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Table of Contents
Revenue-based Debt
Investment Structure Summary
Investor makes a loan to Company with periodic payments sized based on actual revenues, which loan may or may not be secured.
While most credit is extended based on projected cash flows, the parties may agree specifically that periodic (e.g. semi-annual) debt service payments of principal and interest are made in cash up to an agreed percentage of revenues received since the last payment date. Any principal and accrued interest remaining outstanding must be repaid on the final maturity date.
The Company will pay interest on the debt on each payment date up to the amount corresponding to the agreed percentage of revenues received in the corresponding period. The parties will typically agree that, if such amount of revenues is not sufficient to pay all of the accrued interest, interest in excess of that amount is paid-in-kind, by issuing new debt in the same amount or simply capitalizing the unpaid interest by adding it to the outstanding principal amount. Distributions to equity holders are usually not permitted unless the Company is satisfying specific financial tests, including as to meeting early amortization targets and debt service.
If the relevant portion of revenues is in excess of accrued interest, the Company would typically be required to apply the excess revenues up to the agreed percentage to prepay principal on each payment date.
This structure is essentially a form of cash sweep arrangement. While the amount of the cash sweep may be tied to a percentage of revenues as described above, debt documentation will often permit the borrower to pay operating and other critical expenses agreed to be necessary to keep the business running prior to paying debt service, sometimes setting out a cash waterfall for narrower controls over the allocation of cash in each payment period.
This arrangement is beneficial to the Company and the Investor in that it offers protection for the Company against cash shortfalls for the payment of debt service prior to maturity, while mitigating the repayment risk at maturity by applying excess cash flows to prepayment. However, it is critical for parties to make sure the agreed terms will leave sufficient cash in each period to allow the Company to meet ordinary course expenses that are necessary to run its business, at the risk of the cash sweep jeopardizing the Company’s ability to generate future revenue. While this type of funding may be supported by a percentage of gross revenues, in effect the cash flows available for repayment are likely to be limited by the borrower’s operating margin.
There is a range of features that can be agreed to mitigate Investor’s risk and achieve better pricing from the Company’s perspective or longer tenors, including:
- Collateral security, in particular as it relates to the Company’s accounts where revenues are received;
- Account waterfall, where Company can only make payments from the secured accounts as agreed with Investor;
- Debt service reserve accounts, where the Borrower may be required to deposit cash remaining after the cash sweep in each period, until a target amount is reserved (e.g. one or two periods of debt service). The reserved amounts can be used to pay accrued interest in cash during low revenue periods;
- Budget approval requirements to allow the Investor to control the amount of essential expenditures to be paid prior to debt service in the waterfall;
- Restrictions on dividends and other distributions consisting of financial tests designed to prevent cash leakage in case of low business performance; and
- Investor access to equity upside, either by making the debt convertible into shares or other equity interests based on a pre-agreed share pricing framework, or having the Company issue warrants exercisable at maturity for the Investor to acquire shares or membership interests in the Company.
Category
Debt (and equity to the extent of any permitted debt convertibility or warrants in the structure).
In the U.S., the IRS may deem certain debt transactions as “disguised” equity transactions, recharacterizing interest payments as equity distributions to disallow interest deduction by the Investor. Similarly, U.S. courts may recharacterize debt positions as equity, downgrading them in priority in bankruptcy, where debt has priority over equity.
There are a range of factors that may expose a debt transaction to recharacterization as equity, although the threshold for courts to do so is considered relatively high. In the bankruptcy space, federal circuit courts have adopted divergent approaches to the question, in some cases deferring to state laws entirely and in others applying a variety of multi-prong tests. The types of aspects typically taken into account in determining whether a debt transaction is more akin to equity include the following, among others:
- the names given to instruments used to document the transaction;
- whether there is a final maturity date for repayment;
- whether there is a specified interest rate with periodic interest payment dates;
- whether collateral security is provided;
- whether the debt is subordinated to other indebtedness of the Company;
- whether the Company is sufficiently capitalized;
- whether the Company would have been able to obtain financing from unaffiliated lenders;
- whether the investor has (and exercises) typical creditor remedies; and
- whether the proceeds were used to purchase capital assets.
Governance Rights
Generally, there is no dilution of ownership in this kind of financing and lenders do not require a board seat, except to the extent of equity acquired by Investor as a result of conversion permitted by the relevant debt documents or the exercise of warrants received as part of compensation.
Equity participation
Parties may agree that the outstanding principal amount of the loans (including interest paid in kind) is convertible into shares of the borrower according to a pre-agreed pricing methodology after a certain date or upon the occurrence of pre-agreed triggers.
Alternatively, the Company may be required to issue warrants upfront as part of its compensation to the Investor. Warrants give the holder the right to acquire stock from the Company at a specified date and a specified price. In either case the parties may agree on specific methodologies for the calculation of the quantity or price of the shares to be acquired upon exercise.
