I fully support Obvious Ventures’ introduction of the World Positive Term Sheet and the idea that venture capital term sheets should include details on the core non-financial values of the company. I’m less certain, though, about the suggestion that the values section of the term sheet should not have legal significance. If these values are important – perhaps equally or more so than financial return – then why not reflect them in some way in the investment documentation and/or the company’s governance documents?
Without legally binding terms, the company and investors may not be held accountable to the values expressed in the term sheet. Requiring measurement and reporting on impact is an easy place to start. No investor would agree to invest in a company without a legal requirement for regular reporting on financial performance. If an investor is equally concerned about performance with respect to social and environmental indicators, then why rely on a handshake understanding with respect to tracking and reporting on non-financial performance instead of a legally binding provision?
If you would like to learn more about how to incorporate legally binding commitments with respect to social and environmental matters, check out the impact terms project. It includes sample term sheet language for a variety of legally binding non-financial commitments, including measurement and reporting on impact, transitioning to a benefit corporation or certified B Corp, and special voting rights to ensure social and environmental values are upheld.
DC Community Ventures (DCCV) announced its $100,000 variable dividend redeemable preferred stock investment in Broodjes & Bier, a female owned, Dutch inspired sandwich company in Washington DC. The structure of DCCV’s investment gives founder Sarah Frimpong the flexibility to invest in growing Broodjes & Bier while simultaneous providing for DCCV’s exit through an equity redemption schedule.
Continuing the discussion of early-stage investing, a common thought circling around the venture capital community is that their the traditional investment model is broken. In “Investing without Zombies”, I focused on the odd choice of optimizing the system for the least likely case. But there is a second flaw in that system as well. Exits.
Traditional equity investments are worthless until a company “exits”. IPOs are finally happening again, but only 222 took this path in 2013, and not all of these were startups. Nearly every other successful early-stage investment for 2013 was due to an acquisition.
Given that fact, why would any sane investors structure where the outcome is dependent on an third party who comes along at a random time to value the investment, who often illogically believes this particular acquisition will succeed?
Even if you convince me that the studies are wrong and that acquisitions are mostly successful, that still doesn’t explain why investors would want to wait for an undetermined amount of time, for a happenstance meeting with some new investor, who for whatever reason wants to own the company more than the current investors and founders.
Public equities and commodities do not work this way. If I have a share of public stock, I can sell it any day, for a fairly predictable price (i.e. on most days the price will be within a few percent of yesterday’s listed price). Like private equities, I need a third party to value my shares, but the point of the public market, including the role of specialist or market maker, is to ensure that the third party will be there any and every day.
Traditional debt, meanwhile, works in the completely opposite manner to private equity. Government and corporate bonds come with a fixed schedule at the time of purchase. There are no third parties in these transactions, making the whole transaction and value completely predictable at the time of the investment.
Looking at investments in this way, I wondered if there was not a structure for early-stage investments that fell in-between private equity and debt. A structure where the investor would not be beholden to a third party, have a better idea of the value of the investment on any given day, and never be sitting around waiting for a random event to trigger the valuation.
As a bonus, I was looking for a structure that worked for cases where the entrepreneurs were happy running their businesses, not seeking to be acquired. Which also happens to better align the interests of investors with entrepreneurs, building value by building sustainable businesses, rather than spending time shopping for acquirers.
Despite the long wish list, I found such a structure.
The answer is revenue-based financing (RBF), also known as royalty-based financing. RBF comes in a variety of forms, but in general it works like this:
Investors provide $X
Entrepreneurs use $X to earn $R
Investors receive Z% of $R, until a total of $2X-$4X is returned
Or in other words, the investors are buying Z% of “top-line revenues” (typically between 3% and 9%) until they are repaid between 2x and 4x the initial investment. Those two values are tuned to provide a reasonable length of repayment, providing a reasonable rate of return (IRR) given the risks of the specific investment.
For early-stage investments, my accelerator Fledge uses 3%-4% of future revenues and a 3x-4x multiple. For growth-stage investments, revenue percentages range from 3%-9% depending on actual revenues, and multiples are typically 2x-3x.
On most measures, RBF falls mid-way between traditional equity and traditional debt. RBF investors do take a risk on future revenues, but no risk waiting for a third party to come along to provide a future value. The value of an RBF investment is predictable in terms of potential cash return, but unpredictable in terms of time, and thus with an unpredictable IRR.
The biggest objection I hear is that it caps the upside of the investment. At Fledge, we overcome that issue by having some equity that is not part of the RBF investment. Thus if some third party really wants one of our companies, we’re just fine with that. And in any case, I find that objection to be a flaw in our current capitalistic system.
