Revenue Participation Notes: What are they, and why are they an innovative social finance tool?
August 10, 2009
By Terri Spath
Traditionally, enterprises receive capital in one of two ways: they get a loan, or they sell equity in the enterprise. Sometimes, however, neither of these options provides the right fit for an enterprise’s needs and goals, which is where revenue participation notes can provide an innovative solution. But before diving into what revenue participation means, let’s look at the benefits and drawbacks of traditional loans and equity financing.
With a loan, an enterprise receives cash, and enters into an agreement to repay that cash with interest. The tradeoffs for a loan:
Less Expensive Financing: It is generally less risky for someone to lend money than to extend equity. With a loan, there is usually a valuable asset (a guarantee, a piece of land, or machinery, etc) that the lender could legally take if the loan isn’t paid back. Since lending is less risky, it usually carries a lower price than equity, thus being a less expensive choice for financing.
Promise to Pay: With a loan, there is a legal obligation to pay the money back with interest. Also, lenders will only provide so much – at some point there aren’t enough assets to secure the loan and/or the ability to pay the interest.
By selling equity, an enterprise can raise cash by offering the investor some ownership of the enterprise. There are tradeoffs with equity financing, too:
No Short Term Cash Flow Constraints: In exchange for a cash investment, the investor owns some of the enterprise and the investor’s return is expected to come through the growth of the enterprise. Generally, there are no cash interest payments, and no legal obligation to ever give the money back.
Ceding Some Control: Since the investor now owns part of the enterprise, they have a right to some amount of control over the investment – and, therefore, a voice and frequently a vote about business decisions. The investor’s point of view may or may not align with the founder’s. This ownership gives the investor control over the enterprise that a lender does not have.
“Exit” Requirement: The new owner will want their money back plus handsome profits. This generally involves selling the enterprise to a new party, who will want to run the show (usually without the original founder).
An alternative – Note (i.e. loan) plus “Revenue Participation”
The traditional options don’t always fit for emerging social enterprises, entities built to grow profitably around an important social vision.
Case study: A Great Beverage Enterprise (GBE) that has created a healthy beverage to sell in the U.S. that supports sustainability in the Amazon rainforest.
GBE could sell more product if they had more money to spend on marketing (sales people to get into more stores, creating more products to put on more trucks for delivery, free products at sporting events, etc). However, the founders’ vision does not include the eventual transfer of ownership to a Big Giant Corporation that may dilute GBE’s mission in a drive for high profits (e.g. by creating cheaper formulations that no longer support the indigenous farmers of the Amazon).
Equity providers don’t have a clear way to recoup their original investment (no “exit strategy”), and are therefore hard to attract. GBE can try to borrow money, but the risk for the loan is high – many lenders are unwilling to lend as much money as GBE needs. What should GBE do?
One great solution is a note (typical loan with a coupon) plus revenue participation. With this structure, GBE gets a loan and is responsible for the interest and repayment of that loan. Revenue participation is attached to the loan, and defined as a percentage of the sales. As the revenues of the enterprise grow, it is in a stronger position and its revenue participation payments increase (the percentage stays the same, but the total dollars grow). The note plus revenue participation structure gets capital to the enterprise without affecting its ownership, goals or mission. At the same time, the lender/investor is properly compensated for the risks involved.
The RSF Mezzanine Fund is using this innovative tool to meet the needs of social enterprises, while earning a solid return for its investors. Ensuring that mission-driven companies can retain ownership and continue to have a high level of social impact while expanding their business was the key consideration for RSF in creating the Mezzanine Fund. We hope to see this type of financing become more common as an alternative for triple-bottom-line social enterprises whose priorities are not just profits, but people and the planet as well.
Terri Spath is the Managing Director of RSF Capital Management.