Convertible debt and warrants are similar in that they allow the Investor to obtain equity upside if the business thrives. However, warrants can be detached from the debt and do not require an exchange of the debt for shares (i.e. the Investor may exercise the warrant and keep the debt, or sell the warrant to a third party and keep the debt).
Investor Qualification Requirements
There are no specific qualification requirements generally applicable to investors in revenue-linked indebtedness; however, note that certain types of transactions may be subject to such requirements and other regulations, in particular the issuance securities, which is subject to strict federal and state securities laws.
Currency Considerations
There are no specific currency considerations generally applicable in connection with revenue-linked indebtedness, except (1) from a credit risk perspective, in connection with any mismatches between the currencies of the Company’s revenues and expenses, or (2) in cross-border transactions, where it is important to determine that the foreign-based borrower will have the ability to acquire U.S. dollars and remit them abroad to repay the debt, or that a judgment for collection will be enforceable for the full amount of the debt in the currency in which it was originally denominated.
Collateral
To be negotiated among the parties.
In the case of financings that are made available on the basis of contracted cash flows, it would be typical for the Investor to require a collateral assignment of the revenue contract. Although the underlying contract may include restrictions to assignment, such as making it subject to counterparty consent, the Uniform Commercial Code, which governs most security interests on personal property, includes provisions that ensure the ability to assign rights to payments in spite of such restrictions in most cases.
In transactions where Investor control of cash allocations is critical, debt documents may include security interests on bank accounts and a contractual framework to govern cash management. It is also not unusual for corporate loans to be secured by liens on the shares in the Company and a blanket security interest by the Company on most of its assets.
Depending on the borrower’s credit, it would not be uncommon for debt to be secured by a lien on all of the assets of the borrower and/or the shares in the borrower.
Priority Payment Rights
Debt holders take priority over equity holders in bankruptcy. As to other creditors, the Investor will have priority to the extent of any collateral security granted to it, but otherwise generally will rank at the same level as other debt holders, except holders of subordinated debt.
Note that certain types of credits may take priority over unsecured debt holders in general, such as certain claims for wages and work-related benefits, certain tax claims and claims in respect of services, goods or indebtedness provided after the bankruptcy filing.
Legal limitations to pricing or total return
In some states, predatory financing practices could lead to claims under state unfair and deceptive acts and practices, usury, predatory lending, fraud, good faith and fair dealing laws.
Usury laws will typically impose limitations to the interest rate that can accrue on certain types of debt, depending on factors such as whether the interest rate is agreed in writing and whether the borrower is an individual or a business. Usury laws vary by state. In New York, usury laws’ limitations to interest rates only apply to loans under $2.5 million; for transactions below that amount, charging interest above 25% per annum may constitute a crime, and interest charged from individuals for debt below $250,000 cannot exceed 16%.
In some jurisdictions, specific regulations have been enacted that require or will require specific disclosures, and in some cases specific registrations, from revenue-based and other commercial financing providers.
Limitation of Liability
Investors’ liability towards the Company will generally be limited to the amount of their loan commitment.
Transfer Restrictions
There are no standard or mandatory transfer restrictions, although the parties can agree otherwise. Debt securities might be subject to transfer restrictions under federal securities laws.
Comparison to Revenue Sales and Equity Investments
The term “revenue-based financing” is typically used interchangeably to describe different types of financing structures. In some contexts, this term is used specifically to refer to revenue sale transactions, instead of loan financings. In revenue sale transactions, the investor is taking the business risk – it only gets paid if and when the revenues are generated. If the issuer fails and never receives any revenues, the investor never receives a return, approximating it to an equity investment.
Similar transactions may also be structured as a preferred equity investment, where the preferred investor has a preference vis a vis the other shareholders for the receipt of distributions. The amount of the preferred distributions may be determined as a percentage of gross-revenues, and be payable to the preferred shareholders before other shareholders receive any distributions.
Preferred investments may be redeemable or not. Redeemable preferred shares may be redeemable by the issuer or at the option of the investor, upon agreed conditions. Parties may also agree that preferred distributions will be made in the form of share redemptions instead of dividends, such that the investors’ equity position is reduced over time.
In the case of preferred equity investments, as a general rule dividend distributions will be limited by the issuer’s retained earnings – rules vary depending on the jurisdiction of the issuer, but typically companies cannot make dividend distributions in excess of retained earnings outside of extraordinary situations. This might mean that, even if the issuer earned revenues, it may not have cash available for distribution (or which is legally permissible to distribute) – in these cases, parties will typically agree that the distribution is made in kind (i.e. by issuing new shares to the investor) or that the dividends will accumulate and be paid when cash flows permit, or at liquidation or upon redemption.
Non-equity transactions, such as debt financing, are not subject to this retained earnings-related limitation. Additionally, debt transaction have a maturity date by which the loan has to be repaid in full, with the amount of revenues received potentially resulting in faster repayment via de cash sweep. In revenue sale and equity structures, there is typically no maturity date or schedule of payments.
Equity holders also take a backseat to other creditors in a liquidation scenario, and are only paid after debt claims are paid in full.