Case study: redeemable equity direct investment for emerging market green manufacturer

A family office with an environmental mandate invested directly into an emerging market manufacturer, and plans to earn a return when the company redeems investor shares.

Neither investors nor founders believed that a sale or IPO was a viable option within 5-7 years from investment. In addition, both founders and investors wanted to maximize cash spent on operations to catalyze growth, as opposed to servicing debt or revenue share payments.

Target IRR: 15% +

Deal type: Redeemable preferred equity

Company: The company manufactures various products using recycled materials. The company had been cash flow positive for more than two years at the time of the investment, but local capital was unavailable to invest in increasing production capacity. There is no history of M&A or IPO activity in the sector in which the company operates.

Investor: The investment was led by a family office that invests globally to optimize both financial return and social and environmental impact. The other investors consisted of a European foundation and two individuals. The investor group seeks a reasonable return given the risk profile of the investment, with a targeted floor of 15% per year over 5 years.

Key innovation

Redemption incentive when investors cannot elect for redemption: The investor group initially sought to structure a redemption right at the election of the investors. They learned, however, that the law of the country under which the company was organized prohibits redemptions at the election of the investors. As an alternative, they allowed investors to mandate profits be set aside for a “redemption fund,” which can only be used for redemption initiated by the company.

Key Terms

Financial terms: Total raise of $450,000 at $775,000 pre-money valuation.

Legal structure: The terms are structured to closely approximate standard U.S. “Seed” preferred equity investment model (except for the redemption provision, which is not standard in U.S. Seed Preferred model).

Redemption: The company has the right to initiate a redemption at its election after 5 years, but the redemption is only effective if accepted by the investors. The investors have the right to require the company to set aside a reserve fund out of profits to fund a redemption. The objective with the set aside is that the company will be motivated to redeem the shares because of the restriction on the use of funds.

Redemption price: The redemption price equals the greater of (1) the equivalent of a 12% per year return and (2) the fair market value of the preferred stock at the time of redemption, as established by an independent valuation.

Special Considerations

Tax considerations: The relatively short redemption period of 5 years would normally cause concern that the IRS might recharacterize this instrument as debt rather than equity. The risk here, however, is probably very low because the redemption option requires “exercise” by both parties. Other factors may weigh in favor of equity treatment as well (e.g., otherwise “thin” capitalization). The instrument most likely avoids the “original issue discount” rules as exempt “participating preferred stock”, due to its participation in dividends and liquidation proceeds.

Other considerations: This structure would be useful in any scenario in which legal rules prohibit investor-initiated redemption and in cases in which the investors would like to control the timing and amount of any reserve that is set aside to fund a redemption.