ImpactAlpha, June 22 – Traditional investment structures like debt and equity can present challenges for impact entrepreneurs. Debt is often inaccessible, unaffordable and too rigid for most early-stage social enterprises, and equity often requires “exponential growth” and relinquishing of ownership and potentially control.
There are dozens of other options for impact founders and funders to consider, which are neither straight equity nor debt. These underutilized options are generally classified as structured exits.
A structured exit is a type of risk capital agreement where founders and funders agree on a plan for the funder’s eventual exit from the investment, whether fully or partially. Unlike traditional equity, where a funder’s exit is open-ended, relies on specific growth targets, and a future buyer or public listing, structured exits give funders a specific, achievable plan for how they are going to receive their return through dividends, profit sharing, redemptions or a combination of those options.
In short, structured exit contracts take the best parts of equity (flexibility and patience) and mix them with the best parts of debt (self-liquidation and cost) without pressuring founders to achieve exponential growth and force the eventual sale of their business to satisfy investors.
Structured exit models
How do you evaluate the structured exit contracts? There are three key factors to consider before negotiating a structured exit agreement: cost, affordability and future financing plans.
Starting off with cost, it is important to note that structured exit agreements are generally more expensive than bank loans as funders are likely taking significantly more risk. How the exit is structured will also impact the financing terms.
Certain types of structured exits are treated with more equity-like risk, and funders will look for commiserate returns over the duration of their investment, typically multiple years. Convertible revenue-based financing, which is a loan-like agreement that has an option of converting to equity, and redeemable equity, which is an equity investment that a founder can repurchase, are two such examples. In the deals that I’ve reviewed, repayment multiples range from 1.1x (on the more philanthropic side) to 4.0x. This means that a founder commits to repaying one to four times the amount of the original investment.
Seed investments generally require a higher multiple (above 2.5x) than growth-stage investments (closer to 2.0x) because seed investments are seen as riskier.
When Adobe Capital offered Provive, an affordable housing company in Mexico, convertible revenue-based financing in 2015, the firm required a 2.5x repayment multiple. While expensive, this capital came with significant involvement from Adobe and was exactly the risk capital that Provive needed. Antonio Diaz, founder of Provive, described the structure as “an expensive one” but added that as an entrepreneur, he knew that “the most expensive money out there is the money you don’t have. We needed between $40 and $50 million Mexican pesos ($2 and $2.5 million), without it, our dreams would have died.”
Traditional revenue-based financing, meanwhile, behaves more like debt and is often loaned over a shorter term, so multiples tend to be lower. VIWALA, an revenue-based financing lender in Mexico, structures its loans for 36-month terms with a repayment multiple of 1.5x. GetVantage in India lends between $20,000 and $250,000 for a flat fee 6% to 9%, with investment terms of months rather than years.
Finally, mezzanine debt financing often comes with lower fixed-interest rates than traditional loans, but with “kickers,” like profit-share agreements or warrants that offer funders the risk-adjusted return they want.
Weighing costs and needs
From an affordability perspective, structured exits work best for high-margin businesses. Building a realistic structured exit agreement requires entrepreneurs to have a firm understanding of their revenues and/or cash flow projections. In other words, they need to be pragmatic about what they can achieve to make sure the loan is actually affordable (rather than painting a rosy pitch deck for a potential equity funder.)
VIWALA, for example, only lends up to 20% of the borrowing company’s previous annual sales and bases all repayments as an affordable percentage of the company’s revenue projections. GetVantage operates similarly, looking for revenue based payments of 5% to 25% from high-margin software companies.
While revenue-based financing tends to rely on simple revenue-based payments, mezzanine debt, convertible revenue-based financing and redeemable agreements may include more complex calculations around cash flow and profit to ensure that the payments remain affordable over the investment term and allow borrowers to reinvest some of the capital earned from their business operations.
Another important consideration in structured exit agreements is businesses’ future funding needs. For future debt financing, a track record of repayments can help entrepreneurs establish a credit history. Structured exits can sometimes complicate future equity rounds, however, as investors may not appreciate investees having to pay out a percentage of revenue or cash flow to earlier investors.
Emily Stone from Maya Mountain Cacao saw this complication first hand navigating her investors’ convertible revenue-based financing option for the company’s Series A equity round. The convertible revenue-based financing investment provided critical growth capital for MMC to expand to new geographies without the pressure of exponential growth. It worked: MMC’s successful geographic expansion, as well as a significant uptake in premium organic chocolate, readied the company for an equity round.
But negotiating with the convertible revenue-based financing funders took time, and quite a bit of patience, on the part of the incoming equity investors. Eventually, all but one of the investors agreed to convert their debt to equity in the equity round. The one investor that did not was paid their remaining total obligation by the Series A investors.
Gene Howicki of myTurn, a circular economy sharing platform, deliberately sought out redeemable equity so that he would not have to raise future equity rounds or be forced to exit his company. In 2012, myTurn secured a redeemable equity investment from social enterprise accelerator Fledge. (Terms of the deal were not disclosed.) Seven years later, myTurn redeemed all of its shares using its cash flow, making quarterly payments based on its revenues, and paying a final lump sum myTurn negotiated with Fledge.
When considering structured exits, it is important for funders to recognize that structured exits were not created with unicorn companies in mind; they were created to make capital more accessible for the 99% of companies that do not fit the traditional venture capital model.
It’s true that structured exits are more complex than other types of early-stage enterprise funding, like convertible notes, priced equity and “simple agreements for future equity,” or SAFEs. For example, unlike a traditional equity agreement, which identifies multiple pathways to exit, structured exits require entrepreneurs and funders to agree on the terms of an exit upfront.
Aunnie Patton Power is a lecturer at the University of Oxford, the London School of Economics and the University of Cape Town, as well as an advisor and angel investor. Her first book, Adventure Finance, aims to help founders and funders navigate the spectrum of funding options that blend profit and purpose.