Beyond Sell or Bell: Alternative Exit Strategies Every Investor Should Know
By Adam Spence
Co-founder, MaRS Centre for Impact Investing
A smart investor knows that you can’t make a good investment without a good exit strategy. “Sale or IPO” is often considered the mantra for early-stage investors and entrepreneurs. However, while ringing the bell or making the sell are legitimate options for many companies, they don’t work for all.
Ventures that we work with—socially and environmentally focused enterprises, from solar firms to sustainable food companies—can find themselves as very square-peg-faced with two round holes. They can generate solid profits, but they may not generate the eye-watering returns that can be expected of an IPO-ready firm in the heyday of Gordon and Jordan on Wall Street, or match the home-run expectations of a high-octane private equity fund today. But they can offer reasonable, resilient returns to investors while maintaining their social mission and profitability.
Social entrepreneurs and investors have begun to realize that the key to success is to create a structured exit from the start. A number of vehicles have been created that can get money back to investors without going public or selling the business.
These innovative approaches have been gaining traction, and they are worthy of consideration by ventures and investors alike. The much-discussed shift towards fewer but larger IPOs is creating an ever-growing window for alternative exit strategies. The creation of private-market platforms by leaders such as TSX are part of the mainstream market response. As more companies opt to stay private longer, it’s likely we will see a continued diversification in exit strategies.
That may be good news for companies for which sell or bell looked like a choice between a rock and hard place. For smart investors, it also opens up a range of new investment possibilities.
So what are alternative structured exit options?
Revenue Share Loans
Revenue Share Loans have been used for years in the mining, film production and drug development industries, but are now becoming popular in other sectors. Online platforms such as LocalStake in the U.S. have also used these types of securities.
In essence, the company sells a portion of its future revenues in exchange for upfront investment. The company commits to making regular repayments to investors. The amount of each payment is usually between two and 10 per cent of the business’ top-line revenues. Payments continue until the investor has received a pre-agreed maximum total return (usually 1.5 to 2X), or until the maturity date of the loan, when the entire remaining balance becomes due.
The arrangement gives investors a significant effective interest rate on the loan (up to 30 per cent) and regular payments. But there are risks. Revenue-sharing payments will fluctuate and may be low if the company is slow growing. For companies that have thin gross margins, the repayment obligations may hinder their growth.
Demand Dividends are a new type of debt vehicle developed at Santa Clara University. It was designed to provide a reliable return to investors while easing burden of repayments on entrepreneurs and allowing them to maintain control over their businesses. One of the first companies to use the structure was Belizean cocoa bean producer Maya Mountain Cacao Ltd., raising $200,000 from the Eleos Foundation. The structure is fairly straightforward. Payments to investors are based on the venture’s free cash flow (usually 25 to 50 per cent). Once an investor receives a pre-determined multiple of the initial investment (usually 1.5 to 3X), the relationship ends.
This type of structure is similar to preferred stock that has a redemption feature, where dividends are set at a percentage of revenues or profits with a ceiling of a multiple of capital invested. Investors get a reasonable return that’s commensurate with risk. However, the debt will likely be subordinated to other credit or capital, and the repayment period may not be fixed.
These are not the only options. Ventures may consider traditional business loans or selling securities on private markets. Moreover, there are attractive options such as convertible debt, that can have clear exit provisions, and new models tailored for social enterprises such as the Seed Impact Investing Template developed by Echoing Green.
Each of these options allow for reasonable capital growth, provide a structured exit without the expectation of outsized, extractive returns, and can help a venture maintain its mission.
There are a variety of benefits and risks to the models above, and both investors and entrepreneurs should consult with appropriate counsel before taking these new exit routes.
As these structured exits become more common, we can expect investors and entrepreneurs to become more comfortable with these strategies. Eventually, that could translate into more options and greater investment for social impact ventures.
Just remember: There are options beyond the big sell or ringing the bell.
*Adam Spence is Director of Social Venture Connexion (SVX) and co-founder of MaRS Centre for Impact Investing.