Thursday, September 21, 2017

Room for Debate Revenue Share Loans Part 3: Crunching Revenue Share Loan Numbers


ROOM FOR DEBATE
is a series of conversations Benji Taylor Jones and Jim Verdonik, (the Ward and Smith Crowdfunding Team) are having about anything they feel like talking about.  Jim and Benji discuss Revenue Share Loans in three parts: the Good, the Bad and the Numbers.
Viewer discretion is advised.
In this session Benji and Jim talk about:
CRUNCHING REVENUE SHARE LOAN NUMBERS

BENJI:  Jim, We've already discussed the general positives and negatives of Revenue Share Loans, but we've forgotten one important thing.

JIM:  What's that?

BENJI:  The numbers.  How do people know the Revenue Share loan numbers work for them and their business?

BENJI:  Before you start talking numbers, let's do a short recap on how a Revenue Share Loans work.

BENJI: A revenue share is a loan that is paid back over time by the borrower "sharing" a percentage of its "revenue" at regular intervals until it has returned to the lender a fixed multiple of the amount loaned.  The percentage of revenue the business pays can vary widely based on projected revenue and operating profit.  The business' repayment obligation might be open ended (meaning the loan remains outstanding until the stated return is met without a final due date), but more often the payback amount must be repaid in full within a specific time window (say 3 to 5 years).  Having a definite end date may require the business to make a "balloon payment" at the end of that period if the monthly or quarterly revenue percentage repayments are less that the total payback amount. 

BENJI:  Now that I've explained the basic loan terms, let's discuss three basic economic points:

  • What are the returns on investment for Revenue Share Loans?
  • How do businesses know what terms thy can afford to pay so that they don’t default?
  • How do you decide whether selling equity or Revenue Share Loans is I the owners' interests?

JIM:   I'll jump into investment returns first.  There is a correlation between the payout multiple investors demand and the maturity date the business wants.  For example, a Rev Share loan with a three-year maturity might be marketable to investors at a 1.5x multiple.  For a five year maturity, investors might want a 1.75x multiple.

BENJI:  Is there an upside for the investor?  Or is it always the same rate of return?

JIM:  The shorter the length of time the company takes to fulfill its obligation -- the quicker the payout and the higher the rate of return (ROI).  If a company can convince investors that it can repay the loan quickly, it can attract investors with a lower payback multiple.  If a loan has a five year maturity date and the company repays the loan in three years, investors can achieve double digit annual compounded interest rates.  So, investors can "hit the jackpot," if revenue increases faster than the company projects.

BENJI:  Since the total amount investors receive is always the same, explain this jackpot concept.

JIM: The investor wins because the investor can reinvest any money the investor receives earlier than expected.  Any profit from that reinvestment is a windfall for the investor.

BENJI:  So, what are the best types of businesses to sell Rev Share loans?

JIM:  The big three industries are: food, booze, software.  Restaurants, breweries and software all fit the model of starting to generate revenue after a relatively small investment.  They also tend to have repeat customers.  Software has the added advantage of having both relatively high margins and high annual revenue growth rates.

BENJI:  That tells us about industries generally, but are there specific economic characteristics that tell us a particular business is a good Rev Share loan candidate?

JIM:  The business attributes we look for when we recommend Rev Share deals are:

 

  • Either a track record of having revenue or certain near term prospects so that investors will start getting money back within a few months.
  • Companies that are or soon will become profitable.  You can't repay debt from revenue that you have to spend to pay your operating expenses.  Revenue growth without profit growth can cause borrowers to default, because their monthly repayments increase at the same time their other expenses are increasing.
  • High margins hold the potential for profitability, but that's only true if management controls expenses.  So, the best Rev Share candidates are business where expenses don’t grow as fast as revenue.
  • Projections for high annual revenue growth rates enable companies to repay their loans from the faster growth they generate from the loan proceeds.
  • The business can make a good case that every dollar invested in marketing or expanding production has historically resulted in multiple dollars of additional revenue.
     
    BENJI:  Are there any economic tests you use to determine whether a business can repay its revenue share loan?  How do you know you won’t default on the loan?
     
