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.