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 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.
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.
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.
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
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 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 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 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
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) 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.
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)
- how are contingent payment debt securities taxed and accounted for.
- 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