    JIM:  We use the traditional the Debt Service Coverage Ratio that banks use to help businesses decide whether they can repay a Rev Share loan.  Banks usually want a 1.3 to 1 ratio of adjusted net operating profit to total debt service obligations.  A 1:1 ratio is theoretically sufficient to repay, but banks want a cushion to avoid defaults.  Rev Share borrowers must decide how much of a safety net they want to build into their offering terms. 
     
    BENJI:  Are there any other variables?
     
    JIM: Banks also tend to be conservative about projected revenue and profit growth rates, which affect the Debt Service Coverage Ratio calculation after the first year of the loan.  Business owners have to decide whether they really believe their own growth rate projections.
     
    BENJI:  How can businesses easily run the numbers to see whether they make the cut?
     
    JIM:  We have financial modeling tools that use the clients' own data about current revenue and profits and projected growth rates to help clients quickly analyze multiple offering terms and repayment scenarios.  Our tools calculate projected interest rates, projected repayment instalments and Debt Service Coverage Ratios based on the amounts they want to borrow, proposed maturity dates and the payback multiples they are considering offering investors.  We can also run through scenarios that allow businesses to quickly determine whether they are better off selling equity or Revenue Share loans. 
     
    BENJI:  How long does that process take?
     
    JIM:  We collect relevant information from businesses using short questionnaires.  A business can usually provide the information we need in less than ten minutes, if it already has historical financial information and projections
     
    BENJI:  So, then do we guaranty a successful payback?  I don't like the sound of that.
     
    JIM:  Of course not.  Our financial modelling tools just show how the loan terms will work using the loan terms the business wants to test and the data and projections that businesses provide.  Many factors affect whether the loan will actually be repaid.  Projections are often wrong.  If they are, the loan may be defaulted.  Businesses decide what their projections should be.  We just help businesses understand how the loan terms work in light of the data and projections they provide.  Later in the offering process, we ask businesses questions about their projections that help them make disclosures to investors.  Ultimately, however, businesses are responsible for their own data and projections.  We don’t make that decision for them.
     
    BENJI:  So, what happens if business owners don’t know how to do projections?  Are they out of luck doing an offering?
     
    JIM:  No.  If the owners need help, we can recommend other experts to help them.  It's just not what we do.
     
    BENJI: A lot of business owners are trying to decide whether to sell stock or other equity securities.  That dilutes their stock ownership, but they need capital to grow so that they can eventually sell the business for a high price.  Can you tell us whether Revenue Share Loans will provide a higher resale price for owners than selling equity?
     
    JIM:  Selling equity usually promotes faster revenue growth than borrowing does, because if you sell equity you are not repaying debt installments each month like you have to do with a Revenue Share Loan.  That means the business can reinvest more money in growth every year,
     
    BENJI:  So, that means Revenue Share Loans will probably reduce the total resale price of a business compared to the resale price a buyer would pay if the business had sold equity securities.  But that's not the whole story.  When you sell equity, you're selling the investors part of the resale proceeds.  The original owners won’t receive all the resale proceeds.  How do owners know what the best deal is after you take dilution into account?
     
    JIM:  Whether equity or Rev Share is a better dilution deal for the founders and earlier investors depends on a combination of the rate of return on investment the new equity investors would want and the on the multiple of revenue a buyer would pay at exit when the company is sold. 
     
    BENJI:  Let's deal with the multiple of revenue when the business is sold.  There are pretty common industry standards to predict that.  But things like growth rates, margins, net profits and balance sheet items like assets d liabilities can affect the actual multiple.
     
    JIM:  Right.  The price a business will sell for is partially industry related, but company specific factors also play a role.
     
    BENJI: Now, let's deal with the investor expectation factor.  Explain how that varies.
     
    JIM:   Investor return expectations affect the percentage of equity investors receive.  Typically, venture investors want a 10x return on investment.  Sophisticated angel investors are often willing to accept a 5x return on their investment.  In either case, that means you give up a big percentage of ownership that usually results in the investors getting more of the sale proceeds when the company is sold.
     
    BENJI:  10x sounds pricy.  I could buy my own island if all my investments paid 10x.
     