Given the advantages, my biggest question is why I’ve found so few other early-stage investors using this structure?
This blog originally appeared on lunarmobiscuit.com. Luni Libes is a 20+ year serial entrepreneur, (co)founder of six companies.His latest startups are Fledge, the conscious company accelerator, where he helps new entrepreneurs from around the world navigate the complexities between idea and customer revenues, and Aviary, the conscious seed fund, which provides early-stage funding to impactful startups.
Let’s face it: one of the biggest issues for many angels face is building liquidity into their portfolios. Any time new ideas and alternatives come to build returns they are worth a good look.
David Gitlin, who co-leads the Emerging Technology Practice at Greenberg Traurig LP is a passionate voice for one alternative, “structured exits,” which are investment structures designed to achieve a desired investment return without reliance on a traditional exit. The Philadelphia-based attorney told me, “It’s very hard for companies and investors to get into a new mode of thinking, but the concept of structured exits is really a win-win for so many. Hopefully they will be more of the norm in the future. If I was running an investment group, I would seriously look at this.”
The main difference with a structured exit is that it allows you to structure your deal risk. You don’t gamble on whether or not there will be an exit and instead, you can start getting back your investment fairly quickly. While there are several types of structured exits, the key take-away is that this approach offers more options and significant benefits for angels.
Benefits of Structured Exits
Quicker liquidity—instead of waiting years for a big pay out, you receive smaller regular payouts, with the size and rate dependent on how you structure your deal.
Less risk—a predetermined payout is specified over a certain period of time.
Flexibility—deals can be structured in many different ways, for example a fixed or variable percentage; a cap of 3-5x investment or no cap; etc.
In case of an exit – equity “kickers” can be worked into the deal to account for an exit.
For the entrepreneur – little of no dilution in exchange for growth capital.
The flexibility of structured exits are very attractive and they can be adapted to fit the needs of angels and entrepreneurs.
The three main types of structured exits are demand dividends, equity/mandatory redemption, and cash-based loans.
Demand dividends and equity/mandatory redemptions are similar because they can be set up like royalty payments and are typically paid monthly soon after cash is received. It typically takes just a few years to regain your original investment. In an equity/mandatory redemption, your total payout is capped, so payments to you are done after you receive a certain amount past your investment. Demand dividend deals can be structured to include no cap on the investor’s return. Both are taxed favorably to the investor.
With a cash-based loan the investor receives regular payments plus interest, tied in whole or in part to the company’s net available cash flow. If the company ends up liquidating, then the debt is the first thing that must be repaid. For tax purposes the interest earned on the loan is considered ordinary income, not part of capital gains tax, which may be less interesting for many investors.
Determining which of the three structured exits to use comes down to personal preference. The number one thing to consider is whether this type of deal is feasible for the company you want to work with. If there has been cash flow already, or if there is going to be cash flow soon, then a structured exit might be a good option.
Candidate Companies for Structured Exits
Structured exits work best with companies that don’t fit the traditional VC or angel equity deal. However Gitlin maintains they could work for many current venture-backed companies as well once investors think through this alternative way of financing startups. For now, most agree that companies with a limited or long pathway to exit are a good fit for structured exits. These might include:
Impact companies—those with a double mission of being self-sustaining and offering something for the greater good but may not show the high growth of other types of companies.
Revenue generating companies, such as restaurants or consumer novelties—potential upside for good growth, but limited opportunities for an exit as per the nature of the business.
Family-owned or multi-generational business—potential for growth oftentimes complicated by owners not wanting to exit.
Outside U.S./ Underserved geographies—not a lot of buyers for these companies even if they did want to exit as they have smaller markets and fewer ways to exit.
Structured exits offer some interesting options and may open the door to investment opportunities that we might not have otherwise considered. As angels, we need to be on the forefront of learning all we can about structured exits and educating other angels as well as entrepreneurs and their company board members. Gitlin’s detailed article on structured exits is a great primer. It discusses how each of the three types of structured exits work.
This blog originally appeared on Forbes. Marianne Hudson is an angel investor and the Executive Director of the Angel Capital Association (ACA), the world’s leading professional association for angel investors.
As cooperative culture spreads into the tech world, Loomio is part of a new wave of entrepreneurs figuring out how to finance a more democratic, values-centered online economy.
