verifiable impact metrics agreed upon by the fund manager and the fund’s investors. This has the potential to create billions of dollars of incentives for institutional investment managers of all kinds to pursue impact goals alongside financial returns.

Background

Henrik Jones and his company, Buckhill Capital, seek to “finance companies on a mission.” In the course of doing this work, Buckhill encountered a multitude of companies and investment funds claiming to seek environmental, social, and other impact goals, along with delivering a compelling financial return. At times, after investors have signed their agreements and wired their money, Buckhill has observed that the initial focus on impact alongside financial return has faded or took a back seat to financial return and even disappeared altogether. Even when a company or fund addresses impact in the narrative of its periodic reports, it does not always get the same rigorous treatment that the financials get.

Buckhill was not aware of any investment fund manager that has its receipt of carried interest depend directly on whether or not the fund achieves quantified impact goals that are independently audited and verified and that has done so in a manner specifically designed to be easily repeatable and used at scale by other fund managers.

Buckhill decided to things differently when it was presented with an opportunity to gather a group of investors and pitch itself as an attractive source of Series A funding to a highly impactful socially responsible company, Higg Co, that was spinning out of the Sustainable Asset Coalition. Buckhill did not want to give mere lip service to impact and wanted to “put its money where its mouth was” and do something different. That something is the Carried Interest by Verified Impact Calculations (CIVIC).

Carried Interest by Verified Impact Calculations (CIVIC) innovation

BHI’s Carried Interest by Verified Impact Calculations (CIVIC) began with Buckhill’s vision of materially and financially aligning a fund manager’s interests with those of its impact-minded investors and impact-minded portfolio companies. It took the Social Enterprise + Impact Investing team at Morrison & Foerster to fully flesh out and implement the idea both in a way that would work for BHI and its investment into Higg Co but, per Buckhill’s directive, for any venture capital or private equity fund looking to do the same.

CIVIC Overview

The first key feature is the modularity of the BHI CIVIC approach. The documentation Morrison & Foerster prepared for BHI is set up so that any venture capital or private equity fund manager can customize and integrate the CIVIC distribution mechanics from BHI’s term sheet and BHI’s operating agreement into their own fund’s term sheet and operating agreement, leveraging the work that Buckhill and Morrison & Foerster have already done in thinking through some of the details discussed below.

The CIVIC mechanics then reference to a separate quantified Impact Test, which sets forth the quantified impact test for BHI or another fund. The quantified Impact Test is designed to be fully customizable on a fund-by-fund basis. This gives flexibility for different funds to have different impact goals, in different ways, and on different timelines. So the CIVIC provisions do not need to be reinvented with each fund, but each fund has full freedom in defining its own impact goals.

The other key features are reflected by the terms of the CIVIC provisions. To implement BHI’s general idea, Morrison & Foerster thought through some of the details that the solution would need to address. For example, is it more appropriate to the Impact Test be a staged, cumulative test (e.g., whereby the real goal is to reduce carbon emissions by X tons by year 10, but with interim, trend-line goals along the way) or a series of independent annual tests (e.g., prevent X tons of carbon in year 1, then regardless of year 1 results, prevent Y tons of carbon in year 2). Morrison & Foerster advised that the test use the former approach, as it better allows for the potential high variation year to year as a fund pursues impact goals that are intended to be achieved over its entire term. A related issue is what happens if a fund does not meet its interim goal for a given year — does the fund manager forever lose the carried interest associated with that year, or can the fund manager earn it back by overly successful follow-up years that get the fund back to the desired trend-line vis-à-vis its impact goals?

Morrison & Foerster advised allowing the fund manager to earn back carried interest not received in a previous year, again because the impact goals are determined by the desired end of a long journey, and at the outset we might know the rate of progress along the way.

Please find here the terms of the CIVIC waterfall that can be replicated in funds’ Private Placement Memoranda and Limited Partner Agreements.

Conclusion

Buckhill hopes that the CIVIC waterfall will be a standard in impact investing and promote accountability of fund managers across the entire ecosystem. By promoting its adoption, if it is not already in fund documents, investors will have the knowledge to ask for the term.

Resources

Case study: convertible revenue loan for green cleaning product

A Latin American company produces and distributes green household cleaning products. Investors have funded the company with a convertible loan that is repaid monthly through a percentage of revenues as opposed to fixed interest payments, allowing the company more flexibility for growth than with traditional debt.

The company had limited sales and marginal EBITDA, which made valuation challenging, so the investor designed a tailored senior convertible loan that would be paid back through an escalating percentage of sales.

Target IRR: 20-25%

Type of investment: Senior convertible loan to a non-US-based enterprise

Investor: An impact investment fund focused on supporting the early growth of social and environmental companies in Latin America. It invests in a wide range of sectors, such as education, sustainable consumer products, health, housing, organics and clean energy. It seeks to tailor its transaction structures to the needs of each portfolio company.

Company: A producer and distributor of 100% non-toxic and biodegradable household cleaning products. Company is generating revenues and is cash flow positive.

Key innovations

Revenue-based loan: The company’s total loan obligation is fixed, and repayments are determined as a share of revenue, escalating over time until the entire obligation is repaid.