    JIM:  Of course, most investments don't return 10x and Crowdfunding equity investors often expect less. So, a business might find investors who only require a 3x return in investment.  If that happens, you might be better off taking the dilution by selling equity to boost revenue growth, but only if you can sell the company for a very high multiple of revenue. 
     
    BENJI:  So, that means Revenue Share Loans will probably reduce the total resale price of a business compared to the resale price a buyer would pay if the business had sold equity securities.  But that's not the whole story.  When you sell equity, you're selling the investors part of the resale proceeds.  The original owners won’t receive all the resale proceeds.  How do owners know what the best deal is after you take dilution into account?
     
    JIM:  Whether equity or Rev Share is a better dilution deal for the founders and earlier investors depends on a combination of the rate of return on investment the new equity investors would want and the on the multiple of revenue a buyer would pay at exit when the company is sold. 
     
    BENJI:  So, you're saying "It depends."  That sounds like the type of evasive answer people don’t like about lawyers.  Give the folks a break.  Be more specific.
     
    JIM:  OK.  Here it goes.  In most scenarios, our numbers crunching indicates that selling Revenue Share loans produces a higher net sale price at exit to existing owners than selling equity does.  In short:  Rev Share loans protect not only against percentage dilution but protect against value dilution.  I hope I don't get disbarred for giving a clear answer.
     
    BENJI:  That wasn't really so hard.  Was it?
     
    This is Jim Verdonik and Benji Jones (the Ward and Smith Crowdfunding Team) signing off until our next discussion on ROOM FOR DEBATE.
     

    Related conversations include: 
  • PART 1 #LoveRevShare


 

PART 2: Why Some Businesses or Investors Don't Love Revenue Share Loans


 


If you would like to join in Benji's and Jim's conversations, you can talk with Benji and Jim at:

Jim Verdonik (919) 277-9188 and JFV@WardandSmith.com

Benji Jones(919) 277-9142 and BTJones@WardandSmith.com

Here's what Benji and Jim most like to talk about:

Modernizing Venture Capital Services: We help Venture Capital Funds, Angel Investors and their Portfolio Companies achieve their goals by blending their traditional practices with new technology and business practices.

Building the Ecosystem: We are "system integrators" combining business, technology and legal services for turnkey capital raising solutions.

Dynamic Capital Raising System: We integrate Crowdfunding and ICOs with traditional financing solutions to create dynamic capital raising strategies for growing businesses.

Capital Raising Diversity:  We help  underserved populations find their seats at the capital raising table by taking advantage of the new opportunities technology and legal reforms provide.

Blending the For Profit and Non-Profit Worlds:  We help non-profits leverage their resources by partnering with investors who want to increase social and artistic returns on their investments.

Our collective experience includes:

  • Wrote Crowdfunding: A Legal Guide to Investment and Platform Regulation (Thomson Reuters 2016) analyzes securities laws through the prism of Crowdfunding capital raising practices.
  • Write a column about business and legal issues for Triangle Business Journal 
  • Played a critical role in the passage of North Carolina’s intrastate crowdfunding exemption (NC PACES). 
  • Leaders of law firm's Securities practice.
  • Leaders of law firm's Blockchain and Coins practice.
  • Leaders of law firm's Technology practice.




 
The content contained on this article does not provide, and should not be relied upon as, legal advice.  It does not convey an offer to represent you or an attorney-client relationship.  All uses of the content contained in this article, other than for personal use, are prohibited.
 







Room for Debate Revenue Share Loans Part 2: Why Some Investors or Businesess May Not Love Revenue Share Loans


ROOM FOR DEBATE

is a series of conversations Benji Taylor Jones and Jim Verdonik, (the Ward and Smith Crowdfunding Team) are having about anything they feel like talking about. 

Jim and Benji discuss Revenue Share Loans in three parts: the Good, the Bad and the Numbers.

Viewer discretion is advised.

In this session Benji and Jim talk about:

WHY INVESTORS OR BUSINESSES MAY NOT LOVE REVENUE SHARE LOANS

BENJI:  Jim, in our last discussion, we gave a pretty flattering description of Revenue Share Loans.  Two lawyers can't discuss this without also talking about the downside.  Go ahead.  Spoil the party.  What are the problems with Rev Share loans?