Perhaps you remember the scenes, during the Occupy movement in 2011, of hundreds or thousands of people making decisions together in parks and squares. They used strange hand signals, unwritten rules, and a “people’s mic” that amplified speakers’ voices through repetition by the crowd. This ecstatic democracy was short-lived. At the movement’s epicenter in New York City, these general assemblies faded away after police cleared the encampment that November. But in Wellington, New Zealand, a group of activists from the local Occupy group gave their assemblies an afterlife in an app. Now, they face the challenge of making it succeed in an online economy that remains far from an Occupy-style utopia.
True to its democratic ideals, the company is a worker cooperative, owned by the people who develop the software.
Loomio, as their creation is called, has already enabled thousands of groups to deliberate, debate, and make decisions online. It translates the jargon and hand signals of direct democracy into an intuitive pie chart of opinions and a comment thread. True to its democratic ideals, the company is a worker cooperative, owned by the people who develop the software.
Loomio’s values have won it a devoted user base. But they’ve also meant that the usual rules for starting a tech company don’t apply. The most common method for building a big online platform is to raise a lot of money quickly, achieve ubiquity, and then sell the company in a buyout or an initial public offering in the stock market. To get that quick money early on, founders pass considerable ownership and control to investors, who then cash out when the company gets sold.
But this won’t work for a mission-driven co-op. Cooperatives have to remain under the control of their members, not their investors, and mission can’t take a back seat to profits. As cooperative culture spreads into the tech world—a trend some of us have called “platform cooperativism”—Loomio is part of a new wave of entrepreneurs trying to figure out how to finance a more democratic, values-centered online economy.
In recent months, Loomio has raised nearly half a million dollars without giving up control. To understand how, I spoke with Ben Knight, one of the company’s founders.
Nathan Schneider: Since it emerged out of the Occupy experience, how far has Loomio come?
Ben Knight: When we got a prototype up and running in 2012, it was immediately clear that it’s not just activists who need to make decisions together. Over the last four years, Loomio has been used by thousands of change-makers, businesses, governments, city councils, and community groups. It has been used by companies and boards of directors for rapid collaboration, as well as by activist networks to democratically organize large-scale protests. It has been used by governments to engage citizens in collaborative policy-making, right down to families using it to make decisions about how to care for elderly relatives.
People have used Loomio to make more than 40,000 decisions in more than 100 countries, and our international community has translated the software into 35 languages already.
Schneider: So you’ve got a platform being used around the world. Why has financing been so hard?
Knight: The main challenge we set for ourselves was finding a way of funding Loomio to scale that was strongly aligned with our social mission. We’ve felt from the beginning that traditional venture capital is not a good fit for an organization that puts its social mission first. Initially, it was difficult to find models to follow because the default financing mechanisms are built on the assumption that most companies will fail. So investors see the possibility of near-infinite return as a necessary prerequisite for investment.
Schneider: The knee-jerk question of the techno-optimist: Did you try crowdfunding?
Knight: We ran two successful crowdfunding campaigns in the earliest stages of Loomio’s development. The first was a tiny campaign in the first couple of months, when Loomio was literally just an idea. Once we had a prototype up and running, we ran a more substantial campaign to fund the transition from a proof-of-concept to a solid web tool that could scale. We raised enough to fund a year of development, from more than 1,600 people all over the world.
Relying purely on the generosity of our personal networks, however, didn’t feel like a sustainable way forward. We felt we owed it to all the people who had put their trust in us to find a way to pick up the pace without burning out.
Schneider: Last time I saw you in the United States, you were looking for foundation support. How did that go for you?
Knight: We’ve had support from inspiring folks like the Shuttleworth Foundation, the MacArthur Foundation, the Sunlight Foundation, and the Namaste Foundation. But the more conversations we had with people who had been there before, the more apparent it became that the 501(c)3 structure just isn’t built for the type of scale involved in a high-growth software company.
Given that enabling behavioral change at a global scale is such a core part of our social mission, we knew we needed to find a financing mechanism that was aligned with the ability to move quickly and grow appropriately.
Schneider: What came next? What led you toward another approach?
Knight: This realization about alignment led us to reaffirm our roots as a social enterprise—“social” meaning that we put our social mission first, and “enterprise” meaning that we take an enterprising approach to financial independence to drive positive impact.
We settled on a mechanism called “redeemable preference shares,” which was exactly what we were looking for—a way of providing a fair return to investors while also protecting our social mission. Within two months, we had raised $450,000 from a small group of investors. Our lead investor is Sopoong Ventures, a social venture fund based in Seoul. The name Sopoong is an acronym for “the social power of networked groups,” and the fund is a perfect partner driven by the same vision and values as we are. Our investors have been an amazing addition to our team, providing much more than just money.
