Revenue-Based Financing and Foundation Investors: An Ideal Pairing in Our Current Climate?
As others have pointed out, early-stage companies are experiencing dramatically increased funding needs, and specifically, needs for financing with flexible repayment terms. Often, the go-to investment structures for flexible repayments are revenue-based financings, often called RBFs. These instruments are attractive because they not only tie repayments to the borrower’s ability to pay, but may also support potential impact-oriented benefits of:
- Maintaining founder control and ownership;
- Sharing the volatility risk of future revenues; and
- Facilitating long-term independence because investor liquidity is not tied to an “exit”.
For all their benefits, however, RBFs can be difficult to implement, for several reasons. We often encounter difficulty on two fronts: first, an investor or company looking for a “standard” approach may be discouraged by the myriad structuring options available; and second, certain regulatory and tax considerations can add complexity.
Absent tax considerations, RBFs would typically be structured as a debt instrument with revenue-based repayments. This type of financing is typically simple to negotiate and draft and avoids the complexity and expense of issuing equity to investors.
However, RBF debt financings are often disadvantaged by a complicated tax regime: the requirement to accrue and report interest for tax purposes using an IRS-mandated schedule, rather than by reference to actual payments. This regime is known as the “original issue discount” or “OID” rules (described more in-depth here). And, while it is true that some, simpler debt instruments trigger only moderate complexity under the OID rules, RBFs are almost always subject to the more complicated requirements of the OID rules, including the requirement that the borrower make a detailed, hypothetical interest rate schedule and then continuously adjust the schedule to account for deviations between the initial schedule and actual payments of interest.
Investors, on the other hand, typically experience negative effects of the OID rules in the form of recognizing taxable “phantom” interest income prior to the actual payment of corresponding interest – at least – if the investor is subject to income tax. This points to one set of circumstances where simpler RBF debt structures can be used without triggering the OID rules for either party: deals where the only investors are tax-exempt entities.
While the borrowing party would typically be required to report OID accruals on IRS 1099 forms, this is not required with respect to tax-exempt lenders. More than the filing obligation itself, RBF borrowers can avoid the obligation to make detailed hypothetical interest computations and subsequent adjustments when all of the RBF lenders are tax-exempt, effectively removing the most significant issuer-side hurdle to structuring an RBF investment.
So, if impact investors structured as foundations or otherwise tax-exempt needed any more reason to step up their impact investing, then here’s a suggestion: assume the role as a lead investor with other tax-exempts to invest using RBF debt structures. In addition to avoiding the tax-related challenges of the OID rules, RBF debt investments can be structured to support substantial impact-oriented benefits as well as to qualify as foundation program related investments (PRIs).