Revenue Based Financing is the most popular form of contingent payment structures and is often used as an alternative exit structure.
Revenue Based Financing structures 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 Financing 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.
Key Considerations for Deal Structuring
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.
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) requires contingent payment 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. This article goes into more detail on taxes and revenue-based or other similar contingent payment instruments in the US – we highly recommend reading that article if you considering these structures in the US.
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.
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