Schneider: What are redeemable preference shares, and what makes them such a good fit?
Knight: Redeemable preference shares are a fairly conventional financing instrument, but aren’t widely used in the startup world. “Redeemable” means that the shares are not traded externally. Instead, the shares are eventually purchased (“redeemed”) by the company with an agreed-on return, after an agreed-on period of time, provided the company is producing sufficient surplus. In our case, setting up the investment mechanism meant creating a new class of impact-investor shares. These shares sit alongside the worker-member shares in the cooperative, which are non-financial governance shares. The interests of the company and the interests of investors line up.
Schneider: Where’s the accountability? Who holds what risk?
Knight: In terms of accountability, we work closely with our investors as trusted advisors. We take their input seriously, and if they ever feel we’re getting off track, with our business or our social impact focus, then we’ll engage in deliberation to come to a shared understanding. But the bottom-line decision-making sits with the cooperative. And our investors are comfortable entering into a collaborative relationship on those terms.
This trust comes from a strong sense of alignment with a shared social mission, and from the shared risk in the development of Loomio. There has been a huge amount of unpaid time on the part of the founders and workers, so they’re carrying risk just like our investors do. Clearly, the founders aren’t aiming to get rich quick and walk away, so it feels much healthier than the strained founder-investor relationships you sometimes see in the conventional startup world.
Schneider: How long will this arrangement keep Loomio going and growing?
Knight: We’re rapidly building a robust organization to make the transition from a bootstrapping, startup phase into a proactive, growth phase. Another major focus for this year is making it as easy as possible for people to use Loomio alongside the other tools they use in their work. Our goal is to get to the point where making group decisions online is as easy and natural as checking your email. We will be raising another round of impact investment later this year.
Schneider: Is your strategy replicable? How can others get in on it?
Knight: We now know it’s possible to raise capital in a way that doesn’t compromise a company’s social mission. Redeemable preference shares provide a well-tested and flexible framework, and there are other models that can be used to achieve a similar purpose.
Schneider: When were you most tempted to give in and take the big VC money?
Knight: Along the way, people steeped in the Silicon Valley venture-capital mindset told us that we were crazy even to be attempting to find ethical investment. They told us no one cares about social impact that much.
Our experience is that this just isn’t true. The main lesson for us was the importance of sticking to our values and finding that there truly are plenty of values-driven people and organizations that want their money to be doing positive things in the world.
Nathan Schneider wrote this article for YES! Magazine. Nathan is the author of, most recently, Thank You, Anarchy: Notes from the Occupy Apocalypse. Follow his work on Twitter @nathanairplane and on his website, TheRowBoat.com.
The social enterprise community is held up as an innovative ecosystem of investors and entrepreneurs, designing businesses models as diverse as the challenges they address—from poverty in the global south, to recidivism and urban farming in the US.
How are these businesses being funded? Oddly enough, the vast majority are raising capital using the standard equity (or convertible note) term sheets that are designed to support fast-growing tech start-ups. If a company is building a water distribution system in Kenya or local food hub in North Carolina, why would they be funded using the same investment terms that were used to fund Snapchat, Instagram or Uber? When was the last time you saw an artisan sourcing project IPO or get acquired by Google?
At Pi Investments, we quickly came to the realization that we needed to redefine terms to better fit the unique attributes of social enterprises—whether it be longer timelines, lack of scalability, unconventional exits, or broader community participation. And we were thrilled to see that others in the field felt the same way. In this post I want to share some thoughts on why the equity model is misaligned with many of the businesses we are seeing, and to highlight some of the alternative structures that we and others are using to try and innovate.
Standard term sheets: what’s broken?
It’s worth reminding ourselves how the early-stage equity investing model works. Angels and venture capitalists expect a large failure rate. As a rule of thumb about 15% of the companies are expected to generate 85% of the returns. At least half of the portfolio will return less than the capital originally invested. If you often hear that early-stage investors look for 10x returns, there’s a simple mathematical reason for that. Those ‘home runs’ have to make up for all the failed investments. Take those ‘home runs’ away, and the fund would have trouble returning capital to investors. In essence, this means that early stage venture/angel investors should only invest in companies that have at least the potential to become big winners. As Peter Thiel puts it: “only invest in companies that can return your entire fund” (so-called “dragons”, in recent venture lingo).
