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.