JIM:  Like anything that sounds too good to be true, sometimes it is.  Here are the issues you need to watch out for - reasons you might not to LOVE Rev Share:  
  1. Repayments can slow a business' ability to reinvest in long-term growth compared to equity.
  2. Slower revenue growth may mean a lower sale price at exit (if that's what the business owners are looking for).
  3. Paying investors is an ongoing expense and headache.
  4. Paying investors also requires sharing periodic revenue numbers with many people.  This info may leak to competitors and customers. 
  5. In an LLC or other pass through entity, owners will be taxed on phantom profits used to repay the loans.  That's not a problem with equity.
  6. Future lenders may be unwilling to make new loans to the company while the Rev Share debt is outstanding.
    JIM:  Benji, don't make me do all the hard stuff.  It's your turn. 
    BENJI:  OK, I still LOVE Rev Share, but raising capital through investment crowdfunding is complicated.  Businesses need to be prepared for added regulatory and compliance costs, as well as the distractions that accompany taking investments from a "crowd" of people.  Management still has a responsibility to provide information and respond to these investors, even if they are not "owners" of the business.  In addition, businesses raising capital through Rev Share will need to manage the payout process carefully. 
    JIM:  What about investors?
    BENJI:  Investors should recognize that there are always risks associated with any kind of investment, and particularly investments in small businesses and startups.  There is no guarantee that the business you love will actually continue to operate successfully or derive sufficient revenue to repay your loan. 
    JIM:  Can you talk some more about what investors should consider before investing?
    BENJI:  Many of the things that might be appealing for companies about Rev Share cut the other way for investors.  For instance, unlike equity, Rev Share investors don't have any voting, economic or management interest in the business.  Although they are creditors, they typically don't benefit from personal guarantees, security interests, financial covenants, or other restrictions that protect banks or institutional investors.  Rev Share loans are often junior to other loans the business has now or may obtain in the future.  That means that other lenders may get paid while Rev Share loans remain unpaid.  This risk of junior debt is why Revenue Share loans offer higher interest rates than banks typically charge. 
    JIM:  Are there any other reasons investors should be cautious?
    BENJI:  Although Rev Share loans offer the opportunity to support the businesses you care most about – investors should consider all of the terms being offered by the company and all the facts the company discloses, including whether the company is generating revenue, to minimize your risk of not getting paid back and maximize your expected return.  It is critical to understand the terms that govern an investment before you commit. 
    JIM:  What's the best way for investors to deal with these risks?
    BENJI:  Diversification.  Don't invest too much of your capital in any single business or in any single type of deal.
    JIM:  So, Are you advising investors to LOVE Rev Share loans in moderation?
    BENJI:  Yes.  Too much of anything can be bad for you.  Revenue Share loans are no different.
    JIM: What about taxes?
    BENJI:  Rev Share has a more complex tax impact than say, straight debt or equity, due to the variable nature of the installment payments.  Businesses and investors alike will need to understand how tax payments and paperwork will be handled post-closing.  (Many platforms, like Streetwise and LocalStake, offer post-closing payment services to help companies manage these hurdles.)  Before participating in a Rev Share for any business, you should consult your personal tax, accounting and legal advisors before making an investment.
    JIM:  Do you have any parting advice for potential Rev Share issuers and investors?
    BENJI:  I'll tell them the same thing my Mother told me growing up.  It always started like this: 
    Before you get "hitched" . . . and ended with a tragic story.
    Of course, LOVING Rev Share when you plan your deal is a lot like getting married.  Most people are in LOVE when it starts, but how long the LOVE lasts is what counts.  Having a long lasting LOVE of Rev Share depends on whether your projections were realistic and how you manage your business.  So, be careful your LOVE affair with Rev Share doesn't end in a messy divorce.  

     
    JIM:  Of course messy divorces are often caused by misunderstandings.  So, in our next conversation, we'll talk about crunching Revenue Share Loan numbers so that there are no unpleasant economic misunderstandings.