If we (investors and entrepreneurs) are honest with ourselves, we should recognize that most of the social enterprises we are building are very unlikely to have the growth/scale trajectory and to generate the kind of exit that early stage investors need to make these numbers work. This doesn’t mean they are inferior businesses—they are simply designed for a different purpose and have a different path to success. If we try to shoehorn this diverse set of businesses into standard venture terms (as we’re currently doing), we’ll end up with one of two outcomes:
1. Businesses that have a very real chance of being financially viable will not get fundedbecause they’re unlikely to become a home run. This is a shame, since we’d be missing out on a big piece of the investable universe of solutions. It’s as if we’re telling entrepreneurs – “go solve these social challenges, historically the domain of non-profits, using for-profit models. But I’ll invest only if they can look like WhatsApp/Uber/Snapchat, because I still need my 10x return. Otherwise, you should just go back to being a non-profit”
2. Businesses get pushed to aggressively pursue a growth trajectory that may be unrealistic or counterproductive for them. Investors and entrepreneurs manage to convince themselves (and each other) that the business can (and needs to) scale and exit. If investors aren’t able to get their money back from these deals, they will not be able to cycle this money back into new companies. An equity investment without the exit ends up looking a lot like a grant. And despite the insistence on scalability, there are plenty of ways to achieve impact without needing to grow at the aggressive clip required by a traditional VC.
To be clear, there is absolutely a group of companies with tremendous growth and impact potential. Some of these can and do deliver fantastic returns to venture investors. There is even a growing body of evidence that points to these companies outperforming their less mission-driven peers, primarily based on their ability to attract top talent and have a deeper connection with their customers. The question which still needs to be addressed with these high-flying companies is one of mission-drift or ‘mission-aligned exits’ – does the company stay true to its values and mission after it gets acquired by a competitor to generate liquidity for investors. That’s a topic for a separate post – my intent here is primarily to highlight the need to acknowledge companies that do NOT fit this mold and should not be funded using the same terms.
Alternative approaches: where can we go instead?
To counter this “one size fits all” approach, there is a growing group of investors and entrepreneurs that are working to develop and apply deal structures that support the growth trajectory of the business, while providing realistic returns to investors.
We refer to these alternatives as having “structured exits”, in that the path to liquidity is explicitly structured into the deal terms (as opposed to relying on an as-yet-unidentified acquisition or an IPO). In some cases, these are still structured as equity investments, but redemptions are more explicitly defined (i.e. specific terms or timeframes for the company to buy shares back from investors). In other cases, investors are paid as a percent of revenues or profits over time, resulting in structures that can be described as an equity/debt hybrid (returns can sometimes be capped at an overall multiple, like debt, but are tied to the growth of the business, like equity).
The overarching premise and intent of these structures can be summed up as follows: if an investment can realistically be expected to support the business to a point where it is generating enough profits to pay investors back, and it is agreed/assumed that a traditional exit is unlikely (or not desirable), we should be able to come up with a formula to distribute cash back to investors while providing enough breathing room for the business.
The examples of how this gets implemented are varied and evolving. Some of the examples we have seen or participated in include:
Revenue-based loans, where investors earn a % of revenue until they achieve a pre-determined multiple on their investment (e.g. 3% of revenue, until investors earn a 2x multiple on their investment). There are quite a few variations around this theme – some including a fixed coupon debt instrument, some having a conversion option. Our investment in Big City Farms was based on these terms, and we are seeing a number of investors using variations on this.
Equity redemptions, where the share price of the redemption by the company is pre-determined at a given multiple and shares are re-purchased over time using a % of revenue (e.g. 5% of revenue used to redeem shares at 3x the investment price). This structure has been applied by the Fledge accelerator in Seattle, as well as by David Bangs and the Seattle Impact Investing Group.
Preferred equity, where dividend distributions are defined as a % of revenues/profits and capped at a certain multiple on invested capital (e.g. 30% of cash flows distributed as dividends, until investors earn a 2x return). This is a version of the ‘demand dividend’ work that was developed by John Kohler at the University of Santa Clara and applied by Eleos Foundation in their investment in Uncommon Cocoa (where Pi Investments also participated).
Cashflow/equity splits, where the investment is structured as an LLC and any cash flows are distributed to investors based on a pre-determined waterfall (e.g. 90% of cash flows go to investors until some preferred return is achieved, then distributions are based on pro-rata membership rights).
These are all emerging solutions – none is perfect and none should be expected to become the ‘new norm’. There are still plenty of questions for investors and entrepreneurs to sort through, such as tax implications and the ability to raise follow-on rounds of capital (though significant progress is being made on all these fronts). These are real challenges for us to continue to tackle, but we believe the effort is worthwhile. All too often, the supposedly simple alternative – “let’s just default to the venture terms we all know!” – is just poor investing.
