The search is on for innovative financing methods that address the growth capital needs of social entrepreneurs while generating solid returns for their investors, even if a public market offering or an acquisition by a larger company is unlikely to provide an exit. The variable payment obligation (VPO) is one such emerging tool that’s attracting attention among impact-driven entrepreneurs.
The VPO was developed at Santa Clara University’s Miller Center for Social Entrepreneurship. It’s a new class of structured exit investments. It’s primarily designed as a capital infusion to propel social enterprises to positive cash flow. Through VPOs and other structured exits, entrepreneurs and their investors agree on a gradual payback mechanism that suits the needs of both parties.
A VPO is a solid option for social enterprises in need of capital, but few entrepreneurs are familiar with the tool. Fortunately, we’re here with the answers to all of your pressing questions. Read on for the details.
What is a “structured exit” anyway, and what kind of companies should give it a look?
A structured exit is an alternative to traditional exit strategies like an IPO, merger, or acquisition. Essentially, an investor provides capital and, in exchange, a given company agrees to make regular payments to the investor — rather than providing an ownership stake.
Structured exit deals vary based on the needs of a company and its investors. Entrepreneurswho wish to maintain ownership, or with few exit options, such as those based in developing countries or smaller cities, may consider a structured exit to obtain growth capital.
What is a VPO, and what makes it different from other structured exits?
Most structured exit models rely on revenue to calculate a company’s ability to make payments to investors. It’s relatively easy to track revenue, especially with companies in frontier markets. But solid revenue doesn’t mean a company has retained sufficient earnings to meet its outgoing payment obligations to other parties.
If earnings fall short of expectations, companies are left scrambling for more expensive financing options in order to make all their payments.
The VPO takes a different approach that is more aligned to the challenges of running a small-but-growing business:
- The payment amount in each period — usually quarterly — is variable, without penalty. This is especially helpful if a company’s cash flow varies seasonally.
- Repayment obligations are based on free cash flow, not revenue. Further, the structure of a VPO suggests that only a minority share of free cash flow, usually 20 to 30 percent, be assigned back to the investor. This allows entrepreneurs to retain most of their earned income and reinvest it into their businesses.
- Companies and investors agree on an interest rate for the principal investment, as well as a “total obligation” amount. This allows investors to generate a desired return while capping the repayment they receive from a company. The total obligation is generally 1.5 to three times the principal, depending on the investors and their desired internal rate of return. Timeframes for full repayment usually fall in a four- to five-year range.
- An abeyance, or “honeymoon,” period defers repayment for an average of three to 12 months, allowing companies to turn an investment into profit before beginning to repay. This feature is especially helpful for companies with unmet demand for their products or services. A capital infusion allows such companies to build capacity, meet that demand, and begin increasing cash flow quickly.
Who should consider a VPO?
VPOs are ideal for companies based in underserved regions, as well as social enterprises of all types, but not every company fitting that description is ready for a VPO.
To enter a VPO, your company must be able to reasonably estimate future cash flow. If a social enterprise lacks the accounting skills to make a reliable cash forecast, it may not be ready to make a promise of investment return. Social enterprises in this situation may better suited for a philanthropic grant than a structured exit like a VPO.
What are the risks associated with a VPO?
The risks associated with VPOs are low for both companies and investors, but entrepreneurs should keep the following factors in mind:
- Due to the variable nature of VPO payments, if an enterprise temporarily misses cash flow goals, there is no immediate need to renegotiate terms. However, when prospects for cash flow recovery are low, you may need to renegotiate the VPO financing terms with your investors.
- Although payments are variable, the base debt repayment has a fixed term. Most enterprises utilizing a VPO will have accumulated enough cash to repay any remaining principal at the end of their debt terms. If the enterprise is unable to repay the debt at term end, investors can extend the debt repayment term – a likely outcome if the company is generating cash, but below plan.
- It’s unlikely that your company will perform significantly below plan, but if it does, you have options. Investors can choose to renegotiate the terms of the existing note. Or a new VPO financing structure can be put in place to pay off the original note and craft a new note which is more accurately aligned with an enterprise’s outlook.
I’m not sure about such a new mechanism. Are social enterprises already using VPOs?
Yes. Several examples of VPO financing already exist, and evidence of the VPO’s efficacy is amassing quickly. Uncommon Cacao of the United States, Iluméxico and Sistema Biobolsa of Mexico, and PBK Waste Management of India have all used the VPO model to obtain growth capital.
Banco de América Central (BAC) in Nicaragua utilized a form of VPO to create an innovative loan product for women-led businesses that lack the assets to qualify for traditional loans. More than $250,000 has been disbursed through these VPO loans so far. Additionally, ACDI/VOCA, a nongovernmental organization in Washington, D.C., created AV Ventures to fund small agricultural and poultry businesses in Ghana, primarily utilizing the VPO structure.
Project-based financing is another high-value avenue for VPOs. For example, a community-based water sanitation project will generate reliable cash flows after an initial investment, and a farming co-op storage facility can improve farmer cash flow with higher average realized price. Often, these community entities cannot obtain bank debt, are too small for NGO attention, and do not create the type of value that would allow an equity exit. In these circumstances, the VPO model may allow impact-conscious investors to fund beneficial community-based projects.
Summary: About VPOs
The variable payment obligation necessitates that an entrepreneur and investor agree upon a cash flow definition and forecast. The parameters of the VPO can be tuned to the enterprises’s business model and the investor’s required return.
From the outset, social enterprises know the amount required to retire the VPO and understand the necessity of creating positive cash flow. The investor gives the enterprise a chance to succeed, with a honeymoon period and payments based on business velocity, but retains a claim to cash as generated.
The goal of a vehicle like the VPO is to increase the financing options available to investors and entrepreneurs. Selecting a financing vehicle that matches a company’s business model and stage of development helps ensure social enterprise success.