    This is Jim Verdonik and Benji Jones (the Ward and Smith Crowdfunding Team) signing off until our next discussion on ROOM FOR DEBATE.

    Benji's and Jim's other conversations about Revenue Share Loans include:
  7. If you would like to join in Benji's and Jim's conversations, you can talk with Benji and Jim at:
    Jim Verdonik (919) 277-9188 and JFV@WardandSmith.com

    Benji Jones(919) 277-9142 and BTJones@WardandSmith.com

    Here's what Benji and Jim most like to talk about:

    Modernizing Venture Capital Services: We help Venture Capital Funds, Angel Investors and their Portfolio Companies achieve their goals by blending their traditional practices with new technology and business practices.
    Building the Ecosystem: We are "system integrators" combining business, technology and legal services for turnkey capital raising solutions.

    Dynamic Capital Raising System: We integrate Crowdfunding and ICOs with traditional financing solutions to create dynamic capital raising strategies for growing businesses.
    Capital Raising Diversity:  We help  underserved populations find their seats at the capital raising table by taking advantage of the new opportunities technology and legal reforms provide.
    Blending the For Profit and Non-Profit Worlds:  We help non-profits leverage their resources by partnering with investors who want to increase social and artistic returns on their investments.
    Our collective experience includes:

    • Wrote Crowdfunding: A Legal Guide to Investment and Platform Regulation (Thomson Reuters 2016) analyzes securities laws through the prism of Crowdfunding capital raising practices.
    • Write a column about business and legal issues for Triangle Business Journal 
    • Played a critical role in the passage of North Carolina’s intrastate crowdfunding exemption (NC PACES). 
    • Leaders of law firm's Securities practice.
    • Leaders of law firm's Blockchain and Coins practice.
    • Leaders of law firm's Technology practice.

    The content contained on this article does not provide, and should not be relied upon as, legal advice.  It does not convey an offer to represent you or an attorney-client relationship.  All uses of the content contained in this article, other than for personal use, are prohibited.

     


 



Room for Debate Revenue Share Loans: Part 1 #ILOVERevShare


ROOM FOR DEBATE
is a series of conversations Benji Taylor Jones and Jim Verdonik, (the Ward and Smith Crowdfunding Team) are having about anything they feel like talking about. 

Today Jim and Benji discuss Revenue Share Loans in three parts: the Good, the Bad and the Numbers.

Viewer discretion is advised.

In this first session Benji and Jim talk about: #ILOVERevShare

JIM: I'm here with my partner in Crowdfunding Crime Benji Jones.

JIM:  Benji recently returned from a speaking engagement at a West Coast conference about Crowdfunding. 

JIM:  What's the hottest new type of security businesses are using to raise growth capital?

BENJI:  The conference was buzzing about Revenue share loans.  It's not an exaggeration to say that the Crowdfunding world is falling in love with Rev Share loans.
JIM:  I notice that you're wearing a button.  What's the Button say?
BENJI:  You know me.  I'm never half-hearted about anything.  My button screams: #ILOVERevShare
JIM:  Can you tell us why people love Revenue Share Loans?
BENJI:  Revenue Share loans are attracting interest from both accredited and non-accredited investors in Regulation CF and state crowdfunding offerings. 
JIM:  I'll tell our audience what Rev Share is about before you dive into the details.  A revenue share is a loan that is paid back over time by the borrower "sharing" a percentage of its "revenue" at regular intervals until it has returned to the lender a fixed multiple of the amount loaned.  Benji, how about giving us an example?
BENJI:  Let's say a local brewery or restaurant or software company needs $500,000 to expand.  The business borrows $500,000 from investors with a promise to return to them a fixed amount (say, 1.5x or 1.75x the amount loaned) over time. 
JIM: That sounds pretty simple. 
BENJI:  It really is.  The business pays off the loan by paying investors a percentage of its revenue in installments until the fixed return (in this case $750,000) has been repaid.  As an investor, you would receive your pro rata share of such payments based on the amount of money you loaned the business. 