As we continue to work on these new models, we are always looking for thought partners, case studies and co-investors, such as those in theTransform Finance Investor Network. If we are going to wean our sector off of its standard term sheet habits, we’re going to need a community of investors and founders who are willing to think differently. If you are an entrepreneur who thinks that one of these alternatives might be the right path for you, or if you are an investor with an active interest in these structures, we would love to hear from you.
This post originally appeared on the Transform Finance blog. Aner co-leads Pi Investments, which emphasizes community empowerment and environmental sufficiency through a 100 percent impact portfolio approach. In that capacity, he evaluates investments across asset classes, including early stage investments, private equity and debt, and real assets. Pi is a founding member of the Transform Finance Investor Network. Aner can be found on Twitter @anerbenami.
Throughout the Impact Terms website, we describe innovative deal terms in contrast to terms found in “conventional” term sheets—mostly, in reference to early stage equity investment deal terms. Without a firm grounding of these basic terms, much of the content on this site will be out of context.
Are you prepared for the content on this site?
It’s important to have a strong foundation in early stage financing and term sheets in order to benefit from the innovative deal terms found on the Impact Terms Project.
For example, do you know the terms “liquidation preference” and “participation?” A term sheet might read:
Liquidation Preference: In the event of any liquidation or winding up of the Company, the holders of the Series A Preferred shall be entitled to receive in preference to the holders of the Common Stock a per share amount equal to [x] the Original Purchase Price plus any declared but unpaid dividends (the Liquidation Preference).
Participation: After the payment of the Liquidation Preference to the holders of the Series A Preferred, the remaining assets shall be distributed ratably to the holders of the Common Stock and the Series A Preferred on a common equivalent basis.
What does this mean? Simply that, if the company is sold, investors will receive all the money invested multiplied by [X] before anyone else is repaid, and then that they will be repaid alongside other shareholders based on their ownership. For example, with 2X liquidity preference and full participation, if an investor puts in $2 million for 33% ownership, and the company sells for $10 million, they get $4 million in liquidity preference and $2 million from participation.
As a rule of thumb, if you didn’t know both these concepts—or others, like the difference between pre- and post-money valuation, the difference between capped and automatic conversion in a convertible note, or other frequent deal terms like vesting, anti-dilution provisions, or drag-along provisions—it would be worth learning more about conventional term sheets before studying innovations for impact and liquidity.
An overview of common terms
When reading term sheets, it can be useful to divide terms into three categories:
Economic: Economic terms have an impact on the financial return created for investors and entrepreneurs in the deal. These include the price, any liquidation preference, share participation, or other mechanisms used to provide returns to investors.
Control: Control terms include board representation, right of first refusal in subsequent investments, or anything else that affects control over the company’s key employees or major decisions.
Other: Other terms include constraints or requirements for the current or future financing rounds, as well as all of the impact and liquidity innovations described on this website.
A great introduction to term sheets is the book, Venture Deals, by venture capitalists Brad Feld and Mendelson. Or, you can read Feld’s blog, which describes the terms below in detail:
Redeemable Preferred Stock — The Preferred Structured Exit?
Social enterprises present many unique business and legal challenges, including with respect to investment structures. Social enterprise investment structures must be designed to facilitate funding, compensate investors for risk, and align incentives. The most common forms of exits, however, for early-stage companies — public offerings and strategic acquisitions — may be unavailable (or undesirable) for social enterprises. Some social enterprise investors are starting to address these goals and restraints using investments with “structured exits,” which are pre-defined and legally enforceable paths to investor liquidity in which the company (rather than third party buyers) redeems investors.
Of course, almost every debt or lending vehicle provides a structured exit, but loans can present challenges when trying to invoke payment flexibility and comply with usury laws. Variable interest payments, for example, can trigger complex tax reporting requirements under the “original issue discount” rules (which apply to all but the most straightforward lending arrangements). While no silver bullet is available, we have found that redeemable preferred stock may provide a satisfactory balance between payment flexibility and simplicity of taxation if properly structured. Furthermore, this type of equity may qualify for tax advantages that could significantly raise expected after-tax return on investment (relative to debt arrangements and equity investments of traditional issuers).
As equity, redeemable preferred stock can carry a cumulative dividend that functions much like accruing interest, but which doesn’t automatically trigger a default upon non-payment. The issuing company may pay this cumulative dividend regularly or upon a pre-planned redemption. Like convertible debt, it can have a liquidation preference and liquidation premium, and/or may participate with the common stock on liquidation (for example, on an “as converted” basis). Essentially, redeemable preferred stock permits a wide variety of repayment methods.
