Revenue participation

Is a quasi-equity financing instruments class and provide a loan with a promissory note where repayment of the loan is tied to a percentage of the company’s revenue. Instead of repayment being measured in a fixed interest percentage of the loan amount, the return amount is negotiated and that amount is paid through the agreed-upon percentage of revenue. It is relatively new financing model, it has historically been used in the oil, gas and mineral industries. Speculators invested in oil, gas or mineral extraction companies in exchange for a percentage of earnings from successful operations.
Utilizing this method, investors receive monthly payments from the first dollar of revenue generated by the business in which they have placed an investment. It also provides the entrepreneur with the data necessary to more accurately determine the costs of operations because it includes the actual cost of capital. The approach allows for payment to the investor to be taken out of “pre-tax” dollars. Moreover, this approach will improve both budgeting and net-revenue forecasting for businesses, even for early-stage businesses.
The Concept
In a Revenue Participation financing a business or entity offers an investor a percentage of business pure gross revenues in exchange for a capital investment. In its simplest form, the investee offers to give Investor y% of future gross revenues until such time as Investor has been paid “x” times the amount of capital invested. So, for example, in exchange for $100,000 of capital, the investee could agree to pay Investor 20% of future gross revenues until the business has paid Investor 3x the $100,000 capital investment, or $300,000.
The “simple” Revenue Participation transaction - as for the earlier example where Investor provided business with $100,000 in exchange for business or entity of promise to pay Investor 20% of future gross revenue until Investor had been paid $300,000 - is subject to numerous permutations. For example, the gross dollar return can be varied depending on how long it takes to achieve that return (e.g. in the simple example the required return could go up based on the time needed to achieve the return). One could indeed pick a desired compounded annual return target and fine tune the required return multiple to rise over time so that the targeted return rate is hit when the designated return in dollars is achieved.
Revenue participation is taken as a straight percentage of net operating income after deductions for operating expenses, cash flow as well as equity, should be negotiated carefully so that it will not create a cash flow crisis.
Foundational Issues of Revenue Participation Financing
Unlike a traditional risk capital equity investment, the Investor in a Revenue Participation financing does not thereby become an equity stakeholder in the business. Nor does the Investor become a creditor in the traditional sense: that is, there is no promise by the business to “pay back” Investor except to the extent business achieves gross revenues sufficient to fund the revenue participation promise. That said, and as will be further discussed below, in any particular Revenue Participation transaction the parties may negotiate terms that in effect give the parties some of the rights and obligations they might typically have in a more traditional equity or debt investment transaction.
The “simple” Revenue Participation transaction - as for the earlier example where Investor provided entity with $100,000 in exchange for entity promise to pay Investor 20% of future gross revenue until Investor had been paid $300,000 - is subject to numerous permutations. For example, the gross dollar return can be varied depending on how long it takes to achieve that return (e.g. in the simple example the required return could go up based on the time needed to achieve the return). One could indeed pick a desired compounded annual return target and fine tune the required return multiple to rise over time so that the targeted return rate is hit when the designated return in dollars is achieved.
Revenue Participation in Social Finances
A space in the capital markets where the world of investing for profit and the world of investing for desired social and environmental outcomes meet and merge is attracting a growing and diverse group of investors. They are funding sustainable specialty coffee farms in Tanzania, affordable housing projects in New York City, and post-consumer recycled paper manufacturers in San Francisco, Increasingly, entrepreneurs and investors recognize the potential of market based tools to offer new solutions to some of our most pressing social and environmental challenges.
A number of social enterprises cannot issue share capital for legal or structural reasons but also are reluctant to borrow, seeing indebtedness as a root of the financial crisis. Quasi-equity instruments are financial instruments that share characteristics of debt and equity. In mainstream finance, mezzanine capital and risk- and revenue-sharing partnerships are relatively common. For social enterprise, such instruments are only beginning to emerge.
The Revenue Participation flows from an agreed percentage of revenue, the loan gets capital into the enterprise without affecting ownership, goals or mission, while the investor is properly compensated for the risks involved. Some revenue participation agreements are at total risk insofar as there is no floor interest rate. They can be used by social enterprises with mutual or other non-shareholding status, investors view them as risky and may want higher returns by way of compensation. Track record is often a pre-condition, so this instrument is unsuitable for start-ups.
The revenue sharing leads to flexible financing costs for the social enterprise, especially in the initial stages. The limitation of payments and flexible repayment options, as well as increasing sales, will keep valuable liquidity in the company in order to invest in the expansion of business activities. The social mission and the scaling of the business model are substantially supported by the chosen financial instrument.
Some Words of Caution
Revenue Participation financing can be very attractive for investors and businesses alike - when the business fits the Revenue Participation paradigm of relatively predictable (timing and magnitude) high gross margin revenues. Most companies that are good candidates for venture capital investment don’t fit that paradigm, and investors and entrepreneurs alike should be careful not to let the attractions of the Revenue Participation - primarily a first call on revenues and “promised” return multiple/rate for the investor; primarily the lack of any equity interest and related pressure for an “exit” event for the entrepreneur - color their analysis of the future performance of the business in terms of size, magnitude and timing of future high margin revenues. Yes, as discussed, Revenue Participation investors can build in some of the downside protections found in more aggressive convertible preferred venture capital financing. In almost 30 years in and around the high impact entrepreneurship and venture capital space, however, I have yet to meet a venture capitalist (or a counterpart entrepreneur) who considered an investment where those protections kicked in an investment they would want to do again. I very much doubt I will ever meet a Revenue Participation investor who, in similar circumstances, would not share the venture capitalist’s pain.<ref name=":1" />
Revenue Participation agreement is a security subject to regulation by federal and state securities laws, and businesses choosing to use this tool should take steps to comply with those rules. As with other types of securities offerings, there are exemptions from registration that a small farm entering into revenue-based financing agreements with community members will likely be able to use. It is important to note that even if an exemption applies, any sale of securities is still covered by the anti-fraud provisions of the securities laws.
One interesting revenue-based financing agreement that might be considered outside securities regulation is described in the book “Locavesting: The Revolution of Local Investing and How to Profit From It.” In the example, the lender receives repayment of the full loan amount but the revenue sharing portion of the loan repayment (i.e., the interest or royalty amount) is given to charity instead of to the lender. This could be a particularly creative way to encourage local community members to contribute to the financing of a small agricultural enterprise. In this agricultural space, an obvious choice for a local charity would be a local food bank for purchase of local agricultural products. Such a model would keep local money in the local food system as well as provide resources for local food banks to acquire and distribute local food products.<ref name=":0" />

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