Tuesday, January 24, 2017

Startling Increase in Regulation A Offerings Validates Crowdfunding Reforms and Technology





By:  Jim Verdonik


Jim Verdonik is an attorney with Ward and Smith, P.A. in Raleigh and the Author of Crowdfunding: A Legal Guide to Investment & Platform Regulation. 


Reach Jim at jfv@wardandsmith.com
(This article is based on an article appearing in Triangle Business Journal on February 3, 2017)




In 2012 America began a bold experiment to determine whether:
  • Less is more.
  • Addition by subtraction works.
     
    The experiment tested whether reducing government regulation would produce better economic results.  The eliminated regulations were securities law prohibitions against businesses using the Internet, Social Media and other technology to talk with investors.
     
    Breaking the Money Gate Keeping Monopoly – Capitalism without Capital Does not Work
     
    The JOBS Act of 2012 re-wrote most of the old regulations about how most American businesses raise capital, because: 
  • Capitalism doesn't work without capital
  • How can you raise capital if you can't talk with investors?
     
    The JOBS Act's remedy is what I call the "Seven Fingers of the Crowdfunding Fist" that American businesses are using to pound down the doors that lock up capital in traditional financial institutions – commercial banks, investment banks, venture capital, private equity and mutual funds.  Securities laws restricting communications gave these gatekeepers a monopoly on deciding where ordinary Americans invest.  Crowdfunding gives ordinary Americans tools to decide: 
  • Where to invest their money
  • Whether gatekeepers should continue to make decisions
     
    Seven Fingers of Crowdfunding Fist
     
    The tools people are using to directly invest their money in private companies include:
  • Two types of Rule 506 offerings
  • Two types of Regulation A offerings
  • Two types of State Crowdfunding offerings
  • Section 4 (a) (6) Regulation Crowdfunding offerings
     
    All these rules permit using the Internet and other means to talk directly with potential investors rather than going through institutional gatekeepers.
     
    Of course, people have been Internet shopping for more than two decades, including for big ticket items like cars and houses.  Securities laws prevented Americans doing the same when shopping for investment opportunities.  
     
    Startling Regulation A Initial Results
     
    This new freedom raised the question, will Americans invest online?  Or is investing inherently different from shopping?
     
    The SEC's November 2016 report definitively answers this question with statistics about the first 16 months after the SEC amended Regulation A.
Before the JOBS Act, Regulation A was like a bridge to nowhere - during the two previous decades, America averaged only five Regulation A offerings per year.  Now the SEC reports that during its first 16 month after amending Regulation A:
  • 147 Regulation A offerings were filed seeking to raise $2.6 Billion
  • 81 offerings were approved by the SEC seeking to raise $1.5 Billion
  • $190 Million was reported raised (this understates the actual amount raised, because issuers are only required to report sales after their offering terminates)
  • $18 Million was the average offering maximum size
  • 60% of approved offerings were for Tier 2 offerings
  • Two thirds of issuers had no revenue and only 20% were profitable
  • The median offering took 78 days to complete the SEC's review process
  • Most offerings were best efforts and self-underwritten by issuers who had previously raised capital in private offerings.  That means that American businesses were not using traditional
The bottom line is that American investors are walking through the capital raising door that Crowdfunding opened and are taking charge of where their money is going.


Reasons Why Regulation A is Popular 
So, why is amended Regulation A becoming so popular?


Issuers like Regulation A, because issuers:


  • Can test the market before filing documents with the SEC
  • Can sell to both accredited and unaccredited investors
  • Can use Social media and other advertising to sell their offering instead of paying large investment banker fees
  • Can raise up to $50 million each rolling 12-month period
  • Make continuous offerings over long time periods by updating disclosures instead of starting a new offering every year
  •  Can provide liquidity to existing shareholders by letting shareholders sell in the offering
  • Can avoid becoming a full SEC reporting company, because Regulation A incudes exemptions from Section 12 (g) public registration requirements (issuers in Tier 2 offerings do have to file semi-annual reports with the SEC)
  • Can reduce pressure from investors to sell the business before maximum value is achieved, because issuers can provide liquidity to investors, by facilitating private trading markets, because shares sold in the Regulation A offering are not "restricted securities"