General Tax Treatment
U.S. tax rules treat preferred equity very differently from debt. First, the tax code generally characterizes interim payments on equity as dividends, which under current law are often eligible to be taxed at the lower long-term capital gains rates as “qualified dividend income.” Second, the rules generally tax investor gains on stock redemptions as capital gains. Therefore, equity investors potentially receive all investment gains subject to the lower long-term capital gains rates. Additionally, equity investors can reduce tax exposure under two regimes that potentially apply to early-stage investments:
1. Tax Exclusion of Gains from Qualified Small Business Stock (“QSBS”)
Very generally, the tax code excludes up to $10 million per year of gains from the sale or exchange of QSBS. The tax code imposes numerous requirements for QSBS treatment (too many to discuss here), but most stock issued directly by small U.S. corporations engaged in active, non-professional businesses may qualify. For these purposes, “small” means the corporation must never have had aggregate gross assets of more than $50 million through the time immediately following the stock issuance.
2. Ordinary Loss Treatment for Small Business Stock (“SBS”)
The tax code also extends favorable treatment when an investor incurs losses on SBS. SBS has most of the same requirements as QSBS, except that “small” for purposes of SBS means the domestic corporate issuer must not have accepted aggregate capital contributions of more than $1 million through the time of issuance of the stock. Where applicable, investors may annually treat up to $100 thousand of losses on SBS as ordinary losses, eligible to offset ordinary income. This provides dual benefits of being deductible without limitation by the amount of capital gains recognized in the same year as well as offsetting ordinary income typically taxed at higher rates.
3. Illustration — ROI as Affected by QSBS and SBS Tax Regimes
Consider a $100 thousand investment in redeemable preferred stock that is redeemed by the company after 5 years at a 2x return. The following table summarizes the potential after-tax return in both the situation where the stock is redeemed as planned five years after issuance (column A) and also where the venture fails and there is a complete loss of investment (column B). The table also compares the after-tax treatment to that of a similarly structured debt instrument as well as a more traditional investment ineligible for QSBS or SBS treatment. (These figures assume that in the year of redemption the investor is subject to U.S. federal income taxes at the highest marginal rates, files a joint return, has at least $100 thousand of ordinary income, and sells no other investments that year.)
In our field, I hope that means that investors might make investments that they would otherwise be discouraged from making because the risk premium is perceived as too low, or perhaps even agree to a lower cash return (with more money re-invested in impact) because their aggregate, after-tax return could increase substantially with this new law.
This blog first appeared on the website of Blue Dot Advocates. Brian Mikulencak provided most of the content for this blog. Brian regularly collaborates with Blue Dot on tax-related matters. He specializes on the tax treatment of business transactions, including with respect to choice-of-entity analysis, structuring investments, and non-profit formation and operations.
Increasingly, social impact entrepreneurs and investors are calling for investment structures that provide more liquidity, in contrast to traditional investment structures that look primarily to an IPO or major acquisition. Many investors deserve commendation for their creative efforts in modifying more traditional debt and equity instruments in order to preserve the unique goals of impact investing while incorporating this added liquidity. However, investors and entrepreneurs should also be aware of potentially adverse tax consequences that can result under these non-traditional investment structures.
Often, investors and entrepreneurs are surprised to discover that the US federal income tax treatment of their investments can differ substantially from their expectations, often as a result of one or both of the following tax regimes:
equity/debt recharacterization; and
the “original issue discount” (“OID”) rules.
US tax laws have developed their own framework for classifying investments as either equity or debt, rather than deferring to the form agreed upon by the parties to a transaction. This means, for example, that even if an investor and company have signed documents for an equity deal and have treated it as an equity deal in their tax filings, the IRS could retroactively treat the transaction as a debt deal and charge interest income to the investor. The IRS rules for characterization consider many factors. While too numerous to cover them all here, an important rule of thumb is that an equity deal with a redemption provision that can be triggered in less than 10 years should probably be reviewed by a knowledgeable tax advisor.
ORIGINAL ISSUE DISCOUNT RULES
Separately, a set of provisions called the original issue discount (“OID”) rules can significantly alter the tax treatment of debt instruments. Again, an investor and company can find that the IRS may impose additional income on an investment because the IRS views it as having different tax attributes than what the parties intended when they signed the deal documents. With OID rules, there is a risk that the IRS could retroactively alter the tax treatment in the following ways:
tax principal payments and/or repayment “premium” as interest;
attribute interest income to an investor even if interest is not required to be paid under the terms of the documents; and/or
charge interest income at a higher rate than is required under the terms of the documents.
