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: 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.