Conversion option for investors, at investor discretion: The loan may convert into equity at a pre-determined multiple of trailing revenue or EBITDA, at the discretion of investors.

Key terms

Investment amount: The investment was broken down into two tranches: (1) US$300k immediately, and (2) US$150k after 12 months, contingent on reaching predefined operating and financial milestones.

Repayment timeline: The target term is 5 years, with an 18-month grace period for both principal and interest.

Revenue share rate and repayment cap: After the grace period, the company pays an initial 3% to a maximum of 9% of revenues (escalating over 3.5 years) until the investor receives a total of 2.3x its original investment.

Conversion option: Convertibility provision allows the investor to convert into equity at its own discretion and at a valuation equal to the higher of 1x TTM sales or 5x TTM EBITDA. At the time of conversion, the investor can only convert the balance of the total obligation still owed calculated at 2.3x the total loan provided, less any loan repayments made up to that date. Conversion is only allowed after an initial 18-month lock up period.

Governance: The investor assumes one Board seat and has veto right over a number of pre-defined “Major Decisions”, including new share issuance, new debt issuance, CAPEX and budget decisions.

Special considerations

Tax considerations: The local tax regime does not have any special treatment for flexible debt schedules, so not a concern for the issuer in this case. For a U.S. lender, “original issue discount” tax implications could be significant given the grace period, variable nature of payments, and lack of”original issue discount” reporting by the company.

More detailed deal rationale and context:

  1. Company has to be close to profitable or already profitable, so that it can service debt at a % of revenue after about 12-18 months.
  2. Margins need to be strong, if investors are to take up to 9% of revenues by year 5.
  3. Company should not have significant prior debt.
  4. Company should not expect to have a large need for additional equity/debt requirements during the term of the investment.
  5. Structure appealed to investor over equity because it would allow the company to grow and thrive over the longer term without needing to be acquired in the short to medium term to provide a liquidity event, for two reasons: (1) It was not obvious that the company would appeal to a strategic buyer within the life of the fund, and (2) The investor was concerned that sale to a strategic buyer could compromise its mission.
  6. The structure also appealed to the company because the founders liked its equity-like alignment of incentives (the faster the company grows, the higher the IRR for the investor), however they got to retain more ownership than they would have under an equity deal and the investor’s returns are capped.
  7. Local business environment: local founders are often comfortable with the idea of building a company for the long-term, with potential generational succession plan. Therefore, the idea that they wouldn’t be acquired in the next 5-7 years was not off-putting.

Case study: redeemable equity direct investment for emerging market green manufacturer

A family office with an environmental mandate invested directly into an emerging market manufacturer, and plans to earn a return when the company redeems investor shares.

Neither investors nor founders believed that a sale or IPO was a viable option within 5-7 years from investment. In addition, both founders and investors wanted to maximize cash spent on operations to catalyze growth, as opposed to servicing debt or revenue share payments.

Target IRR: 15% +

Deal type: Redeemable preferred equity

Company: The company manufactures various products using recycled materials. The company had been cash flow positive for more than two years at the time of the investment, but local capital was unavailable to invest in increasing production capacity. There is no history of M&A or IPO activity in the sector in which the company operates.

Investor: The investment was led by a family office that invests globally to optimize both financial return and social and environmental impact. The other investors consisted of a European foundation and two individuals. The investor group seeks a reasonable return given the risk profile of the investment, with a targeted floor of 15% per year over 5 years.

Key innovation

Redemption incentive when investors cannot elect for redemption: The investor group initially sought to structure a redemption right at the election of the investors. They learned, however, that the law of the country under which the company was organized prohibits redemptions at the election of the investors. As an alternative, they allowed investors to mandate profits be set aside for a “redemption fund,” which can only be used for redemption initiated by the company.

Key Terms

Financial terms: Total raise of $450,000 at $775,000 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).

Redemption: The company has the right to initiate a redemption at its election after 5 years, but the redemption is only effective if accepted by the investors. The investors have the right to require the company to set aside a reserve fund out of profits to fund a redemption. The objective with the set aside is that the company will be motivated to redeem the shares because of the restriction on the use of funds.

Redemption price: The redemption price equals the greater of (1) the equivalent of a 12% per year return and (2) the fair market value of the preferred stock at the time of redemption, as established by an independent valuation.

Special Considerations

Tax considerations: The relatively short redemption period of 5 years would normally cause concern that the IRS might recharacterize this instrument as debt rather than equity. The risk here, however, is probably very low because the redemption option requires “exercise” by both parties. Other factors may weigh in favor of equity treatment as well (e.g., otherwise “thin” capitalization). The instrument most likely avoids the “original issue discount” rules as exempt “participating preferred stock”, due to its participation in dividends and liquidation proceeds.

Other considerations: This structure would be useful in any scenario in which legal rules prohibit investor-initiated redemption and in cases in which the investors would like to control the timing and amount of any reserve that is set aside to fund a redemption.

Case study: lump sum redemption option for emerging market mobile tech co.

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:

  1. 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.
  2. 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.
  3. 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.
  4. The company and investors may also want to evaluate the ability to finance the redemption through debt or through a later stage equity investment.