Generally speaking, the OID rules may apply in the following circumstances:
if interest is not required to be paid in regular intervals and at least once in each calendar year during the term of the loan (e.g. the loan instrument contemplates an interest “holiday”);
if interest can be added to principal in lieu of cash payment;
if interest is charged at a “below market rate”;
if the interest amount is variable or contingent (e.g. “stepped” or based on revenue or some other metric of company performance) rather than fixed;
if the principal value of the loan is discounted; and
if a loan agreement is paired with a related agreement (e.g. a revenue share agreement or warrant).
The last point is of particular importance, as the parties may not realize that the IRS has the ability to combine separate but related agreements for the purpose of assessing the tax treatment of the entire transaction. Some common areas of concern with respect to related agreements triggering or contributing to unexpected tax results are as follows:
a revenue share agreement that provides for variable payments based on company performance; and
a debt instrument paired with a warrant agreement in which the exercise price of the warrant is less than the fair market value of the company’s stock on the date of issue.
SECTION 305 RULES
Equity instruments are not subject to the OID rules, but may be subject to an analogous set of deemed dividend rules unless characterized as either common stock or “participating preferred” stock for US federal income tax purposes. Under these analogous rules, for example, accrued dividends may be subject to income tax even if not paid and certain payments could be taxed as ordinary income even if capital gains treatment was expected.
Very generally speaking, preferred stock should be treated as “participating preferred” and not subject to these rules if upon a liquidation event the investor is paid the greater of either (i) the investor’s liquidation preference or (ii) the amount that would be paid to the investor if the preferred stock converted immediately prior to the liquidation event. “Participating preferred” status may also be lost if the stock is mandatorily redeemable or subject to a redemption option. In US venture capital deals, the “greater of” provision is standard and there is rarely a built-in option to redeem. At a minimum, investors and companies will want to confirm that the same or similar language is included in their documents, even if the equity is issued outside of the US.
Here are two examples of how the re-characterization, OID, and Section 305 rules could be triggered:
EXAMPLE #1 – RECHARACTERIZATION AND OID ACCRUALS
A corporation issues convertible preferred stock that entitles the holders to a liquidation preference equal to the greater of a 14% return or the amount that would be received if converted. The holders also have the right to require that the corporation redeem the preferred stock for 3 times the issue price at any time after 5 years (provided there is sufficient profit).
For US federal income tax purposes, the instrument could be characterized as debt, largely due to the investor redemption option after only 5 years. As debt, the OID rules could: (a) characterize as interest the expected payments from the liquidation preference and/or the redemption premium, and (b) include such deemed interest in the investors’ taxable income. However, even if the instrument were to retain equity characterization for tax purposes, the parties should consider whether the liquidation preference could create taxable deemed dividend payments under the Section 305 rules.
EXAMPLE #2 – OID ACCRUALS ONLY
A corporation issues 10-year notes with a fixed rate of interest and principal due at maturity. The notes contain an interest-payment “holiday” for the first 2 years. In addition, lenders are granted a “revenue share” right to distributions of 2% of net revenue for as long as the notes are outstanding.
In most cases, the “revenue share” right would be characterized as a payment on the debt instrument itself. The OID rules would likely be triggered by the variable nature of the “revenue share” right and the payment “holiday,” requiring investors to report and pay tax on deemed payments of interest over the life of the note (likely commencing before actual payments).
CONSEQUENCES OF NON-COMPLIANCE
The tax rules affecting debt/equity characterization and OID are extremely complicated and can impact different instruments and parties in significantly different ways, making it impossible to accurately estimate the cost of non-compliance without thorough analysis of the instrument at issue.
For example, the situation described in Example #1 could trigger taxable deemed interest payments, subject to the higher ordinary-income tax rates and occurring in pre-payment tax years. Investors not reporting these payments could be subject to interest and penalties. By contrast, certain tax-exempt investors such as charities and retirement plans may be relatively unaffected by these tax rules.
Investors and entrepreneurs are encouraged to seek guidance on the effect of these recharacterization and OID rules, particularly with respect to transactions containing terms similar to those discussed here.
This content is provided solely for general informational purposes. It does not constitute legal advice regarding any specific facts and circumstances, and its dissemination does not create an attorney-client relationship. If you are interested in learning more or want to discuss a particular situation, you should contact one of us or another attorney or tax adviser.