Exits

Case study: lump sum redemption option for emerging market mobile tech co.

An emerging market technology company provides services via mobile phones. The entrepreneur is confident in an acquisition opportunity, but investors wanted an alternative liquidity provision because acquisition has been uncommon for African tech companies in the social sector. The deal includes a provision for the company to redeem investor-owned equity at investor discretion after 7 years, mirroring a traditional “liquidity event” payout.

Investors did not want to rely solely on an exit via sale or IPO. At the same time, both founders and investors wanted to maximize cash spent on operations to catalyze growth, as opposed to servicing debt or revenue share payments. In addition, the founders believed that an equity investment would be more attractive to subsequent institutional capital.

Target IRR: > 15%

Investment type: Redeemable preferred equity

Company: The company supplies information content in emerging markets that is accessible from mobile phones and tablets. The company has revenue and initial signs of direct-to-consumer and channel uptake. There is no established market, however, for the product, and no history of M&A in the sector and region where the company operates.

Investor: The investor group is led by a foundation that invests in early stage emerging market companies. The lead investor seeks a reasonable return, with an emphasis on supporting high risk/high impact companies.

Key Innovation

Redemption exit option: Conventionally, redemption provisions are used as downside protection and with the expectation that they are likely to have little practical use. Here, investors believe that redemption is just as likely—if not more likely—than a traditional exit by sale or IPO. The deal is structured to provide an attractive financial return through redemption after 7 years in a transaction that resembles an acquisition from the investor’s perspective.

Key Terms

Valuation: Total raise of $500,000 at $2 million 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).

“Lump sum” redemption: Investors can elect to redeem all or a portion of their shares at any time after 7 years. The right to redeem is individual, rather than based on the affirmative election of a minimum percentage of shares as is often seen in redemption provisions.

Redemption price: The redemption price equals the greater of (1) the equivalent of a 15% per year return and (2) the fair market value of the preferred stock at the time of redemption, as established by an independent valuation.

Redemption payment: The Company may elect to pay the redemption consideration over a two-year period, but subject to 8% interest during that period.

Special Considerations

Tax Consideration: The redemption option raises a question of whether the instrument could be characterized as debt for tax purposes, but such re-characterization is unlikely given the minimum 7-year term and option to redeem only a portion of the shares. Furthermore, other deal-specific factors support equity characterization (e.g., otherwise “thin” capitalization). See “original issue discount” details for more detail on potential tax issues.

“Lump sum” redemption considerations: The big question with this type of “balloon” redemption provision is what happens if the company does not have adequate resources to redeem the stock at the time of the election date. A few notes on this point:

  1. Investors should analyze the company’s projected cash flow and consider the likelihood that the company will be able to generate sufficient cash to redeem the stock.
  2. Investors and company may need to work together to modify the redemption payout in order to balance the company’s and investor’s cash needs.
  3. The company may have negotiating leverage in a scenario in which cash is constrained, depending on the governing laws for the company and investment agreement. For example, even with a mandatory redemption provision in the certificate of incorporation, Delaware law prohibits companies from redeeming stock if the redemption would leave the company insolvent.
  4. The company and investors may also want to evaluate the ability to finance the redemption through debt or through a later stage equity investment.

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.